The Security and Exchange Board of India made some cheerful announcements for the capital markets. If all of them are implemented, they should make the markets a level playing field for large and small investors alike.

To begin with no one would have any objection to the new requirement that  all types of investors should bring in 100% of the application money as margin along with the application for securities in public issues. Currently Retail and HNI categories are required to pay full amount while the QIBs are allowed to pay just 10% of the amount for which the application is made. Yes, the requirement of full amount may hurt marginally, but it will not hurt the IPO subscriptions, as these investors never over trade. This may become an issue only if the issues start getting massively oversubscribed and there is a clubbing of attractive IPOs.

The regulator has also decided that the reservation for employees in public or rights issues would be available to employees of subsidiaries and material associates of the issuer whose financial statements are consolidated with the issuer’s financial statements. This well help the issuing companies to use the currency of stocks to hire and retain talents in the subsidiaries. A logical step forward is that they should also allow stock option scheme to be extended to subsidiary employees as well.

SEBI has given the nod to the stock exchanges to introduce equity derivatives contracts with tenures of up to 5 years from the current 3 years. These long-term options in the Nifty are not for the common man but for the large financial houses, asset managements companies and insurance companies who sell structured products. When an insurance or a asset management company promises to protect the highest NAV they use these long term options to ensure that.

Such long term contracts account for around 23% of the total OI, their volumes are hardly 0.15% of the total derivative volumes on a given day. So it’s not going to change your and my life in any meaningful way.

The introduction of a volatility index is logical graduation of our markets into sophisticated products. But I don’t think it is actually going to be a hit. It is also likely to ultimately join the Junior Nifty, CNX 100 and the Defty in the cemetery, which were given an unceremonious burial on 31^st July 2009.

But the joker in the pack is the green signal given to the exchanges for introduction of much desired delivery based settlement of derivatives. Currently the derivatives are settled in the cash segment.

I am calling it a joker in the pack primarily because the finer rules are not known. Would it be compulsory settlement be delivery or there will be an option with the buyer. What will be the rights of the seller? What happens when the buyer of a stock option exercise his right to buy the stock? How much time would you give, What would the new margins be. Would a seller of an option also have to give delivery of the stock as margin or he can pay cash? We will revisit these issues after the guidelines are in place.

One thing is for sure, volatility will rise and not fall as most academicians have opined.

A success of this system pre-supposes a vibrant stock lending and borrowing mechanism (SLBM). While we do have a system in place, it is far form being robust and vibrant.  NSE’s SLBM recorded just 10 transactions in 3 stocks from January 1 to 5^th March 2010. Do I need to comment any further?

Earlier logic of postponing a cash settlement of derivatives was that there was no active SLBM in place. Today it is worse. But the SEBI should go ahead and force the exchanges to do it. SLBM will develop on pressure. Given an option, every body will resist change.

Speculators will find ways to misuse any system. The compulsory delivery mechanism will help those companies where the promoters stake is high and there is no institutional holding. Speculators can chase these stocks to the moon as there will be very less float. In view of this, I think, SEBI should revisit its eligibility criteria for admitting a stock in the derivative group.

There will be hiccups, shortcomings and flaws when you introduce a new system. But that’s no excuse for not doing this. Go ahead and do it Mr. Bhave!

The settlement by way of delivery is fundamental change of the derivative mechanism the way we have known it. When you are actually over hauling the system, why not address the issue of perennially changing market lots? I have some thoughts on the issue. But that will be in a forthcoming article. 

Disclosure : No holdings or trading positions in stocks mentioned or recommended to clients

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