F&O flip-flop: Why Sebi and NSE should share the blame

With Sebi raising the eligibility bar for futures and option trading in individual stocks, more securities appear set to fall off the F&O list in the coming days. Already 51 securities were excluded last week when the new rules took effect. And the drastic tightening in eligibility norms shows that the regulator has finally woken up to the risks from allowing derivatives in thinly traded securities. Prices of illiquid securities - market parlance for securities with low trading volumes - can be easily manipulated as it does not take much to control the volumes.

But how did so many illiquid securities land up in NSE's F&O list in the first place?

The answer could lie in the diluting of norms by Sebi in July 2004, perhaps to improve volumes in the derivatives segment, by including more securities.

To begin with, F&O was permitted in 31 of the 50 Nifty in November 2001. In December the following year, Sebi specified certain key criteria for inclusion of more securities; median quarter sigma order size and market wide position limit (MWPL).

Quarter sigma order size is defined as the order size (value) required to cause a change in the stock price equal to one-quarter of a standard deviation, and trailing six-month median quarter sigma order size was initially set at Rs 5 lakh. 

Simply put, quarter sigma order size is an important measure of liquidity in a stock. Bigger the order value required to move the stock price, more liquid is the stock and less prone it is to volatility and manipulation.

Market wide position limit (which when triggered prohibits creation of fresh derivative positions), was taken as the lower of either

* 30 times the average number of shares traded daily, during the previous calendar month, in cash segment of the Exchange

or 

* 10% of the free float (shares held by non-promoters)

In addition, stocks had to figure among the top 500 companies in terms of average daily market capitalization to be considered for inclusion. Given that even all of the 50 Nifty stocks are not liquid, top 500 may have been too wide a band.

There were no additions to the F&O list in 2002. The following year, 18 securities were added, having cleared the eligibility criteria.

Then Sebi changed the eligibility norms in July 2004. The trailing six-month securities median quarter sigma order size over was lowered to Rs 1 lakh from Rs 5 lakh. If nothing, the limit should have been retained as market capitalisation of a majority of stocks had nearly doubled from the time the original rules were framed.

The market wide position limit was set at Rs 50 crore; only stocks with a MWPL in excess of that could make it to the F&O list. In hindsight, this may have been too low a threshold limit, but one that was not increased for almost five years.

In 2004, there were just two inclusions to the F&O list, as the stock market was still recovering from the crash in May when the Congress-led coalition assumed power at the Centre.

The market kept rising through 2005, and 37 securities were included in the NSE's F&O list. Another 35 securities made the cut the following year as the bull run continued. But 2007 was easily the high water mark for NSE's derivative segment; 73 securities were included that year. Entry into the hallowed list was a symbol of prestige for the promoters of most mid-cap companies, and many are said to have thrown lavish parties to celebrate the occasion. By then, market was rife with allegations that many dubious companies had managed to find their way into the derivatives segment, and that promoters, in collusion with market operators, were using the futures to manipulate the stock price.

There were parameters like market capitalization and daily average turnover to be eligible for derivatives trading. But with some help from market operators and a buoyant market, meeting those criteria were not too difficult.

At that point, Sebi should have tightened the norms; but there was no action from the regulator and the party was allowed to go on. And NSE cannot pin the blame entirely on Sebi. NSE’s contention all along has been that it only followed Sebi guidelines while adding securities to the list. But surely the bourse would have been aware of the antecedents of many of the mid-caps which had seen a sudden spurt in trading volumes. If it had so desired, the NSE could have made a strong case to the regulator for not including some of the companies. But a long F&O list helped NSE in two ways: higher turnover fee and increased market share as traders could trade in both the stock and future on the same exchange.

The market meltdown in January 2008, sparked off by the global financial crisis, was to a large extent aggravated by the massive build-up of positions in single stock futures. When sentiment turned for the worse, many mid-caps crashed nearly 50% in a couple of trading sessions, as traders were unable to meet margin commitments and brokers promptly liquidated the positions. Even today, many of those stocks are trading well below their peaks of 2007, their shaky fundamentals having been exposed.

And despite turbulent market conditions, 42 companies still got into the F&O list in 2008, though another 16 had to make an undignified exit.

In December 2008, a Sebi committee on derivatives recommended that securities median quarter sigma order size over the last six months be hiked to Rs 5 lakh from Rs 1 lakh and the market wide position limit be doubled to Rs 100 crore from Rs 50 crore.

This would have been a good opportunity to weed out the illiquid names in the F&O list. But the committee's recommendations were implemented in part.

In April 2009, Sebi hiked the median quarter sigma order size to Rs 5 lakh, and MWPL to Rs 100 crore, but only for new entrants. For existing securities, the respective limits were Rs 2 lakh (up from Rs 1 lakh), and Rs 60 crore (up from Rs 50 crore).

As a result of the new rules, 50 securities were excluded from the F&O list immediately. Already 15 had been dropped a couple of months back. In all, there were 71 exclusions that year. The number would have been higher, if Sebi had raised the bar for the existing securities as well.

But as the market rallied for the next 18 months, 48 securities were added in 2010 (there were 4 exclusions as well).

Again, there were allegations about promoters of many mid-caps pledging shares, and using the funds to manipulate the stock through the F&O segment. And the crash in many mid-cap stocks in 2011 showed that market talk was not entirely unfounded.

There is something the NSE could have done to curb volatility in F&O stocks, say market participants. It should have given the option of physical settlement in equity derivatives, which would have made it tough for promoters and operators to manipulate prices. Currently, futures and options positions are settled in cash, based on the difference between the price at which position was created, and the price on settlement day.

So, for instance, if a trader is long on Airtel futures, and the price on settlement day is lower than his purchase price, he should have the option to take delivery of the equivalent shares. Similarly, a trader who short sold a stock’s futures should have the option to offer delivery of the shares, if the settlement price is above his selling price. If the trades are settled based purely on the price differential on settlement day, the player with superior money power will prevail more often than not, because he just has to hold on to the price till the contracts expire.

The latest eligibility norms for F&O trading, issued a few days back, makes things tough, for aspirants to gain entry as well as for existing companies to stay on the list.

Median quarter sigma order size for new entrants has been doubled to Rs 10 lakh (Rs 5 lakh for incumbents, against a minimum of Rs 2 lakh earlier) and MWPL trebled to Rs 300 crore (Rs 200 crore for incumbents, against a minimum of Rs 60 crore earlier).

If market continues to remains sluggish, there would be more drop outs than inclusions in the near future.

But even otherwise, Sebi and the NSE may have killed the F&O market for individual securities. Annual turnover in single stock futures hit a record high of Rs 75.48 lakh crore in 2007-08, when the maximum number of securities were included. That declined to Rs 40.74 lakh crore in 2010-11. Turnover in stock options rose from Rs 3.59 lakh crore in 2007-08 to little under Rs 10 lakh crore in 2010-11.

But the real action is now the index options segment, where notional turnover has risen from Rs 13.62 lakh crore to 227 lakh crore during the same period. And that does not spell much cheer for either brokers or the exchange, as brokerage and turnover fee on options trades is a fraction of that collected on futures transactions.