India's derivatives delusion: Regulatory triumph exposes market flaws

Last month the regulator had caught Jane Street, a high-frequency trading firm, allegedly influencing the market. It may seem like a regulatory triumph, but in truth, it laid bare deep structural flaws at the heart of India’s derivatives market after years of breakneck growth. 

For one, the indices used to trade in futures and options (F&O) are flawed. Two, policymakers’ claim that the derivatives market enables efficient price discovery, improves market liquidity, and permits investors to manage risk, on the basis of the massive volumes it generates, is not entirely correct. The gigantic volumes in index derivatives are limited to just two indices: The Nifty 50 and the Bank Nifty, and, to a lesser extent, the FinNifty. Let’s look at two factors: Index construction and the efficiency of the F&O market. 

Lopsided indices 

Index construction is often seen as a nerdy exercise: One that involves debating methodology such as weightings, liquidity, free float, and sector representation, and then reviewing all this on a periodic basis to add and delete stocks from the indices. Such technical decisions may seem peripheral to trading and speculation, but have profound implications. Of the two indices that hog almost the index F&O market, the Bank Nifty is further skewed. Two of its constituents — HDFC Bank and ICICI Bank — account for a staggering 53 per cent of its weighting. The top five stocks in the index together have an 82 per cent weighting. 

If this index was a product that merely signalled the direction of banking stocks (even though flawed due to faulty weightings), it would be harmless. But if a mutual fund wants to launch a banking-sector fund, it would use the Bank Nifty as the benchmark index. This is where the trouble starts. The Securities and Exchange Board of India (Sebi) wants investment managers to take the benchmark index seriously. But how meaningful is an index where 53 per cent of the weighting is in two stocks? And if a banking-sector fund has investments spread across 25-30 stocks with even, say, 10 per cent allocated to HDFC Bank and ICICI Bank, how meaningful will the benchmark index be for such a fund? Conversely, should a banking fund put 53 per cent in two stocks that would mirror the index? 

Worse, Sebi allowed the National Stock Exchange (NSE) to launch Bank Nifty futures, monthly options, and then, horrifyingly, weekly options on this unsound index. The most liquid banking stock is HDFC Bank: Last Thursday, an expiry day, just around ₹1,900 crore of the stock was traded in the cash market. Meanwhile, the traded volume of the Bank Nifty call option at only one strike price of ₹57,000 was 398,000 contracts, worth a notional value of ₹79,898 crore that day. The smart guys at Jane Street saw the absurdity of the situation. In their hands, the harmless Bank Nifty index of 12 stocks got weaponised in weekly options.  The trading in options was 10-12 times the trading in the less liquid heavyweights of the Bank Nifty. By manipulating a few underlying stocks it could swing the entire index — and with it, a tsunami of options. Jane Street made the dog (HDFC Bank) wag the tail (options). The Bank Nifty is not alone. Its financial cousin, the Nifty Financial Services Index (FinNifty), exhibits the same distortions. HDFC Bank and ICICI Bank account for a combined 54.5 per cent of its weighting. Sebi has permitted derivatives on this index as well, though mercifully weekly options are not allowed here. 

Efficiency question 

The larger question is whether India’s F&O market serves any real purpose. Between 2017-18 (FY18) and FY24, the notional turnover in derivatives skyrocketed from ₹1,650 trillion to nearly ₹80,000 trillion. India now accounts for up to half the global exchange-traded derivatives volumes, with equity index options dominating. 

These statistics suggest that India has reached the free-market utopia of price discovery, liquidity, and hedging. However, that would be a false belief. The bulk of this activity is concentrated in two indices: The Nifty 50 and Bank Nifty. Behind their frothy volumes lies an ugly truth: Even though the NSE has launched over a dozen other indices, most of them lie dormant. What about claims that F&O volumes help to manage risk through hedging? Mutual funds, portfolio management services, and individual investors have 60-80 per cent of their portfolios in small and midcap stocks. What will they hedge this with? Surely not the Nifty (comprising 50 large companies) or the Bank Nifty (a sectoral index). Yet there are no viable options markets for indices like the Smallcap 50 or Midcap 50. Even the Nifty Next 50 is a ghost town in derivatives trading. This underscores the fact that what happens inside the frothy F&O market has nothing to do with the cash market. Price discovery is illusory. Liquidity is superficial. Hedging is a theory, not a practice. 

How did it come to this? Sebi has taken a hands-off approach to index construction, allowing skewed benchmarks to be used. It has greenlit the NSE’s speculative offers. And having allowed these products, the regulators have failed to monitor their “use cases”, and thus failed to impose market-wide position limits and intraday monitoring. The speculative zeal in some derivatives has ballooned to unhealthy levels, while other derivatives, which ought to be more useful, are languishing in illiquidity. Jane Street may have scammed a faulty system. But it did not build it. 

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The author is editor of www.moneylife.in and a trustee of the Moneylife Foundation; @Moneylifers