Mint Explainer: Impact of Sebi's planned measures for index derivative framework

Mint explains why Sebi is concerned with the rising trade volumes, the measures it plans to take, and the impact of these steps.

What are derivatives?

Derivatives are financial contracts that derive their value from an underlying asset. Derivatives are of two types – futures and options contracts. They help in better price discovery, improve market liquidity and allow investors to manage their risks better.

The National Stock Exchange of India launched weekly options on the Bank Nifty index, the Nifty, the Nifty Financial Services index and the Nifty Midcap Select index in 2016. The BSE started Sensex weekly options in 2019. Currently, one option expires on each day of the trading week.

Why is Sebi concerned about rising trade volumes in this segment? 

Following the pandemic of 2020, weekly options became a hit with retail and proprietary traders. In a consultation paper released on 30 July, the regulator pointed out that weekly index derivatives found favour with market participants, especially around their expiry. This was evident by the hyperactive volatile trading Sebi found on expiry day compared with levels on other trading days.

Index option volumes on the NSE, which enjoys a market share of over 90%, surged almost 13-fold to  ₹138 trillion in FY24 from ₹10.8 trillion in FY20. This brought the market segment under Sebi’s radar.

Also Read: Sebi’s seven measures to tame the “tail that's grown bigger than the dog"

To add to this, Sebi found that 9.25 million individuals and proprietorship firms traded in the index derivatives segment of the NSE and cumulatively incurred a trading loss of  ₹51,689 crore in FY24. 

“Sebi’s study of 2023 showed that 9 out of 10 individual traders in the equity F&O segment incurred losses, which added to its concern that such speculative trading may have implications on market stability," said Vasudha Goenka, a partner at Cyril Amarchand Mangaldas, a law firm.

Sebi chairperson Madhabi Puri Buch has said that the surge in derivatives trading had become a macro issue because household savings were going into speculation instead of capital formation.

What measures has Sebi proposed?

To actively enhance investor protection and ensure market stability, Sebi set up an expert working group headed by a former chief general manager of the Reserve Bank of India. The group submitted its recommendations to the Secondary Markets Assessment Committee (SMAC), which deliberated over the report on 15 July. Based on these discussions, Sebi released a consultation paper to invite public comments on the matter by 20 August.

The key points are:

Minimum contract size

Sebi proposed increasing the minimum value of a derivatives contract to  ₹15- ₹20 lakh from  ₹5-10 lakh and, after six months, raising it to  ₹20- ₹30 lakh. Sebi claimed the benchmark indices had gone up nearly three times in the past nine years.

“Given the inherently higher risk in derivatives and the large amount of implicit leverage, increase in minimum contract size would result in reverse sachetisation of such risk-bearing products," Sebi said in the paper.

Deepak Shenoy, CEO of Capitalmind, an investment advisory firm, posted on social media site X that increasing the minimum contract size would hurt traders with smaller capital, who are mostly buying, but not the sellers.

Increase in margin near contract expiry

This measure involves raising the upfront margin on sellers. At present, the increase in market volatility is not factored in the form of a higher margin to account for the increased risk, act as a deterrent or build additional buffers to absorb sudden price shocks. Currently, the premium traded decreases near the expiry date, creating a higher risk on a notional basis in options.

“This means that the capital requirement in trading will go up, which means your exposure margin will increase. With lot sizes going up to  ₹30 lakh, one may need up to  ₹6.5 to  ₹10 lakh per lot," Vijay Bhambwani, founder of trading firm Bhambwani Securities Ltd, said on his YouTube channel. 

Rationalisation of weekly index products

Currently, weekly contracts across different indices expire on each of the five trading days, which results in speculative money moving from one expiry to another. The volatility and speculative trading on expiry day and during closing time, with a poor profitability outcome for individual investors, compelled Sebi to propose rationalising weekly index products. Sebi has suggested reducing the number of weekly expiries to just one per exchange.

“This change will likely impact volumes as the recent volumes in the equity derivatives segment have been driven by weekly expiries," said Dhiraj Relli, managing director of HDFC Securities.

Rationalisation of strike prices for options

Sebi proposed to widen the price intervals at which out-of-the-money (OTM) options strike (even when the option has not reached its strike price) to make it harder for retail investors to buy them because of the unfavourable risk-reward ratio.

The strike price refers to the price at which the underlying security can be bought or sold when an options contract is exercised.

Also Read: F&O trading: Sebi to discuss ways to tighten the screws on retail speculation

The regulator proposed to keep the strike interval uniform at 4% near the prevailing index price and increase it to 8% as the strikes move away from the prevailing price. It added that not more than 50 strikes would be introduced at the time of launching an index derivatives contract. 

Sebi claimed this measure is to tackle sudden price movements for short-tenure option contracts and the purchase of cheap options at far away strikes, regardless of how low the odds of success are. 

Shenoy of Capitalmind disagreed with this measure, saying if the market index moved down by even 10%, a lot of new strikes would be needed. He suggested restricting the maximum to 50 strikes only in the initial phase. 

Removal of calendar spread benefit on expiry day

Currently, the margin requirement for an F&O position reduces significantly, offsetting positions on future expiry, as the calendar spread margin applies instead of the normal margin. To be clear, on the day of expiry of an option, the trader buys another option that expires the following month. Since the exchange risk is restricted, it provides a discounted margin on the contract, which enjoys a lower margin. This led to significant risk. 

Sebi proposed to remove the calendar spread margin benefit for positions involving contracts expiring on same day.

“This means the trader will have to pay the 100% margin and capital requirement will shoot up tremendously as Sebi does not want traders to crowd markets on expiry day, especially on small priced contracts," Bhambwani said. 

Intraday monitoring of position limits

On the day of expiry, there remains the possibility of undetected intraday positions beyond permissible limits as end-of-day open positions would be NIL.

To tackle this, Sebi proposed that clearing corporations and stock exchanges monitor the position limits for index derivative contracts on an intra-day basis, with an appropriate short-term fix and a glide path for full implementation.

Shenoy said that while this may impact large volumes on expiry day for larger brokers, going beyond Sebi-specified limits is a systemic risk issue, so continuous monitoring will be helpful.

Upfront collection of option premiums

While there is upfront collection of the margin for futures and options positions, there is no upfront collection of option premiums from option buyers by members. Option prices are timed contracts with the possibility of very fast-paced price appreciation and depreciation. 

To avoid undue intraday leverage to clients and to discourage any market-wide practice of allowing positions beyond the collateral at the client’s end, members will be allowed to collect option premiums on an upfront basis instead of at the end of the trading day. 

What would be the impact of the proposed measures?

Kinjal Champaneria, a partner at Solomon & Co, a law firm in Mumbai, clarified that these guidelines did not recommend barring any retail investor from participating in the derivatives segment.

Binoy Parikh, executive director at Katalyst Advisors, a structuring and advisory firm, said these reforms are crucial to ensure that the F&O markets serve their primary role as tools for risk management and liquidity provision, rather than cater to speculative excesses.

"The latest measures will provide a level playing field between the high frequency traders, who use superior data analytics, algos and colocation, and retail who use mobile and luck to trade F&O," said Nilesh Shah, MD & CEO of Kotak Mahindra AMC. 

Also Read: As Sebi comes down hard on speculative trading, investors turn to other options

Relli said these measures may not be the only interventions by the regulator.

“We may see more measures, including product suitability and customer-level certification. With the realignment of exchange transaction charges, higher STT (securities transaction tax) introduced in the budget, and the proposed regulatory framework, it is expected that there could be rationalisation in equity derivative volumes," he said.

Anand K Rathi, co-founder of wealth management firm MIRA Money, was apprehensive that while these measures may not affect overall market volumes, it may divert a good set of flows in the futures markets to the options market as futures margins may become unaffordable. He said creating awareness about F&O, including reasons for trading in the derivatives segment, was an important measure. However, it would bring down the volatility of the market, which would benefit long-term traders.

“Like there is a campaign saying, ‘Mutual Funds Sahi Hai,’ there should be a campaign so that retail investors do not fall for ‘finfluencers’ claims. Sebi should try and bring down social media and Telegram channels that say that markets are like a gambling machine and one can become rich by investing in futures and options. Certification for trading in futures and options should be made mandatory. These measures would help Sebi control retail participation in F&O, which is not necessary," Rathi said.