The best way to make a lakh in derivatives markets is to start with 10 lakhs.’
This version of the Wall Street joke would be familiar, through hard experience if nothing else, to the many retail traders who dominate India’s derivatives markets. Starting with the larger amount will – through a trader’s hard work and diligent efforts – often result in closing account equity nearer the small amount.
Derivatives have been around a long time. One early reference from Aristotle’s Politics concerns the philosopher Thales of Miletus who, based on his knowledge of astronomy and the elements, discerned in winter that there would be an abundant olive crop the following summer. Thales bought the right – but not the obligation – to use the presses of Miletus and Chios to turn the olives into oil. When the abundant crop came in and the presses were overburdened, Thales sold his option to use the presses to others who needed to use them, presumably for valuable consideration. Philosophers, Aristotle concluded, could also make money on occasion if they chose to, but he hastens to add that it was not something they cared much about.
In India, too, the two basic types of derivatives – futures and options – have been around since the markets themselves. Trading usually started in the commodity markets before adoption by the stock market, and this is a historical pattern. Early Bombay traders dealt in cotton futures, and Roychand’s time bargains from the Cotton and Share Mania of 1865 were unmargined naked forward contracts on stocks. By the late nineteenth century, Marwari traders were using fatkas (futures) on jute in Burrabazar and the other markets of Calcutta.
Local Calcutta firms used the price signals generated by the fatka futures market to offer quotes on upcountry jute and occasionally to hedge; expatriate British firms usually did neither and were at a disadvantage. Options were also pioneered in the commodity markets and trading in the grain markets had option-like characteristics; trading for the rise was through indigenous options like the teji (call) and trading for the fall was through the mandi (put), with the option premium known as the nazrana, and to this day, jargon for a market in a bull or bear phase is teji or mandi, respectively. Derivatives practice in early twentieth-century Bombay included trading on daily closing prices of New York cotton futures; today’s options traders are familiar with American and European options, but these contracts were called American futures.
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Because of its speculative nature and the absence of delivery, derivatives trading generated predictable complaints from the authorities. Established agency houses claimed fatkas had been invented by traders who had been deprived of the pleasures of rain gambling, to satisfy ‘their craving for the gains of chance in a system of contracts purporting to evidence the purchase and sale of jute … but we believe in no single instance has jute ever been delivered under them.’ In later years, SEBI would occasionally rumble about the large size of India’s derivatives markets and then fiddle with lot sizes or eligibility requirements, but this is not new and it has all happened before.
Yet, unlike stock markets, commodities markets had formal derivatives activity. Derivatives markets in agri-commodities had the advantage of sound founding legislation through the Forward Contracts (Regulation) Act of 1952. But these markets had to deal with a government that was struggling to feed a growing population through lower agri-commodity prices; such a government was always psychologically short a price trend, and it readily banned derivatives markets when they inconveniently went up instead of down. Commodity derivatives periodically went through such existential crises, disappearing from time to time after normative issues resulted in government bans. In effect, substantial price surges usually resulted in bans that were subsequently revoked and markets reinstated.
Nevertheless, some of this derivatives trading resulted in speculative profits that were ploughed back into industry. Industrialists G.D. Birla and Ramkrishna Dalmia both generated substantial surpluses trading jute and silver derivatives respectively during the commodity surges of the First World War, surpluses that were later used as foundation capital for industry.
This excerpt from ‘Running Behind Lakshmi’ by Adil Rustomjee has been published with permission from Hachette India.