Friday’s carnage in NBFCs, midcaps underscores vulnerability of F&O positions

The September 21 crash in shares of non-banking finance companies (NBFCs) like Dewan Housing Finance (DHFL) and Indiabulls Housing Finance and a host of midcaps yet again underlines the market’s vulnerability to huge positions in stock futures.

Stocks eligible for derivatives trading on both exchanges are not subject to intra-day circuit filters. This means that stock prices could rise or fall to any level. For stocks not in the derivatives segment there is a 20 percent intra-day circuit filter, which means that prices cannot rise or fall more than 20 percent over the previous day’s closing price.

The charm of trading in stock futures is that investors need to pay only 25 percent of the value of their position, also called margin money.

Much of the damage during the 2008 meltdown was caused by reckless build-up of positions in the futures market — stock as well as index — by high networth individuals and retail investors. Brokerages goaded their clients into derivatives trading, well aware that most of them had little or no understanding of equity derivatives.

During FY08 — at the peak of the bull market — average daily turnover in single stock futures climbed to around Rs 30,000 crore, double of what it was in the previous fiscal. After the market crash, retail investor interest in single stock futures dwindled to less that Rs 17,000 crore by FY13.

Other factors contributed to the decline. The Securities and Exchange Board of India (SEBI) tightened eligibility norms for securities which could qualify for derivatives trading and increased average ticket size of trades to keep smaller investors out.

With their stocks battered in the downtrend, promoters of many midcap companies approached the National Stock Exchange (NSE) to have their securities excluded from this derivatives trading list. Many of these promoters were the same people who had joined hands with market operators to manipulate their stock price to meet the eligibility criteria for inclusion in the derivatives list.

For a while, it appeared that everybody had learned their lessons and become wiser. But as the market entered a bull phase from FY15, old habits and practices resumed. The list of securities eligible for derivatives trading began to expand. There were eligibility rules, but crafty promoters would ensure those were met by getting market operators to increase trading volumes in their stock.

Most promoters like their stocks to be part of the derivatives list as it offers them an additional handle to control the price of the stock. Brokers again started egging their clients to trade in futures. Between FY16-18, daily average turnover in single stock futures doubled from around Rs 32,000 crore to around Rs 64,000 crore. In FY19 so far, the daily average has further climbed to around Rs 68,000 crore.

The market regulator is doing its bit. It implemented physical settlement in derivatives in a phased manner, further tightened eligibility norms for inclusion of securities in the derivatives list, and proposed linking a client’s market exposure to his/her networth.

Despite all these measures, it is still not hard to game the system. In many stock futures, the outstanding positions are of brokers trading on behalf of the company’s promoters.

In some cases, promoters have arrangements with fund managers overseeing arbitrage funds, which have offsetting positions in the cash and futures market. They may buy a stock and sell the same quantity of futures, or sell a stock and buy the same quantity of futures.

So, a promoter seeking cash may sell shares held in ‘benami’ (fake ownership) accounts to the mutual fund and receive the full value of the shares. The promoter will then buy the same quantity in the futures market by paying only 25 percent of the value. On the other side of the futures trade will be the same mutual fund that has purchased the shares from the promoters. At the end of the settlement cycle, the positions are reversed or carried forward, depending on the promoter’s need for liquidity.

Payment systems have become far more efficient over the last decade. One of the main reasons for the sell-off in the futures market in 2008 was that clients could not transfer margin money to their brokers in time.

But an efficient payment system is no shield against a panic wave in the market, whenever it occurs. When stock prices start to fall, many traders prefer to cut their losses than holding on their positions by paying additional margin (the difference between the purchase/sale price and the current market price).

There is a general view among market participants that a steep fall in stock prices like in 2004 or 2008 is highly unlikely. Back then, most retail investors had direct exposure to equities, unlike today when an outsized flow of retail money into equities is through mutual funds.

In theory, that may well be the case. But in reality, things don’t pan out that way. Operators have positions in multiple stocks and futures. When they lose heavily in one stock or its future, they try to make up for it by exiting other positions. This causes a domino effect and other stocks too start tumbling despite there being nothing wrong with their fundamentals. As much as fund managers may preach the virtues of long term investment, they are known to sell-out in panic to avoid a hit on their net asset value.

1. In 2000, the Sensex crashed 18 percent from its high of 6,033 to a low of 4,943 in just three weeks (mid-February to early March) as sentiment for technology stocks soured


2. In May 2004, the Sensex lost 23 percent from a high of 5,487 to a low of 4,225 points in just three trading sessions. Exchanges had increased margin money and stock prices that were already under pressure fell as many traders began trimming their positions. A tactless remark on divestment by a senior Communist leader immediately after results of the general elections were announced yanked the floor below stock prices


3. In 2006, the index crashed 25 percent from a high of 12,217 to a low of 9,200 in less than three weeks (mid-May to early June) as the outlook on emerging markets turned negative


4. In January 2008, the index nosedived 24 percent in just a week from a high of 19,868 to a low of 15,332 as the sub-prime loan crisis started to unravel in the US

All the above crashes still pale in comparison to the carnage seen during October 2008, when the Sensex crashed 41 percent from a high of 13,203 to a low of 7,697 - as the yen strengthened. This caused largescale unwinding of ‘carry trades’ in which global investors had borrowed in a cheaper yen and ploughed that money into emerging market equities.