The Securities and Exchange Board of India (SEBI) has raised concerns about the derivatives market in India. In a consultation paper released on 30 July 2024, SEBI proposed several changes to curb speculative trading in the derivatives market. The stated objective of these changes is to protect retail investors from the risks associated with high-frequency trading and excessive speculation.
In this article, we will explore the reasons behind SEBI’s proposals, the specific measures being introduced, and their potential impact on the market and investors.
Understanding Derivatives
Have you heard about futures, options, forwards, or swaps? These are different types of derivative instruments. Let’s delve into what each of them is and how they work as a hedge against risks or as a tool for speculating on potential price movements.
What Are Derivatives?
Derivatives are financial contracts whose value is derived from an underlying asset, such as stocks or indices. There are four types of derivatives: futures, options, forwards, and swaps. These instruments are used for hedging risks, improving price discovery, and enhancing market liquidity.
Types of Derivatives
These financial instruments can be categorised into four kinds:
1. Futures Contracts: Agreements to buy or sell assets at a future date at a set price. They are standardised and traded on exchanges.
2. Forward Contracts: Similar to futures, forward contracts are customised agreements traded over-the-counter and are not standardised. They are not traded on exchanges.
3. Options Contracts: Contracts that grant the holder the right (but not the obligation) to buy (call option) or sell (put option) an asset at a predetermined price before or at a specific date.
4. Swaps: Agreements between two parties to exchange cash flows or other financial instruments over multiple time periods. The most common types include interest rate swaps and currency swaps.
Booming Derivatives Trading in India
The derivatives market in India has experienced a massive surge, with its turnover now surpassing that of the cash market. Reports show that Indian markets contribute 30% to 50% of global exchange-traded derivative trades. This growth is driven by technological advancements, increased digital access, and a variety of product offerings.
Start investing in Index Funds.
India’s retail investor activity spiked sharply after COVID-19. By May 2024, the number of demat accounts in India reached 15.8 crore, with 12.2 crore accounts opened since April 2020. This increase also coincided with the National Stock Exchange’s (NSE) launch of weekly derivatives contracts on benchmark indices in February 2019, shifting trading activity towards index options contracts.
Trends in the Derivatives Market
Derivatives market turnover has significantly surpassed cash market turnover. This indicates that investors and traders are increasingly preferring derivatives trading. For instance, take a look at the annual turnover for different derivatives since FY 2018:
There has also been a major increase in the number of individual investors in the derivatives segment. For example, the total number of demat accounts rose to 15.8 crore by the end of May 2024, with 12.2 crore accounts opened since April 2020. Here is the trend in annual turnover of individual investors in the F&O segment since FY 2018:
However, a study conducted by SEBI in January 2023 found that 89% of individual traders in the equity F&O segment incurred losses. These losses represent over 32% of the net inflows into growth and equity-oriented schemes of all mutual funds during FY 2024 and over 25% of the average annual inflows into all mutual funds across all schemes over the past five years. Such data shows the high-risk nature of derivatives trading and the challenges individual traders face in this market segment.
It is clear from the chart above that the growth in derivatives trading is mainly due to the rise in index options. Over the years, this segment has shown significant turnover growth, outpacing the benchmark index increase. In FY 2018, only ₹2 out of every ₹100 traded by individual investors went into index options. By FY 2024, this figure had jumped to ₹41.
In FY 2023-24, around 92.50 lakh unique individuals and proprietorship firms traded in the NSE’s index derivatives segment, collectively losing ₹51,689 crore, excluding transaction costs. Of these, only 14.22 lakh made a net profit, meaning about 85 out of every 100 investors faced net trading losses.
SEBI’s study highlighted that, in addition to trading losses, those who lost money spent an extra 23% of their losses on transaction costs. Profit-making investors spent 15% of their trading profits on transaction costs in FY 2022. Including these costs, FY 2024 results are similar to FY 2022, where 9 out of 10 traders lost money.
SEBI’s Concerns About Derivatives Trading
The growth trend in F&O trading is an alarming cause for trading losses. The rate at which derivatives trading in India is a growing concern as it turns household savings into losses. Here are the 3 main concerns in the derivatives market:
1. Rising Trade Volumes
The volume of index options trading on the National Stock Exchange (NSE) has surged dramatically, from ₹10.8 trillion in 2019-20 to ₹138 trillion in 2023-24. This exponential growth has raised concerns about the stability of financial markets.
2. Retail Investors’ Losses
SEBI studies revealed that most retail traders in the derivatives market incur losses. In 2022-23, about 70% of intraday traders experienced losses. A previous study found that 9 out of 10 individual traders in the equity derivatives segment lost money.
3. Speculative Trading Risks
SEBI is particularly worried about the speculative nature of derivatives trading, which can lead to market instability. The regulator noted that household savings are being diverted into speculative trading instead of long-term investments, which is detrimental to capital formation.
Proposed Measures by SEBI
SEBI released a consultation paper dated 30th July 2024 which states the changes that have been proposed to curb the growing losses in speculative trading. Here are the changes that were proposed:
Proposal 1: Increasing Minimum Contract Size
SEBI proposes increasing the minimum contract size for derivatives from ₹5-10 lakh to ₹15-20 lakh initially, and then to ₹20-30 lakh after six months. This measure aims to reduce the participation of small retail investors who may not have the financial capacity to withstand significant losses.
Proposal 2: Higher Upfront Margins
To mitigate risks, SEBI suggests increasing the upfront margin requirements for trading, especially near the contract expiry. This means traders will need to provide a higher amount of capital to cover potential losses, which could deter excessive speculative trading.
Proposal 3: Rationalising Weekly Expiries
Currently, weekly contracts expire on different days of the trading week, leading to confusion and high volatility. SEBI plans to reduce the number of weekly expiries to just one per exchange. This change is expected to lower speculative trading and stabilise market conditions.
Proposal 4: Wider Strike Price Intervals
SEBI proposes increasing the price intervals for out-of-the-money (OTM) options to discourage retail investors from buying high-risk contracts. This measure aims to make speculative trading less attractive by reducing the potential for quick profits on low-probability bets.
Proposal 5: Removal of Calendar Spread Benefit
The regulator suggests removing the calendar spread margin benefit on expiry day. This benefit currently allows traders to hold positions with reduced margins, leading to significant risk exposure. Eliminating this benefit will increase the capital required for trading, thereby reducing speculative activities.
Proposal 6: Intraday Monitoring of Position Limits
To ensure compliance with position limits, SEBI proposes intraday monitoring of index derivative contracts. This will help detect and prevent traders from exceeding permissible limits, thus reducing systemic risks.
Proposal 7: Upfront Collection of Option Premiums
SEBI recommends collecting option premiums upfront to avoid undue intraday leverage. This measure aims to ensure that traders have sufficient capital to cover their positions, thereby reducing the risk of default.
Intentions Behind SEBI’s Measures
These reforms aim to protect the savings of middle-income households by curbing speculative trading. If implemented, these reforms would help market players with mitigating risk. Here are the intentions behind these proposed measures:
1. Investor Protection
These measures are designed to protect retail investors from significant losses. By increasing the minimum contract size and upfront margins, SEBI aims to ensure that only those with sufficient financial resources participate in derivatives trading.
2. Market Stability
Reducing the number of weekly expiries and increasing strike price intervals are expected to lower market volatility. These changes will likely create a more stable trading environment, benefiting long-term investors.
3. Reduced Speculation
SEBI’s proposals are intended to curb speculative trading, which has been a major concern due to its potential impact on market stability. By increasing the capital requirements for trading and removing benefits that encourage speculation, SEBI wants to align the market more closely with its original purpose of risk management.
Wrapping Up
SEBI aims to create a safer and more stable financial market by increasing capital requirements and reducing speculative opportunities. What do you think about the proposed changes?
See the detailed consultation paper here.
FAQs
What are derivatives?
Derivatives are financial instruments whose value is based on an underlying asset, such as stocks or indices. They include futures and options contracts used for hedging risks and improving market liquidity.
Why is SEBI concerned about derivatives trading?
SEBI is concerned because of the dramatic increase in trading volumes and the high losses incurred by retail investors. Speculative trading has led to market instability and the diversion of household savings into high-risk activities.
What are the proposed changes to derivatives trading?
SEBI proposes increasing the minimum contract size, higher upfront margins, rationalising weekly expiries, widening strike price intervals, removing calendar spread benefits, and monitoring intraday position limits. These measures aim to reduce speculation and protect retail investors.
How will these changes impact retail investors?
The changes will make it more difficult for small retail investors to participate in derivatives trading due to higher capital requirements. However, these measures are intended to protect them from significant losses and reduce market volatility.
What is the rationale behind removing the calendar spread benefit?
The calendar spread benefit allows traders to hold positions with reduced margins on expiry day, leading to significant risk exposure. Removing this benefit will increase the capital required for trading, thus reducing speculative activities and improving market stability.
Interested in how we think about the markets?
Read more: Zen And The Art Of Investing
Watch here: How To Save Income Tax On Your Mutual Fund Investments
Start investing through a platform that brings goal planning and investing to your fingertips. Visit kuvera.in to discover Direct Plans of Mutual Funds and Fixed Deposits and start investing today.
AREVUK Advisory Services Pvt Ltd | SEBI Registration No. INA200005166
DISCLAIMER: Mutual Fund investments are subject to market risks. Read all scheme related documents carefully. Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors. Investments in securities market are subject to market risks. Read all the related documents carefully before investing. The securities quoted are for illustration only and are not recommendatory.
