The Securities and Exchange Board of India (SEBI) is considering overhauling various aspects of equity derivatives regulations. The market regulator is expected to soon float a discussion paper and seek stakeholders’ views. 

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Some major aspects that are under review include relooking at open interest (OI) formulation and coming up with the concept of Future Equivalent Open Interest (Fut EQ OI) which will give a sense of inbuilt risk in the positions. Open interest is the number of contracts outstanding in any underlying. Besides, a review of the entry criteria for F&O stocks, redefining the Market Wide Position Limit (MWPL) and restricting the overheating in derivatives with linkage to cash position, a review of the intraday monitoring mechanism of MWPL, and also a review of Individual Position Limits for single stocks may be included. MWPL is the upper limit of permitted position in an underlying.

The significant change under discussion is the regulator’s proposal for a review of open interest formulation. According to sources, “SEBI is of the view that the existing formulation of open interest does not give a meaningful measure of market risk because it does not give much information about the risk undertaken by the participants and is just a composite measure of participant’s activity.”

Review of open interest formulation mechanism

The argument is the current, existing open interest formulation is devoid of sensitivity to the movements of the underlying security. Also, the existing mechanism has scope for misuse; if few participants collaborate and take large Out-of-the-Money (OTM) positions in a scrip, which has a combined open interest close to MWPL, then the stock may be pushed to a ban period.

So, SEBI is considering the concept of Future Equivalent open interest or FutEQ OI, where the delta (a unit change in the underlying) adjusted open positions across Futures and Options (F&O) will be considered across portfolios and exchanges will share the Fut EQ OI data like the existing OI. NSE has already started sharing this data since October last year.

Relook on entry criteria for F&O stocks

The regulator is also thinking of reviewing the entry criteria for stocks in the F&O segment. The regulator had earlier proposed to double the existing criteria for a minimum Market Wide Position Limit of Rs 500 crore to Rs 1,000 crore, and the Average Daily Cash Volume criteria from Rs 10 crore to Rs 20 crore in the previous six months on a rolling basis, while a stock’s median quarter-sigma order size over the last six months may also be doubled to Rs 50 lakh against the existing Rs 25 lakh (a stock’s quarter-sigma order size is the order size in value terms, required may cause a change in the stock price equal to one-quarter of a standard deviation). Only after fulfilling all the above criteria, a stock may be included in the F&O segment. 

Besides these parameters, SEBI may introduce new parameters as the issue is still under discussion and various data sets are being examined. The product success framework may also be a factor to be considered like the underlying must be traded for a minimum of 75 per cent of trading days by 15 per cent or a minimum of 200 of the brokers. According to sources aware of the development, “SEBI is not looking to restrict the number of F&O stocks and have no particular number in mind.”

Rescaling of MWPL

Similarly, the rescaling of the Market Wide Position Limit (MWPL) on account of Fut EQ OI is also under consideration. FutEQ OI is generally expected to be less than Notional OI. SEBI believes that this will create room for more positions within the existing limit. MWPL is linked to the free float of shares and is limited to 20 per cent of the number of shares on a free float basis. According to people aware of the developments, “SEBI may propose a study-based limit for MWPL, based on the relation between FutEQ OI and Notional OI for a period of 3-6 monthly expiries and then the existing MWPL could be scaled down by the said ratio for next expiry.” For example, if for a scrip, the Fut EQ OI is 20,00,000, and on an average, for the last six months, FutEQ OI is 70 per cent of the Notional OI, the MWPL for the next expiry would be 14,00,000.                 

Restricting overheating in derivatives with linkage to cash volume

SEBI is also thinking of linking FutEQ OI with Average Daily Delivery Value (ADDV) in the cash market. SEBI believes the underlying cash market should have sufficient liquidity compared to the open position in the derivatives segment so that any shock of excess demand or excess supply can be absorbed. Likewise, if FutEQ OI in any scrip starts to become very high in relation to the Average Daily Delivery Value, in the cash market, it may have a risk of spillover from the F&O to the cash market. So, SEBI believes that positions created in the derivatives segment should have an in-built mechanism to slow down further position building. However, the department-related SEBI committee comprising of experts and stakeholders is not convinced with this proposal, because it could have led to higher and additional margin in case of excess build of FutEq OI as compared to average daily delivery volume.

Relooking intraday MWPL monitoring mechanism

SEBI’s discussion paper may also consider reviewing the intraday monitoring mechanism of MWPL. Currently, the combined open interest is computed at the end of the day across exchanges and clearing corporations to check if it is breached or not. In the past, there have been incidents of MWPL breaching the trigger of 95 per cent by the end of the day and resulting in scrip going in a ban. SEBI is of the view that Fut EQ OI intraday should be monitored four times a day along with risk computation measures. Exchanges should take remedial measures when Fut EQ OI goes beyond the MWPL.

Fixing individual positional limits for single stocks

The regulator is also discussing the idea of a Review of Individual Position Limits for single stocks. SEBI is concerned that in case of high MWPL but less OI, there is a scope of concentration of open positions with single or few entities. As the positions are monitored by clearing corporations at the end of the day, there can be a possibility of an entity taking multiple positions through different clearing members of different clearing corporations beyond the limit. Hence, to deal with this issue, SEBI is considering the idea of linking the position limits in single stocks to total OI in the scrip across all exchanges. SEBI may fix the OI limit for clients at 15 per cent and for brokers, FPIs, and MFs it could be 25 per cent. In case of a passive breach, there will be a leeway to run till expiry. Currently, the position limit for brokers/Cat 1 FPIs and MFs, is 20 per cent of MWPL, and for clients, it is the higher of 1 per cent of the free float or 5 per cent of the OI in the scrip. 

As per the regulator’s policy-making process, a discussion paper will be floated soon, and after consultation and considering the views of all stakeholders, SEBI will move forward to formulate the regulations.