Systematise Margin Lending:
Derivatives will be too early
By Nabaraj Pokhrel
While NEPSE is planning to introduce derivatives (New Business Age, February 2007 issue), the regulators are busy tightening margin lending. They are of the opinion that the over-extended margin loan to the stock investors by financial institutions is endangering not only their own financial health but also fuelling speculation in the capital market in general and the stock market in particular. In this context, it is necessary to properly understand the implications of derivatives trading.
By derivatives we mean futures and options contracts. These are more risky investment tools when compared to the existing direct and physical settlement system of security transactions.
Futures are commitments to buy (a call) and sell (put) at a set price at a future date, and an option is similar but is a right rather than an obligation. Both are known as derivatives. Because they are derived from something else, such as stocks of individual companies, they are highly geared and very risky. Therefore, is it really the right time to introduce derivatives in our market?
Most people are not very successful even in the direct physical transaction of shares. Therefore, it is too early to introduce derivative trading. The cost of failure is going to be too high as failure in this case would mean that the majority of the existing investors will fail. In case of futures, one has to buy shares and deliver them at a future date. That is almost impossible in a small market like ours. And the rate of speculation and even the level of manipulation will be quite unpredictable.
That is why it not good enough to start a futures market unless the players are fully educated about the length and depth of the existing capital market. Enlarged size and liquidity are other essentials prerequisite for futures trading. Options are less risky than the futures even though the risk involved in options is higher than the risk involved in the present trading system. It has both intrinsic and time value involved. That is really harder to calculate. All these demand more sophisticated technique of evaluation along with proper knowledge and infrastructure. However, futures trading is already taking place in forex while recently Commodity and Metal Exchange Nepal (COMEN) too has started futures trading in commodities. Still, it would be better for the regulator to think twice before opting for the controversial new instruments. Before introducing derivatives, market requires more standard disclosure and reporting practices, accounting and auditing standards, clear cut rules against insider trading, professional standards of stock brokers and underwriters. Otherwise, consolidation or crash that are normal in futures trading may prove very harsh on the players in the short-run. So, the process of strengthening mutual funds, institutional investors, market makers and systematising margin lending will prove more beneficial.
