India's Derivatives Delusion

Last month the regulator had caught Jane Street, a high-frequency trading firm, allegedly influencing the market.

- Debashis Basu

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 indicesIndex 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.