Sebi proposes tighter index derivatives norms to protect households against harsh realities of F&O trading

Is trading in derivatives - or futures and options - for everyone? Capital market regulator Sebi has just floated what could be best understood as a means to protect investors against the harsh realities of the derivatives segment. 

On a day when Sebi Chairperson Madhabi Puri Buch highlighted that households in the country are losing up to Rs 60,000 crore a year in the problematic F&O segment, the regulator proposed stricter norms for index derivatives. And how does the market regulator plan to achieve that? In a consultation paper floated on Tuesday, Sebi proposed a host of measures aimed at protecting small traders, including rationalisation of strike prices as well as weekly index products, intraday monitoring of position limits, removal of calendar spread benefit on expiry days, and higher near contract expiry margins.

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KEY TAKEAWAYS FROM SEBI'S PROPOSALS

Now, here are a few noteworthy steps proposed by Sebi: 

• The minimum contract size should be revised for index derivative contracts in two phases
  • Phase 1: The minimum value of the contract should be Rs 15 lakh-20 lakh at the time of introduction 
  • Phase 2: It should be Rs 20-30 lakh after six months
• Rationalising of options strikes with a uniform strike interval of four per cent around the prevailing index price and expanded strike intervals beyond the initial coverage (to reduce the number of strikes further from the index price; the minimum contract size requirement was last set for derivatives in 2015, at Rs 5-10 lakh)
• There will be a maximum of 50 strikes at the time of introduction, with new strikes introduced daily to maintain these intervals 
• Members should collect option premiums from clients upfront 
• There should be no margin benefit for calendar spread positions on contracts expiring on the same day 
• Position limits for index derivatives should be monitored in intraday trade by clearing corporations as well as stock exchanges 
• Weekly options contracts should be provided on a single benchmark index of exchange

Sebi invited public comments on the paper till August 20. 

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Why tighter rules for index derivatives?

According to the document, the steps proposed by Sebi seek to enhance investor protection and promote market stability in derivative markets while ensuring sustained capital formation. 

Sebi highlighted a few key aspects about the F&O segment: 

• The derivatives market assists in better price discovery, helps improve market liquidity, and allows investors to manage their risks better
• However, speculative hyperactivity in derivatives can come in the way of sustained capital formation, impacting investors as well as the market
• Market dynamics have changed in equity derivatives over the years owing to:
  • increased retail participation
  • availability of short-tenure index options contracts 
  • heightened speculative trading volumes in index derivatives (especially on expiry days)

'Lower expiry day premium makes F&O trading accessible & cheap'  

“Mathematically, everything else being constant,  option premiums reduce sharply as one approaches expiry. Illustratively, 30 minutes before expiry, ceteris paribus, the option premium of a comparable at-the-money strike could be just a fifth or less of the closing premium of the day before expiry,” Sebi elaborated. 

“Similarly, 5-10 minutes before expiry, ceteris paribus, the premium could be as low as a tenth or less of the premium of the day before. This lower premium on expiry day likely makes F&O trading on that day an accessible, cheap, and enticing lottery ticket for some individuals to purchase, sell, and speculate on, irrespective of how low the odds of success may be. It is very difficult to attribute any kind of benefit to the overall securities market ecosystem and capital formation from such concentrated hyperactivity in derivatives on expiry date,” it added. 

Harsh realities

Sebi also released some interesting findings of a study conducted by it in January 2023. As per the study, 89 per cent of individual traders in the equity F&O segment incurred losses in FY24. 

As many as 92.50 lakh unique individuals and firms traded in stock exchange NSE's index derivatives in FY24, incurring a cumulative trading loss of Rs 51,689 crore excluding transaction costs. And about 85 per cent of those traders made net losses.

The release of the consultation paper comes at a time when retail investor participation in F&O trading has surged dramatically and suddenly, days after the finance minister announced a hike in the securities transaction tax (STT) on futures and options trades with effect from October 1 while acknowledging a surge in activity in the segment.

According to the Economic Survey 2023-24, released on the eve of the presentation of the Narendra Modi 3.0 government’s first Union Budget in Parliament, speculative trade has no place in a developing country, and the sharp increase in retail investor participation in F&O trading in the country is likely driven by humans' gambling instincts.

What market voices say

"One of the proposals is to rationalise weekly expiry and restrict it to one per week on the benchmark index per exchange. This change will likely impact volumes, as the recent volumes in the equity derivatives segment have been driven by weekly expiries. We will need to monitor the impact of the other measures if and when they are implemented. All the measures suggest that the regulator wants to control the exuberance in equity derivatives volumes," said Dhiraj Relli, MD and CEO, HDFC Securities. 

"These may not be the only interventions by the regulator. We may see more measures, including product suitability, customer-level certification, etc.," added Relli.

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