- Wealth PMS
I’ve been railing about the cash volumes in the market recently. With volumes reaching 12,000 cr. – lesser than most of 2007 – and as I recently tweeted, less than the daily volume of one share, Apple, in the US market. Our market has obviously seen very low participation levels since the crisis; volumes in the cash market are lower today than in 2007!
But the F&O volumes are much higher. So is there some other explanation?
Some structural issues exist in the cash markets. And the derivatives bazaar, specifically stock futures, solve these issues.
1. If you buy in cash, you have to put the full money down. So buying a 100 shares of Reliance costs you Rs. 100,000 out of your bank account.
2. You get the settlement after two days. Cash flows out of your account tomorrow, if you purchase today; you get the shares in your account in two days. If the seller did not own the shares, there is then an auction – you get the shares in your account five to six days after your purchase. The interim period is weird – if your stock hits a stop loss then, you can’t even exit.
3. Institutions like mutual funds are not allowed to do margin trading in stocks. So switches are a mess. A purchase has to go into the demat first before it can be sold, and full money has to be available before a purchase. Why is this painful? Imagine you are a mutual fund manager who has 10 crores worth stock which you decide to sell and buy something else. What do you need to do?
It takes four days to sell and then buy. Meanwhile, whatever you wanted to buy could have run away!
4. Stocks have low liquidity. Of the top 50 stocks in India – the Nifty 50 – the least liquid trades just 8 crores in the cash market, per day. A 1000 cr. fund, if it chose to allocate just 1% of its portfolio per stock, can’t even buy 10 crores worth of that stock – it will move the market so much that the impact cost can be 4-5%! And buying it slowly, piece by piece, is not fun at all; you never know what price you will get in future days.
5. Regulation does not allow funds to own than x% of a certain stock, or require disclosure if the percentages go greater than 1%. Some stocks have a market cap of just 1000 cr. and funds or HNIs like to expose themselves to beyond 10 cr. but don’t want to report.
6. Can’t go short a stock. The SLBS is dead.
If you buy a future instead of a stock, you pay only 50-60% as margin – the remaining money can sit in your account and earn interest; in fact, even the margin money can be given as a fixed deposit which earns interest. There is no settlement wait period – you buy a future, it is immediately in your account. No problem in intraday switching – you can sell one future and buy another right away, margins are released immediately on selling and is available to buy something else. Futures markets are a lot more liquid: for example today, the notional value of cash market trades was 13,000 cr. versus 66,000 cr. in F&O. Individual stocks too show 2x to 3x more volume in their futures trades than in the cash market. Regulation only provides for an upper limit of all F&O on each stock, but there are no disclosure requirements. And of course, you can go short as easily as you can go long.
Still, the futures markets have challenges.
The cost differential, if you test back the last two years, is very little for the benefits one gets. And in the two years, we have fallen a lot and risen a lot and futures have been a better way to invest. Prior to 2007 liquidity wasn’t all that great in the futures market (for individual stocks) so it’s difficult to test and conclude.
Net of the above, if markets remain volatile a long-only kind of fund is likely to see substantial benefits using futures instead of buying in the cash markets. For going short, F&O is the only choice. It may just be that the smartest money is moving into the futures markets and cash markets are following through largely because of arbitrageurs.