Thursday, December 5, 2024

F&O action: Can new Sebi rules tame wild bulls of the derivatives market?

If you thought this is a scene from a movie, it’s not. To call it a one-off celebration would also not do any justice to the large-scale participation that India’s equity markets are witnessing—and how!

The frenzy in Indian markets since the pandemic-induced asset slump has been unparalleled. Traders and investors, energized by elevated levels of excitement, are pouring crores into them (and into certain segments), throwing caution to the wind.

On one hand, domestic mutual funds witnessed inflows for the 43rd straight month in September, sending a clear message that investing is truly being democratized. 

On the other, exponential growth in derivatives trading by retail traders has set off alarm bells everywhere, with regulators, including the central bank, expressing serious intent to rein back animal spirits.

Also read: SEBI increases position limits for trading members in index F&O contracts

That is not without reason. Average daily volumes so far this year have exploded to $4.6 trillion from $180 billion in 2019, an increase of about 26 times in merely six years. 

A whopping 97% of this activity is concentrated in the options market, with the influx of retail traders stoking fears of excessive leverage and systemic risk. 

The mania has been so excessive that India’s derivatives-to-cash market volume ratio stands at 280 times. Additionally, 102 billion derivatives contracts have been traded this year in India, compared to 9 billion in the US, a market

known for its sophistication and innovation. Such has been the scale of speculative activity.

Studies undertaken by the Securities and Exchange Board of India (Sebi), the capital market regulator, have set the cat among the pigeons. A report it published in early 2023 showed that nine out of 10 retail traders had lost money trading derivatives. 

A follow-up study showed that 80% of retail intraday traders trading the cash market were loss-makers. What was even more of an eye-opener was that 93% of young traders (aged below 30 years), representing 43% of the trading population, incurred losses.

More recent statistics have raised an even bigger red flag. A staggering 99.3% of traders engaged in options trading at least once during the last three years, while only 5.9% traded futures. 

The most logical explanations one can find for this are, one, the lure of leverage, and two, buying options can offer unlimited rewards while limiting the risk to a known maximum amount. 

Not surprisingly, the findings further highlighted that losses were more prevalent in options trading, with over 91% of traders losing money compared to 60% in futures.

The findings attest to a long-known fact: derivatives have always been sophisticated instruments for informed market participants with the research and technological prowess to generate alpha (greater returns that a benchmark like an index).

In India, this held true until the pandemic hit in early 2020 and the dramatic rise of financial influencers (or ‘finfluencers’) began to raise concerns about qualifications and lack of regulation.

Many of these finfluencers offer advice online on how derivatives can give traders a bigger bang for the buck because of their inherent leverage. The usual pitch is that one can take a much larger exposure by depositing a small margin.

That’s true, and when you win, the returns can be manifold and come quickly. However, what is missing is awareness of the potential downside, which can be

enormous and sometimes wipe out entire amounts of capital. This is where the true nature of the problem lies.

This also explains Sebi’s recent crackdown. In addition to banning regulated entities from engaging with finfluencers or unlicensed individuals to promote products, Sebi’s 1 October circular introduced several measures to make derivatives trading “enablers” more restrictive for retail investors. 

These include limiting weekly expirations to one benchmark per exchange, raising the minimum index derivatives value from ₹5 lakh to ₹15 lakh, requiring upfront margin collection for options, and enhancing margin requirements on expiration days. The common aim is to curb retail speculation and contain systemic risk.

These measures are changing the face of derivatives trading as we know it today. For instance, restricting weekly option contracts to one benchmark index per exchange can minimize losses and reduce intraday volatility. 

Also read: NSE cash volumes sink to six-month low ahead of Sebi’s F&O curbs

Additionally, collecting upfront premiums and increasing expiry margins will cut down financial leverage and deter uninformed trades. Sebi’s crackdown sends a clear message to market participants that it is unwavering in its intent, having identified fault-lines.

Derivatives aren’t the only focus of regulators. Initial public offerings (IPOs) of small and medium enterprises (SMEs) have also raised concerns of a buildup of froth. 

Launched in 2012, the SME platform has garnered over ₹14,000 crore, with 40% raised last year. Regulators note listing-day volatility as a key risk, leading the National Stock Exchange (NSE) to cap price movement at 90% to promote genuine price discovery.

It has not been all about policing securities markets. That is a critical task any regulator must perform to ensure investor confidence remains high and stakeholders feel safe.

Driving innovation is also a goal. To that end, Sebi has always led from the front. Whether it’s the introduction of the Application Supported by Blocked Amount (ASBA) facility more than a decade-and-a-half ago, creating an ecosystem for T+1 settlement, or using artificial intelligence to reduce the age of IPO applications, the regulator has embraced and furthered innovation in capital markets.

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