SEBI’s expert panel explores suitability framework for F&O trading: Sources

Market Regulator Securities and Exchange Board of India’s (SEBI) expert panel on suggesting measures to deal with the equity derivatives frenzy is exploring a product suitability framework for F&O trading.

As per multiple sources, an expert working group led by former Reserve Bank of India (RBI) executive director (ED), G Padmanabhan, called a short notice meeting last week and sought the views of all stakeholders on the suitability issue.

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Officials of exchanges, clearing corporations, select brokers, and subject matter experts participated in the meeting.

The expert working group will meet on December 10 to deliberate on the views received. 

Income, net worth, education, and what more?  

According to one source, who was part of earlier discussions on plans to slow down the F&O frenzy, “The working group will discuss, whether income, net worth, education, and experience are the sufficient parameters to decide on the suitability. Once agreed, the expert working group will then debate the minimum threshold of the parameters”.

There has been growing demand from stakeholders that SEBI should have thought of a product suitability framework for F&O traders before implementing any major policy change.

So, there are defined criteria for deciding who should be allowed to take risky F&O bets.

An industry source said, “In the meeting, Sebi officials did not suggest anything from their side, but asked all the stakeholders to share their views, SEBI has no starting view on this concept”.  

As per one person part of the discussion, one exchange, a big broking firm, and a few associations had suggested SEBI consider the product suitability framework, and hence the issue was communicated to the expert working group, and now views are being sought.

Risk profiling and verification is not an easy task!

But another source added, “The setting up of an entry criteria is easy, but who will verify the income, net worth, educational, and experience credentials?

Brokers should not be expected to take the role of an auditor; also, there are around 18 crore demats, and verifying such a huge number will be challenging”.  

The discussion on the product suitability framework is not new; earlier also, when SEBI floated a discussion paper in 2017 and sought views on product suitability, two issues were prominently highlighted for discussion.

First, considering the profile of participants, what measures would be required to create balanced participation in the equity derivatives market, and second, taking into account the trading of individual investors in derivatives, especially options, is there a need to introduce a product suitability framework in our market?

Suitability was discussed earlier also but not materialised

Later, the product suitability framework proposal was approved by the Sebi board.

Then the board note said, “Individual investors may freely take exposure in the market (cash and derivatives) up to a computed exposure based on their disclosed income as per their Income Tax Return (ITR) over a period of time. For exposure beyond the computed exposure, the intermediary would be required to undertake rigorous due diligence and take appropriate documentation from the investor. Determination of the computed exposure and details of due diligence documents required shall be formulated in consultation with market participants."

But despite the board’s go-ahead, the plan could not be materialised.  

Risk Disclosure Document already there

As per one regulatory official, “The suitability part is still there in regulation, but it's hardly in practice.”

Brokers at the time of onboarding can identify who should be allowed to trade derivatives and who should not.

At the time of the onboarding of a client, a broker must execute a Risk Disclosure Document (RDD), and the same is included in the documentation related to client registration.

The RDD has a separate detailed paragraph, which contains information about the risks involved in trading in the derivatives segment.

This specifically mentions that transactions in derivatives carry a high degree of risk, losses may exceed the original margin amount, risks of option holders, and risks of option writers are also well explained.

Can we adopt the South Korean model?

But there are also examples that can guide, like South Korea, which had a model, South Korea had the 'Qualified Retail Investor' scheme.

To prevent retail investors from making reckless investments and incurring huge losses in derivatives markets, South Korea allows only 'qualified' retail investors to enter the derivative market by establishing two stages of entry barriers.

Under the first stage, retail investors who have completed prior education programme and mock trading and are subject to depositing a certain amount of money as initial margin are allowed to trade but only in simply structured futures of indices or individual stock futures.

In the second stage, retail investors with more than one year of trading experience are allowed under the first stage, and after the deposit of the higher amount of margin, are allowed to trade in complicated structured futures and options.  

The impact of F&O measures taken is yet to be seen

SEBI’s circular on tightening regulation regarding F&O has been in force since November 20, and the effect will be known only after a few months.

SEBI’s tweaks included an increase in lot size, cutting down weekly expiries, increasing ELM margin towards expiry, removing calendar spread margin, collecting of upfront premium on options, and monitoring of intraday positions. 

93% of retail traders lose money in F&O, low-income earners lose more

Since the last one and a half years, at various forums, concerns have been raised about the increasing number of individual traders getting into complex derivative trading.

SEBI also published two studies on the trend and the losses suffered by retail traders.

As per the latest study of SEBI, 93% of over 1 crore individual F&O traders incurred average losses of around Rs 2 lakh per trader (inclusive of transaction costs) during the 3 years from FY22 to FY24.

The top 3.5 per cent of loss makers, approximately 4 lakh traders, faced an average loss of Rs 28 lakh per person.

In contrast to individual traders, proprietary traders and Foreign  Portfolio Investors (FPIs) as a class booked gross trading profits of Rs 33,000 crore and Rs 28,000 crore, respectively, in FY24, before accounting for transaction costs.

Against this, individuals and others incurred a loss of over Rs 61,000 crore in FY24 (before accounting for transaction costs).

Most of the profits were generated by larger entities that used trading algorithms, with 97 per cent of FPI profits and 96 per cent of proprietary trader profits coming from algorithmic trading in the same period, inclusive of transaction costs.

The SEBI study further says that nearly 76 per cent of the individual F&O traders had declared annual income of less than Rs 5 lakh and approximately 94 per cent of the individual F&O traders had declared annual income of less than Rs 10 lakh in FY24.

The percentage of loss-makers in the “low income” (i.e., less than Rs 5 lakh) traders’ category was the highest (92.2 per cent in FY24) as compared to the average proportion of loss-makers (91.1 per cent in FY24) and also compared to other income groups.  

Here, if the income criterion is applied, it can substantially impact the volume.

Also, if an age bar or experience criteria is applied, it may reduce the youngster's trading activity, as per the latest data, the maximum (43 per cent) retail traders are of less than 30 years of age.

Once the expert working group finalises its recommendations, the matter will go to SEBI's committee, and after its approval, a formal consultation paper may be issued to seek larger public views.

Zee Business wrote to SEBI seeking comments, but no reply was received.