[By Siddharth Melepurath]
The author is a student of National Law University Odisha.
Introduction
Recently, the Securities and Exchange Board of India (“SEBI”) released a consultation paper in which it proposed measures to curb speculative activity in Futures and Options (“F&O”) trading. Speculative trading involves taking guesses at the direction in which the market will go and trying to make money from an unexpected market volatility. SEBI note that a lot of speculative activity happens on the day of contract expiry, particularly in the last hour, which happens to be the most volatile time as compared to other days. Such speculative activity causes unnatural alterations to the actual value of companies, leading to instability in the secondary market.
There are three major objectives with which SEBI has taken this measure – first, to protect the interests of retail investors, second, to promote stability in the derivative market and third, to ensure sustained capital formation from the derivatives market. This post aims to analyse the implications of this move for the derivative market and to evaluate whether it effectively fulfils the rationale behind it or not.
Background
The market regulator had conducted a study in January 2023, titled “Analysis of Profit and Loss of Individual Traders dealing in Equity F&O segment”, which showcased that over 89% of individual traders in the equity F&O segment incurred losses in 2022. Data shows that the share of volume in derivative trading has risen from 2% in 2018 to 41% in 2024. According to the Economic Survey of 2023-2024, this increase in retail participation is due to ‘gambling instincts’ among the retail traders, since it holds potential for outsized gains.
The impact of such speculative trading is two-fold. First, it may lead to large-scale price fluctuations, especially caused when speculators buy or sell large quantities of derivatives. Second, it may infuse a large number of investors into the market, creating market price bubbles, or escalation in the underlying value of assets. Consequently, it may severely impact market stability, especially due to the large volume of retail traders incurring losses.
In view of all this, SEBI had created an Expert Working Group (“EWG”) to examine and suggest measures to ensure stability in the derivatives market and to protect investors by improving risk metrics. SEBI’s Secondary Market Advisory Committee (“SMAC”) reviewed these recommendations, pursuant to which SEBI proposed these measures for the index derivatives segment. This move also comes in the backdrop of the Government hiking the Securities Transaction Tax (STT) to 0.1% in options and 0.2% in futures, up from 0.0625% and 0.0125% respectively.
Analysing the proposals: What has changed?
SEBI has recommended 7 broad changes to the existing framework, some of which directly impact retail investors trading in the secondary market. Two primary changes – increasing the minimum contract size for index derivatives and rationalisation of weekly index products are aimed at reducing speculation and have a direct impact on retail traders.
Currently, the minimum contract size for index derivatives stands between 5 lakhs and 10 lakhs. SEBI has now proposed to increase this in two phases, with the first phase being 15 lakhs to 20 lakhs and the second phase subsequently being increased to 20 lakhs to 30 lakhs bracket. This measure, which SEBI terms ‘reverse sachetization’, has been done in light of the high risk that derivatives markets pose, and to reduce the leverage that retail traders currently have.
While it is definitely an effective strategy to counter speculative trading, it also impacts beginner options traders entering the market with lower amounts and also leads to an increase in margins. This will also impact in a large-scale decrease in volume, with investors moving out of the market, possibly shifting to the primary market or even outside the primary market. Dabba trading, an illegal form of trading which is executed outside SEBI-recognised stock exchanges is also expected to become popular, in view of investor exits caused by the move. However, it is pertinent to note that SEBI has maintained its position with respect to the equity cash market – stating that there will be no restrictions in the intraday equity cash market as of now.
Further, SEBI notes that due to expiry of weekly contracts almost on all 5 trading days of the week, there exists a lot of speculative trading in the secondary market. Exchange data shows that there is increased volatility on expiry day which leads to a lot of speculative activity. Therefore, as a direct measure to curb this speculation, SEBI has suggested fewer weekly expiries. While this move would counter speculative behaviour by creating a systematic secondary market, it results in the market becoming relatively less liquid. This, in turn, directly impacts discount brokers and stock exchanges catering to retail traders, who benefit from the liquidity rates in the market. Although the regulator has only aimed at reducing the hyperactive trading on the expiry day and has tried to ensure that there is no restriction on trading, market-making or hedging, it will inadvertently affect the volumes in these exchanges due to large-scale exits.
Implications of the move
The earlier model of normal-price, high volume has now been replaced by a more stabilised high-price, low volume in the options segment of the derivative market. The extreme price movements, often caused by traders engaging in speculative activity are mitigated through these measures. These measures also reduce the chances of heavy losses incurred by retail investors. Therefore, there is a pressing need to have a threshold to allow investors into derivative markets, which this move has only partially done.
While this move will aid retail traders in the market, who, as per SEBI statistics are incurring losses and contributing to market instability, there are some concerns which the proposed measures pose. One may argue that SEBI has proposed to protect the interests of retail investors by flushing most of them out of the market. However, these measures are expected to have a direct impact on premiums, which will be forced to have larger spreads. Additionally, hedgers would also be affected as trading would now be more expensive for them.
While the interests of retail investors are protected, concern arises that this move might lead to institutionalisation of the F&O segment due to the increased contract sizes and retail investors pulling out. Further, it might also lead to a loss of revenue for stock exchanges (particularly the NSE) due to the setting of new limits.
Conclusion
The proposed measures to curb speculative activity aim to enhance market stability and protect retail investors. SEBI intends to mitigate the risks involved in high volatility and eradicate speculative trading through measures like increasing minimum contract size and rationalising weekly index products. While these steps are bound to cut down the number of retail traders and speculative transactions in the market, this can also have the unintended effect of lowering trading volumes. The impact on traders who use the secondary market for hedging, along with the chance of the markets now being institutionally-dominated raises important questions on the long-term implications of these changes.
While many of the vital issues have been addressed, it is essential that a delicate balance between regulation and market participation be maintained so as to ensure continued capital formation and investor protection. The regulator needs to continuously monitor, F&O trading and actively engage with stakeholders, so as to protect their interest and reduce such crackdowns which inadvertently affect the market. In light of the same, adequate revisions to the proposed measures are required so that factors such as volume of trading and market stability are not affected.