Author: Vaibhav Gautam
Third-year law student at National Academy of Legal Studies and Research, Hyderabad
I. Introduction
The role of the derivatives market cannot be understated, particularly on account of its function to enable efficient risk management, hedging and speculation. Such activities also allow for increasing the liquidity and overall investor participation in the market. Hedging allows for the market participants to protect themselves against adverse price movements. Speculation, on the other hand allows for traders to bet on the future price positions of the indices or the assets, without holding the underlying securities. Retail investors are crucial to this financial ecosystem, with significant participation in the speculative transactions of the derivatives market.
On October 1, 2024, the Securities and Exchange Board of India (“SEBI”) issued a circular, laying down seven measures to strengthen and stabilize the framework of index derivatives in India. Admittedly, the measures are rightly aimed at addressing the highly speculative nature of the derivatives market, and to foster market stability. However, at the same time it is necessary to take note of the serious implications, particularly for the retail investors, which is the main consideration of this article. Furthermore, the author also discusses how SEBI’s intent to enhance market stability through these measures, might be a double-edged sword, owing to the implications for risk management, and reduced participation in the derivatives market.
II. What do the Measures Entail?
Regulation 28(2), read with Part – C of Schedule II of the Securities Contracts (Regulation) (Stock Exchanges and Clearing Corporations) Regulations, 2018 (“SECC Regulations”), establish functions such as risk management, surveillance, etc., to be the core functions of SEBI. Furthermore, the Securities and Exchange Board of India Act, 1992 (“SEBI Act”) mandates SEBI to protect investor interest, to develop and regulate the securities market. In furtherance, of the same, on July 30, 2024, SEBI issued a consultation paper, and later, the aforementioned circular to strengthen and stabilize the framework underlying the derivatives market. SEBI based its measures on the observations of the Expert Working Group (“EWG”). Commendably, SEBI has also provided definite timelines for each of measures’ timely implementation.
To address the risk of undetected positions during peak trading hours, SEBI has introduced stricter oversight by implementing intraday monitoring of position limits. This measure is advantageous as it helps curb potential manipulation of positions and contributes to reducing the overall market volatility. Additionally, the measure to increase the risk tail coverage by an additional 2% extreme loss margin on the expiry day of options, ensures that reserves are maintained for traders, in addition to protecting investors against defaults. Contrary to the rest of the SEBI’s measures, these contribute to the overall market stability, without disproportionately affecting the retail or institutional investors.
According to the circular, one of the measures encompass an upfront collection of the option premiums from the buyers to address the excessive speculative trading, especially during the expiry days. Another measure which addresses the volatility of the expiry days, is the removal of the calendar spread treatment. The calendar spread method is a common hedging strategy for both the institutional and retail investors, hence its removal is likely to hold implications for both categories of investors. SEBI has also limited each exchange to offer the weekly expiry contracts to only one exchange, which aims to focus on long-term capital formation, instead of short-term speculative profits. Despite the discernible benefits of the measure, SEBI’s restriction to a single benchmark index is likely to reduce the variety and flexibility of the derivatives market, due to the short-term maturity, and cost efficiency of the weekly contracts. Lastly, there has also been an increase in the minimum contract size for index derivatives from earlier INR 5-10 lakhs, to INR 15-20 lakhs.
III. The Overlooked Implications on Market Participation & Hedging
Despite the good intention behind SEBI’s measures to increase the overall market stability, such measures might turn out to hold significant implications, particularly on the retail investors. A SEBI study noted that more than 89% of the retail investors incurred losses in the Futures & Options trading (“F&O”). As reported by Reuters, Zerodha has expected a significant loss in revenue ranging from 30% to 50%, post the implementation of SEBI’s measures.
Looking at the overall context of the F&O trading, SEBI’s concerns would appear to be misplaced since the derivatives market is not only used for speculations, but also for effective risk management, through hedging. As noted by Economic Times, the regulator should have taken note of the investors engaged in hedging in the derivatives market as well, instead of addressing only speculation while overhauling the derivatives framework. Weekly index derivatives product are amongst the most popular derivatives products for the retail investors. Institutional investors could be also be impacted by SEBI’s measure to rationalise the weekly contracts to a single index, since they use multiple indices to hedge their specific portfolio risks. The flexible hedging offered by the weekly contracts, would be extensively constrained for both retail and institutional investors, post the rationalization of the weekly contracts to a single index. Another measure which would disproportionately affect hedging would be the removal of calendar spreads, since it is a widely used risk management strategy tool. It might also lead to heightened market risks for participants who are unable to afford the additional margin requirements. Calendar spreads play an important role for stabilizing markets by offsetting near-term and long-term risks, and its removal might discourage traders from maintaining balanced positions, leading to increased volatility on expiry days. This would completely go against SEBI’s aim to increase market stability, especially on expiry days. Ultimately, the trading volumes would be affected negatively, which would drive up the costs and complexity for different investors to effectively manage their risks.
The increase in the minimum size of derivatives contracts to INR 15-20 lakhs, would also raise significant barriers for the retail investors, distorting their participation in the derivatives market. It might also lead to a concentration of institutional investors in the market, which would be detrimental for the overall diversity in the market. Lastly, the requirement for upfront collection of options premiums, would also reduce affordability for small investors to participate in the market. However, the long-term benefits of such a measure could not be understated, for it would lead to a more informed and disciplined investor base.
Apart from the grave concerns of market participation and diversity, since retail investors make up nearly one third of the derivatives market, they could inadvertently shift to alternative less-regulated segments of the market, such as offshore derivatives platforms, crypto derivatives or even over the counter market (“OTC”). An enormous shift to unregulated platforms might redefine new problems for market stability for SEBI. Although such a shift might not be instant, it is still in SEBI’s best interest to consider the overall context of the financial ecosystem, while also upholding market integrity, by ensuring that the investors are not being disproportionately affected by such measures.
IV. Concluding Thoughts
From the above discussion, it would be right to conclude that although SEBI’s intent is not questionable to stabilize the derivatives market by acknowledging the excessive speculative behavior, there might still be several unintended implications of the measures. A tightening of the derivative norms, could see a shift of retail investors to other segments of the market, owing to the significant drop in market liquidity, and participation. These potential consequences can also potentially impact market perception, which would entail an erosion in the investor confidence, and long-term growth of the derivatives market. However, the measures are a step in the right direction for strengthening the derivatives framework, and reducing the excessive speculative behavior, especially on expiry days. Additionally, the phased timelines for implementation of the specific measures would ensure that the market participants are given adequate time to adjust to the SEBI’s measures in the derivatives market.
It is the author’s opinion that while SEBI’s measures hold the promise of stabilizing the derivatives market, and curbing the excessive speculative behavior of the participants, they may also inadvertently create unintended consequences for investors who use the derivatives primarily for hedging their risk portfolios, and the retail investors who rely on the flexibility and affordability that derivatives products offer. The primary aim of the market regulator in introducing such measures was to strengthen the derivatives framework of the market, however such an approach without considering the broader context of the market, could do more harm than good in the long run with regards to the investor confidence, and their participation in the market.