Sebi's F&O restrictions likely to boost dabba trading in Indian markets

The decision of the Securities and Exchange Board of India (Sebi) to tighten the derivatives framework could provide an impetus to ‘dabba trading’ — an unofficial parallel market.
 
According to market participants, the concept of ‘product suitability’ and physical settlement can see many proprietary traders and wealthy investors shift to dabba trading. The move could revive the activity in the grey market, adversely hit after demonetisation.
 
Dabba trading occurs in a manner similar to a stock exchange, without any regulatory oversight or tax burden. As these are unofficial trades, investors don’t have to pay the securities transaction tax or capital gains. Also, there is no need to provide know your customer (KYC) documentation. The platform was misused for money laundering and tax evasion purposes, prompting the government to declare them illegal.
 
“Sebi’s decision could have long-standing impact on the Indian derivatives market. With trading curbs and lack of an alternative platform, investors could shift to parallel markets such as dabba trading where there are no restrictions. Such a shift will also affect the liquidity and price discovery in the Indian markets,” said K Suresh, president, Association of National Exchanges Members of India (ANMI) — a brokers’ body.
 
According to the new rules, individual investors can have free exposure to the derivatives market only up to a certain extent based on their total disclosed income in the tax filings. In case an investor chooses to have an exposure beyond the specified limit, Sebi has directed brokers to undertake rigorous due diligence and collect appropriate documentation.
 
Also, the market regulator has proposed physical settlement of contracts in place of cash settlements. In case of cash settlements, the difference between the entry price and final settlement amount is either deposited or debited from the account of investors depending on their position. However, in physical settlement, investors will have to take delivery of shares for a long position. In case of a short position, they will have to provide for underlying shares.
 
According to the Sebi data, 85 per cent of the derivatives volumes come from prop trades and retail investors. In fact, a fourth of the volume comes from individual investors who use futures market for trading purposes rather than for hedging. With the product suitability coming in, dabba platform could be a more viable option for investors who prefer taking larger risks.

“Sebi’s decision creates a restrictive environment around the Indian derivatives market. Derivatives are key financial instruments in modern markets and no one should be discouraged to participate. However, placing curbs will lead to investors exiting the market or shifting to other parallel markets,” said Deven Choksey, managing director, KR Choksey Investment Managers.
 
Market participants also say the regulator should strengthen the support systems before announcing such measures. Physical settlement is mandatory in several global markets. However, all these markets have strong stock lending and borrowing (SLB) mechanism through which investors borrow stocks at a marginal cost. However, SLB in India is still evolving, leaving little choice for derivatives investors who take short positions. Also, domestic brokerages have raised concerns over the responsibility of additional due diligence, including conducting educational and income checks of clients.
 
Unlike India, such parallel market arrangements are very popular in the developed markets. For instance, in the US there are privately traded exchanges catering to big-ticket investors popularly known as ‘dark pools’. Institutional investors use such platforms when they have to place large trade orders without distorting the price of the security.
 
Arrangements such as over-the-counter (OTC) contracts are also very popular in global derivatives. These are standard contracts among private parties outside the stock exchange platform. OTC contracts comprise securities that are not traded on regular exchanges. Such contracts are legally valid and loosely regulated.