Steps to check volatility at Dalal Street on the anvil

While measures taken by regulators in other emerging markets like India—with a high level of vulnerability to foreign capital flows — would also be mulled over, the direction toward some specific steps is already clear. And these pertain to the futures and options market, where the unwinding of highly leveraged positions last week contributed in no small measure to the historic fall in the Sensex and Nifty.

‘‘We need greater democracy in the futures and options market. All institutional investors should be allowed to sell short. This is the only way to self-correct such volatile situations in the market,’’ a finance ministry official said.

What the official is referring to is the anomaly in the current capital markets framework with regard to short selling. A short selling strategy is the exact opposite of a long position—when investors expect a security’s price to drop instead of rise. The strategy, respected by most world markets, has been a ‘bad word’ on the Indian bourses all these years.

While there is no prohibition today on short selling by retail investors, institutional investors — the mutual funds and the foreign institutional investors (FIIs), banks and insurance companies — are expressly prohibited from short selling. This is all set to change.

A veteran market dealer explains how this disparity affects the indices. ‘‘Retail investors and speculators are usually long on stock futures, while institutions take advantage of any arbitrage opportunities between the cash and the future markets by buying in the cash market and selling in the futures market. Now when the market reverses, the bullish retail investors with long futures positions get squeezed as no one else is allowed to sell short and hence rescue them from their leveraged positions’’.

This has a cascading effect on the liquidity in both markets. ‘‘The individuals lose their shirts, so they won’t be in any position to buy futures like before (as we saw today). Institutions don’t get the arbitrage opportunities anymore and don’t buy in the cash market as they would have,’’ the dealer explains.

If everyone is allowed to go short, they will have the freedom to take different viewpoints on the market direction and create more liquidity. Today, institutions depend on individual investors for liquidity.

Incidentally, the Secondary Market Advisory Committee of the Securities Exchange Board of India (Sebi) had already recommended this in late December. There is a need, the committee had noted, to ‘provide equal leveraging opportunities for all classes of investors.

The introduction of a full-fledged securities lending and borrowing scheme should be simultaneous with the introduction of short selling by the institutional investors, the Sebi committee had underlined.

The government would also address the fear that several retail investors may have overleveraged themselves in the recent bull run, by virtue of having to pay low margins for their futures positions. “Margins on futures positions could also be increased,” the ministry official says.

WHAT’S AHEAD

• All classes of investors to be allowed to sell short

• A full-fledged Securities Lending and Borrowing scheme

• Margins for futures and options trading likely to go up

vikasdhoot@expressindia.com