SEBI's F&O Clampdown: Will It Protect Small Investors, Contain Systemic Risk?

This, despite a need for India's equity culture to rise and fund its growth. But the ongoing frenzied hyperactivity in the F&O market has little discernible benefit for anyone.

So on October 1, SEBI decided to bite the bullet and contain the F&O frenzy in the country, when it came out with six regulatory measures that are expected to discourage small-time speculators from entering a domain they don’t quite understand. 

The unsuitability of derivatives as investment products for small traders is reflected in the fact that nine out of ten individual traders make losses in the F&O segment.

In the last couple of years, derivatives have become a push product for the brokerage industry, even as technology upgradation and higher internet penetration has made access to these products easy, even beyond the big cities.  

SEBI data shows that more and more traders with income of less than Rs 5 lakh per annum are indulging in the trade of derivative products.

What is worrying is that half of all traders in fiscal year 2023-24 were first-timers, mostly below 30 years of age, 92.1 per cent of whom made losses to the tune of Rs 46,000 per person in that fiscal. 

Even more worrying is the fact that dabbling in derivatives is becoming a habit with small traders, given that 75 per cent of loss-makers persisted with trading in F&O, despite incurring losses in the two preceding consecutive years.

Of course, along with a rise in India's equity culture, it also needs speculators, investors, hedgers, jobbers and arbitrageurs to make its electronic market dynamic. But the current F&O frenzy benefits no one.

F&O: Favouring FPIs & domestic brokerages, Taxing Individual Traders

Who is the casualty in the process? At stake is the markets’ ability to aid capital formation.

For instance, in fiscal 2023-24, a SEBI study showed that 91.1 per cent of the total 86.26 lakh individual traders who dabbled in the derivatives market lost money to the tune of Rs 61,000 crore.

This money could have been routed towards constructive capital formation in the economy or towards some primary offerings in the capital market. 

So who are making the profits from the losses by small-timers? In fiscal 2023-24, while individual traders lost money, foreign portfolio investors (FPIs) and proprietary traders of domestic broking firms made gross profits of Rs 33,000 crore and Rs 28,000 crore, respectively.

Interestingly, 97 per cent of the profits of FPIs and 96 per cent that of proprietary traders came from algorithmic trades, which is beyond the means of small traders.

Clearly, it’s not a level playing field.

Interestingly, while individual traders lost money between fiscal 2021-22 and fiscal 2023-24, they also incurred huge transaction costs.

About Rs 25,000 crore was in the form of brokerage, followed by Rs 13,800 crore to the government in the form of Securities Transaction Tax (STT), GST and stamp duty, while another Rs 10,200 crore was in the form of stock exchange fees.

It was high time something was done to make small investors understand the pitfalls of the derivatives market, the primary function of which is to hedge the underlying cash market, not to speculate.

That raises three broad concerns around India’s derivatives market: 1) heightened participation by small investors; 2) possible delinking between derivatives and the underlying cash market caused by higher participation; and 3) Expiry Day volatility, along with the risk it poses, if any, to the market. 

SEBI Steps In To Restrict Individuals, Contain Expiry Day Volatility

The regulator would have been mulling over the above concerns for some time now. It released various studies, highlighting risks in the derivatives market, but these warnings were left unheeded.

The six measures that SEBI has now undertaken, have two underlying themes: 1) make it dearer for traders to participate in the market; and 2) contain system risk by clamping down on Expiry Day activity. 

To be sure, the new measures are applicable only to index derivative products and not stock derivatives. Let’s look at these measures and their possible impact(s):

1) Increase in lot size: The contract lot size has now been increased to Rs 15-20 lakh, from the existing Rs 5-10 lakh.

Likely impact: Because increase in lot size means higher absolute margin requirement for traders, this measure is likely to dissuade small traders, who were benefitting from small lot sizes so far. 

2) Only one weekly expiry per exchange: Currently, the National Stock Exchange (NSE) has four different indices that expire Monday to Thursday, while the Bombay Stock Exchange (BSE) has two indices that expire on Monday and Friday.

This means there are expiries of some index or another on all days of the week.

While this has boosted volumes, there also has been a lot of volatility due to this. According to one research, weekly contracts make up for around 65 per cent of industry premiums in index options. The new rules allow only one weekly expiry for any one benchmark index per exchange.

So, the expiry of the rest of the derivative contracts will take place on a monthly basis.  

Likely impact: The move will lower speculative activities. Any spillover of trading activity from a discontinued index into the continuing index will be keenly watched.

3) Intraday monitoring of position limits: Currently, monitoring of compliance happens at the end of each day. Now, SEBI wants stock exchanges to consider a minimum of four position snapshots through a trading day. 

Likely impact: Often, open positions go undetected, and are only noticed at the end of the day. Sometimes these positions go beyond permissible limits for various types of investors.

Now, revising positions in intraday compliance may lead to lower volumes, while raising compliance workload of stock exchanges.

4) Upfront collection of options premia: Currently, upfront margins for the end client is collected in futures (both long and short positions) and options from the sellers alone.

At an aggregate level, clearing corporations block collateral at the broker level for options buy trades. SEBI is now proposing upfront margin collection of options premiums for buy trades, payable at the client level. 

Likely impact: The move will decrease leverage positions in the market and can also bring down volumes. Compliance requirements would also increase at the levels of the broker and the clearing corporation. 

5) Removal of calendar spread benefit on Expiry Days: Currently, if a trader takes an offsetting position on a future Expiry Day, the margin requirement is significantly lower than that applicable to two separate positions. According to the new rule, this benefit will not be available on the Expiry Day. 

Likely impact: Currently, a volume spike is seen on the Expiry Day, as traders take the benefit of lower calendar spread margin. This also disturbs price discovery, leading to undesired movement in prices of all derivative instruments of that underlying asset. In light of the changes, the trader will be required to put up more margins, while the new rule will force players to do rollovers early, and not wait till Expiry Day. 

6) Increase in margin for near contract expiry: Currently, the extreme loss margin (ELM) — the additional margin exchanges charge as a safety measure, over and above the normal margin (to take care of any volatility due to any rare event on Expiry Day) — is at 2 per cent for index derivatives and 3.5 per cent for stock derivatives.

Now, an additional 2 per cent ELM will be applicable on short option contracts on Expiry Day. 

Likely impact: An additional ELM will act as a check against abrupt market moves driven by leveraged short options. This will protect both investors and the broader market from significant downside risk.

SEBI's Steps: Disruptive Or Positive? 

Some tweaking of F&O regulations was on the cards, given the heightened activity in the space and the concerns around it.

While the jury is still out about the new measures, it should cut down speculative activities in the market. Some experts even expect a 30-40 per cent drop in volume of derivatives. 

However, the market and its intermediaries are expected to take these measures in their stride and swim through these.

After all, no one would like to kill the goose that lays golden eggs. Indian markets have grown by around 15 per cent in US$ terms over the last 5 years, making it one of the best performing markets, globally.

The new measures are also not going to be disruptive, as their implementation will be phased between November 20, 2024 and February 1, 2025.

"We see the phased implementation over the next 3-6 months as a big positive for market health, as it prevents any systemic shocks and leads to a calibrated tightening of the market," Jefferies India said in note on October 1. 

Another positive is that the new measures are more lenient than what were recommended in the consultation paper in July 2024. 

Only time can tell if SEBI, with its various measures, will succeed in altering trading behaviour of small investors and dissuade them from speculating in the derivatives market, while also encouraging a healthy equity culture in the country.

The good thing is that the government is on the same page as the exchange board.

The increase in the securities transaction tax (STT) from October 1, as announced in the Budget, can be seen as its own attempt to discourage heightened participation in the derivatives markets.

For, as and when the tide turns and investors suffer, the government runs the risk of becoming unpopular.

(The author is a Mumbai-based analyst and researcher. Views expressed are personal)