Needed: more research based decisions from Sebi

This column has often rued the lack of data and research supporting some of Securities and Exchange Board of India’s (Sebi’s) decisions. A recent case in point is its decision to increase the minimum contract size in the equity derivatives segment from Rs.2 lakh to Rs.5 lakh.

The decision was communicated through a sudden circular, with no data or research provided to justify the move. A little over three years ago, Sebi had, in similar fashion, changed the criteria for selecting stocks that can be part of the derivatives segment. As a result, 51 stocks were excluded from the list.

A team of researchers, most of them from the Indian School of Business (ISB), have studied the impact of the stocks’ exclusion from derivatives trading. They find that the move resulted in a decline in price efficiency and a reduction in liquidity, which is hardly surprising. But if the regulator had hoped that this was a price it was willing to pay for reduced speculative activity, and hence volatility, it will be disappointed. The research points out that “contrary to the expectations of regulators, volatility remains largely unchanged”. In other words, the above-mentioned research suggests that Sebi’s move was misguided. The paper Do derivatives matter?: Evidence from a policy experiment was presented by Ramabhadran S. Thirumalai of ISB at the Emerging Markets Finance conference hosted by Indira Gandhi Institute of Development Research. Thirumalai and his co-authors found that a large number of liquidity and price efficiency parameters suffered soon after these stocks were excluded from derivatives trading. The stocks underperformed the broad market for an extended period of time after the exclusion, their turnover fell significantly, and the number of analysts tracking the companies declined meaningfully. And, as pointed earlier, they concluded that “derivatives have little effect on the overall volatility of stock returns”. In fact, thanks to the new short-sale constraints as a result of the derivatives ban, the researchers found that “extreme returns become not only more likely but also more intense after exclusion of derivatives.” So much for Sebi’s good intent to protect investors from high volatility and extreme returns.

The researchers also ruled out regulatory targeting, or, in other words, a possibility that these stocks were eventually going to be excluded in any case, and that the regulator only expedited the process by bringing in more stringent criteria. They find, instead, that for each of the three main criteria used by Sebi for inclusion or exclusion, the performance of the excluded stocks was relatively stable in the six months prior to the exclusion. Besides, there was no dramatic increase in these measures immediately prior to the change by Sebi. So, this comes across as an ad hoc decision by Sebi, for reasons best known to itself.

Having said all this, it may well be possible that at least some of the stocks that were excluded had a high amount of speculative activity owing to the leverage provided by derivatives contracts. And that Sebi’s move may have helped curtail this. The problem, however, is that Sebi has made no attempt to demonstrate this by providing any research. The only research out there on the subject appears to contradict any such suggestion.

This is clearly an area for the regulator to grow, especially with the increase in its responsibilities after the merger of the Forward Markets Commission with itself. Besides, regulators had agreed at the Financial Stability and Development Council (FSDC) that even for all subordinate legislations such as circulars, notices, guidelines and letters, they will comply with certain minimum standards effective 31 December 2014. These standards include a board resolution determining the need for the said legislation, along with a statement of objectives, the problems the legislation seeks to solve and a cost-benefit analysis. Sebi’s circular increasing the minimum contract size in July this year fell short on each of these aspects.

While the finance ministry has reminded regulators about the FSDC resolution, by issuing a Handbook on adoption of governance enhancing and non-legislative elements of the draft Indian Financial Code, it looks like regulators are taking their time to fall in line.

It’s been nearly two months since the increase in the minimum size of equity derivatives contracts. On National Stock Exchange, average daily turnover has fallen by about 20% to Rs.1.78 trillion this month, compared with Rs.2.21 trillion in October, when the minimum contract size was still Rs.2 lakh.

The fall has been more at 25-30% in the futures segment, which is expected since the outlay for traders is much higher. In the low-cost options, average daily turnover has fallen 16-17%. Of course, December tends to be a soft month for trading activity, and the uncertainty about the US Federal Reserve’s rate hike also led to lower trading.

As such, it makes sense to wait for some more months before coming to a firm conclusion on the actual impact.