Futures trading in India - are we ready?

Abstract

The article examines the nature of futures market and its development abroad. It provides a theoretical framework reviewing behaviour of future prices and a need for an effective arbitrage between spot and futures market to ensure competitive and fair pricing for hedge seekers. In the Indian context, it examines the hedging needs of Indian investors and probes the robustness of cash markets. Major deficiencies in out cash markets are absence of facilities for margin trading, short sale, dematerialised settlements and electronic funds transfer among participants. Efficient arbitrage is the key to functioning of the futures market. In India arbitrage can be done only in one direction which is to buy in spot and sell in futures market when basis (that is difference between spot and futures prices) after adjusting for carry cost is at premium. If basis is at discount arbitrage would involve sell in spot and buy in future, but this would not be possible in the absence of short sale. This skewness in arbitrage would delink the two markets and futures market would turn into a casino. The article also critically examines the empirical work of Shah and Thomas and questions the validity of their estimates of impact cost and other event studies in support of futures market. The article ends asking the regulators what is the hurry? Derivative trading requires a critical mass of sophisticated investors, supported by credit and stock analysts, serviced by market-makers prodding a modicum of liquidity and protected by keen regulators. If SEBI is finding it hard to manage system for carry-over business (that is, badla which is akin to a weekly forward market), how is it going to regulate risk in a futures market where transactions would remain outstanding for 6 months and more. Regulators are cautioned to avoid economically unjust demands of a few vested interests and let public interest of several million shareholders take precedence over a few interest groups which are know for peddling hot money.