Last month, the regulators had caught Jane Street, a high-frequency trading firm, allegedly manipulating the market. It may seem like a regulatory triumph, but, in truth, it laid bare the deep structural flaws at the heart of India’s derivatives market, after years of breakneck growth. For one, the indices that are used to trade in futures & options (F&O) are flawed. Two, the massive volumes that the derivatives market generates, are proof, policy-makers think, that the F&O market enables efficient price discovery, improves market liquidity and permits investors to manage risk. However, this is not so. The gigantic volumes in index derivatives are limited to just two indices: Nifty 50 and the Bank Nifty and, to a smaller extent, the Nifty Financial Services Index (FinNifty). Let’s look at two factors: index construction and efficiency of the F&O market.
Lopsided Indices
Index construction is often seen as a nerdy exercise that involves debating methodological issues such as weights, liquidity, free float and sector representation to construct indices 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 they have profound implications. Of the two indices that hog almost the entire index F&O market, the Bank Nifty is further skewed. Two of its constituents—HDFC Bank and ICICI Bank—account for a staggering 53% of its weight. The top-5 stocks in the index, together, have 82% weight.
If this index were a product that merely signalled the direction of banking stocks (even though flawed due to faulty weights), it would be harmless. But if a mutual fund wants to launch a banking sector scheme, it would use Bank Nifty as the benchmark index. This is where the trouble starts. SEBI wants investment managers to take the benchmark index seriously. But how meaningful is an index where 53% of the weight is in two stocks? And if a banking sector scheme has investments spread across 25-30 stocks with even, say, 10% allocated to HDFC Bank and ICICI Bank, how meaningful will the benchmark index be for such a scheme? Conversely, should a banking scheme put 53% 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 Rs1,900 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 3.98 lakh contracts, worth a notional value of Rs79,898 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. Trading in options was 10-12 times the trading in the less liquid heavyweights of 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 its tail (options). The Bank Nifty is not alone. Its financial cousin, the FinNifty, exhibits the same distortions. HDFC Bank and ICICI Bank account for a combined 54.5% of its weight. 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 FY17-18 and FY23-24, the notional turnover in derivatives skyrocketed from Rs1,650 lakh crore to nearly Rs80,000 lakh crore. India now accounts for up to half of global exchange-traded derivatives volume, with equity index options dominating.
These statistics suggest that India has reached the free-market utopia of price discovery, liquidity and hedging. That would be a false belief. The bulk of this activity is concentrated in two indices: Nifty 50 and Bank Nifty. Behind their frothy volumes lies an ugly truth: even though 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% of their portfolios in small- and mid-cap 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 offerings. 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.
(This article first appeared in Business Standard newspaper)
"Mutual funds (portfolio management services and individual investors) have 60%–80% of their portfolios in small- and mid-cap stocks."
Are you sure about this? Flexicap, multicap, large cap funds etc. all have high weightage to large caps. Some data to back up this claim of yours would be appreciated.
Everything is political masked under the garb of economics. All the policies, data etc. are made up and ineffective. Look at the skills of the topmost business people and it will be self evident.
Very well analysed article.
I'll paraphrase it differently: the markets are working as intended. Someone saw the imbalance and took advantage of it. Yet the broader question is whether the markets stood "corrected" and got rid of its excesses, whatever that is. In other words, did it purge the markets of the loose speculators? Did the outcome punish "bad actors" (aka Jane Street). Did the regulator learn anything from this? After all, market is simply a signaling mechanism in more ways than one.
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Are you sure about this? Flexicap, multicap, large cap funds etc. all have high weightage to large caps. Some data to back up this claim of yours would be appreciated.
Very well analysed article.
I'll paraphrase it differently: the markets are working as intended. Someone saw the imbalance and took advantage of it. Yet the broader question is whether the markets stood "corrected" and got rid of its excesses, whatever that is. In other words, did it purge the markets of the loose speculators? Did the outcome punish "bad actors" (aka Jane Street). Did the regulator learn anything from this? After all, market is simply a signaling mechanism in more ways than one.
My guess: SEBI has learnt nothing.