OTC Equity Derivatives in India

I wrote an article in the Business Standard today arguing for the creation of an OTC equity derivative market in India.

I made the following points

• Competition between Over the Counter (OTC) markets and exchanges forces each market to lower costs and to adopt the best practices of the the other market.
• Standardized and highly liquid contracts are best traded in organized exchanges because of the enhanced transparency and lower systemic risk. However new contracts are often best incubated in OTC markets until they achieve a critical mass of liquidity and widespread participation at which point they can be moved to the exchange traded format. Long dated equity options are today best incubated in OTC markets.
• Exchanges should be allowed to introduce flexible options where market participants can choose parameters such as exercise prices, expiration date and type of expiration (American or European style) provided they trade the contracts in large blocks (say $10 million notional value). These flexible options are listed, margined and cleared like the standard options and therefore combine the flexibility of OTC options with the transparency and low systemic risk of exchange traded options.
• The Participatory Note (PN) or Offshore Derivative Instruments (ODI) market which the Foreign Institutional Investors (FIIs) have created outside India is essentially an OTC market in Indian equity derivatives. Indian regulations have driven this important market outside India and the result is a loss of liquidity for Indian markets, a loss of income for Indian financial services firms and a loss of access to OTC derivative markets for Indian securities and investment firms.
• To bring the PN/ODI market back to India, we need to do two things.
  1. The Securities Contract Regulation Act should be amended quickly to allow OTC equity derivatives in India. (Flexible options are a short term measure that avoids this statutory amendment).
  2. We must also establish a tax system for portfolio investment similar to that of the United States. The US does not tax “Portfolio Interest” income, capital gains on securities and income from derivative transactions (“Notional Principal Contract” income) earned by foreign investors. For too long, India has used the Mauritius double taxation agreement as an excuse for not doing something similar, but the Mauritius solution works only for investment in equities and not for investment through derivatives. The time has come to take Mauritius out of the loop altogether.
  I look forward to the day when a securities firm in India can sell an OTC derivative to a foreign hedge fund without any of the fee income leaking out of India to Mauritius or elsewhere.

Posted at 3:55 pm IST on Wed, 14 Nov 2007         permanent link

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