On July 30, the Securities and Exchange Board of India (SEBI) unveiled measures aimed at reigning in the burgeoning speculative trading in futures and options (F&O) index derivatives. In the consultation paper, SEBI detailed changes designed to shield investors and traders from substantial losses. The proposals include the upfront collection of margins, the rationalisation of index options, and a substantial increase in the minimum contract size. These initiatives are designed not only to enhance market stability but also to strengthen investor protection in a financial landscape that is becoming increasingly volatile.
The effectiveness of SEBI’s proposals will hinge on the market’s response and the broader economic environment. As participants adjust to the new regulations, there is potential for a more mature and stable derivatives market to develop, which could benefit both investors and the overall financial ecosystem in India.
Proposed interventions
The consultation paper meticulously outlines seven steps designed to curtail speculative trading in index derivatives. One such measure entails rationalising index options by expanding the intervals of strike price movements relative to the prevailing price. This approach aims to consolidate liquidity, thereby mitigating its dispersion across many strike prices. SEBI has also mooted the upfront collection of premiums, a move intended to curb excessive intraday leverage among participants. Notably, while there is currently no explicit mandate to collect margins from option buyers, this contrasts starkly with the established practice of upfront margin collection for long and short futures positions and those selling options.
SEBI has proposed the elimination of the calendar margin benefit spread on the expiry day. Presently, this benefit serves to reduce the required margin for a futures and options position by offsetting it against a position set to expire in the future. In a bid to ensure more robust oversight, SEBI has also recommended the implementation of stricter monitoring of intraday position limits for index derivative contracts.
A key proposal from SEBI is to increase the minimum contract size. This plan is designed to unfold in two phases: Phase 1 will elevate the minimum contract size to a range of Rs 15 lakh to Rs 20 lakh, and following a six-month period, Phase 2 will further escalate this minimum to a range of Rs 20 lakh to Rs 30 lakh.
This increase is likely to widen the bid-ask spread, thereby raising overall transaction costs for all investors. With fewer participants, market liquidity could decrease, leading to increased volatility and potentially higher costs for executing trades. Critics argue that these measures, while aimed at enhancing market stability and protecting investors, may inadvertently drive retail traders towards unregulated markets. Consequently, the proposed measures, while intended to enhance market stability and protect investors, may inadvertently create a less accessible trading environment, particularly for smaller players and algorithmic traders focused on rapid transactions.
Furthermore, SEBI has recommended that exchanges limit weekly expiries to a single benchmark index, aiming to enhance market stability and safeguard investor interests. In addition, SEBI has proposed raising the extreme loss margin (ELM) to 3 per cent, with an incremental increase of 5 per cent as the expiry date nears. These measures collectively aspire to create a more secure and balanced trading environment.
Potential outcomes
The proposal by SEBI to increase the minimum contract size for index derivatives from the current INR 5-10 lakh to Rs 20-30 lakh is likely to have significant impacts on market liquidity. The higher minimum contract size will make index derivatives less accessible to retail traders, as the capital required to participate will increase substantially. Many small traders may be priced out of the market, leading to a decline in retail participation. This could result in lower trading volumes, especially in the short term, as the market adjusts to the new requirements.
The reduction in retail participation may lead to a shift in trading activity from index futures to index options, as options typically require lower capital commitments. However, SEBI has also proposed measures to curb speculative trading in options, such as the upfront collection of premiums and rationalising strike prices. These changes may limit the ability of traders to shift their activity to the options segment.
While there is no universally accepted standard for measuring excessive speculation, various regulatory frameworks provide guidelines. In the United States, the Commodity Exchange Act (CEA) allows the establishment of speculative position limits to curb excessive speculation. These limits are determined by market conditions and are intended to prevent market manipulation and ensure price stability. In the Indian context, the equity market is notably speculative, with participants frequently trading based on price fluctuations rather than the intrinsic value of assets. The derivatives market, particularly the F&O segment, is primarily used for hedging against unfavourable price movements. However, the F&O market often draws the attention of regulators due to concerns about excessive speculation, which can contribute to increased volatility in the underlying equity markets.
Market makers play a crucial role in providing liquidity to the market. The higher minimum contract size may make it more challenging for market makers to maintain tight bid-ask spreads, as the capital required to provide liquidity will increase. This could lead to wider spreads and reduced liquidity, particularly in the initial stages of implementation.
With fewer participants in the market due to the higher minimum contract size, trading activity may become more concentrated among larger institutional investors and professional traders. This could lead to increased volatility as the market becomes more susceptible to the actions of a smaller number of participants.
Going forward
The initial impacts are likely to include a reduction in retail participation, as smaller traders may find themselves priced out of the derivatives market. This shift could lead to lower trading volumes in the short term, potentially affecting liquidity. However, the consolidation of trading activity among more sophisticated investors might foster a more stable trading environment over time, as these participants are generally better equipped to manage risks associated with derivatives trading.
Shares of Angel One and the Bombay Stock Exchange (BSE) have surged by 7 per cent following SEBI’s announcement of proposed changes to F&O trading. The proposed measures could encourage a more disciplined approach to trading, promoting longer-term investment strategies rather than short-term speculation. As the market adjusts, it will be crucial for regulators to monitor these developments closely and remain flexible in their approach to ensure that the derivatives market evolves in a way that protects investors while maintaining robust liquidity and stability.
Ultimately, while it is still in the early days, the effectiveness of SEBI’s proposals will depend on the market’s response and the broader economic context. As participants adapt to the new regulations, the potential for a more mature and stable derivatives market could emerge, benefiting both investors and the overall financial ecosystem in India.
