Somnath Mukherjee: Sebi's Jane Street order was the canary our market needed
The Securities and Exchange Board of India's (Sebi) order has some interesting findings. On 17 January 2024, the expiry day for Bank Nifty derivatives, the index opened 2% lower due to weak earnings of some of its constituents. However, options on the Bank Nifty traded at a level where the implied price was higher, resulting in an anomalous price spread.
JS did what textbooks tell us: buy stocks that make up the Bank Nifty while selling options on this index. The trade worked as textbooks say it would: the spread narrowed within six minutes. But here's the twist: the total value of Bank Nifty stocks purchased was ₹572 crore while the total notional value of the options sold was ₹8,751 crore, which is more than 15 times.
This oddity continued. By mid-day, JS had bought Bank Nifty stocks and futures worth over ₹5,000 crore and sold options worth over ₹30,000 crore. Arbitrage is about hedging, but one doesn't hedge a bet on India winning the Border-Gavaskar Trophy by placing 15 bets on India not-winning it. So JS started selling its stock/futures positions.
But liquidity in these segments is so low that its trades tanked prices, resulting in losses for JS in its long index positions. But its large short options position (5-6 times in notional exposure to its cash/futures positions) got settled at market close at a massive profit. In short, JS appeared to move prices in the illiquid leg of the market (cash/futures) so that it could profit from its large position in the liquid leg (options).
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Arbitrage or manipulation? Either way, Sebi's order has acted as the proverbial canary in the coal mine to reveal potentially poisonous fumes in our capital markets.
Fume 1—Lopsided market structure: India's equity market is the second largest among emerging economies by market capitalization and volumes both. However, volumes are skewed—over 90% are in derivatives (futures and options or F&O), with options accounting for the bulk. The cash segment is shallow. Daily volumes in the shares of HDFC Bank, the largest Bank Nifty constituent, for instance, are only about ₹2,000 crore. To put this in context, the total equity assets under management of India's mutual funds (MFs) are over ₹30 trillion, with ₹50-60,000 crore worth of flows every month. This skew causes distortions.
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Fume 2—Skewed tax structure: A small ₹5,000 crore trade could move prices because there is no countervailing Indian entity that's able to provide liquidity by playing the other side of JS's 'arbitrage' trades. The reason is simple—tax rules.
In India, the securities transaction tax (STT) on derivatives is a fraction of what it is on stocks, incentivizing investors to move to F&O from the cash segment. Further, foreign portfolio investors (FPIs) enjoy a large tax advantage over Indians. FPIs' F&O trades qualify for capital-gains tax (and are taxed at 20% if short-term and 12.5% if long-term), but for Indian entities, the same gains are deemed to be income (taxed at 25% for corporates and 39% for individuals/trusts).
Fume 3—Regulation stifles Indian institutions: For many years, FPIs provided the dominant share of liquidity in Indian stock markets. Over the last decade, Indian institutions, especially MFs, have risen in stature and now account for a larger share of India's market capitalization and volumes than FPIs. This provides a diversified pool of liquidity in the cash segment. But in the F&O segment, a regulatory overhang prevents the creation of such counterweight liquidity. Why?
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First, domestic institutional investors are mostly not allowed to use leverage, but FPIs are.
Second, short-selling, which lets market participants act on bearish views, exists mostly in the realm of theory; its process is such that participation and liquidity are low.
Third, a prudential aversion to leverage has left F&O trading as its only source. Bank lending to capital markets is heavily circumscribed and non-banking financial companies have limited capacity to lend. This reduces domestic market liquidity and pushes participants towards the F&O segment.
Fourth, while there are all sorts of limits in equity markets, index options face none. This means participants can build positions in index options many times the stock position limits on the underlying stocks.
Fifth, a very high proportion of market liquidity is concentrated in short-term options contracts. India is unique as a large market with zero liquidity in derivatives of more than three months tenor.
Also Read: Sebi's Jane Street interim order made India's stock market sit up for good reason
Solutions are within grasp: India's financial markets are world class. So are its regulators (think of Sebi and the Reserve Bank of India). Diversified liquidity is the lifeblood of any well-functioning market. Small tweaks in tax laws, alongside a rethink on the flexibility afforded to Indian institutions (especially MFs) would be a great fresh start.
The appointment of market-makers for longer-dated derivatives is another idea that is well-tested in India; in the 1990s, RBI licensed a slew of primary dealers as market-makers for government bonds with great results.
India's capital markets are valuable. Sebi has done its bit as the canary by highlighting emergent risks. It is time now to make space for fresh ideas so that the mine continues to prosper for India.
These are the author's personal views.
The author is chief investment officer of ASK Private Wealth.
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