[Jyoti is a student at Dr Ram Manohar Lohiya National Law University.]
Derivatives markets play a pivotal role in modern financial systems by enabling investors to hedge risks and engage in speculative trading. The growth of the derivatives market has been in consonance with the surge in retail participation. Traditionally dominated by institutional players, the derivatives market has seen a dramatic increase in retail participation, especially in short-term index options trading. This shift has coincided with the introduction of weekly options contracts, which have become popular tools for speculative trading due to their low premium costs and shorter expiration cycles. This has resulted in increased volatility, especially around expiry day, when large volumes of trading occur within a short period. A recent SEBI study found that 89% of individual traders in the equity F&O segment incurred losses. The same study also highlights that trading in derivatives has proliferated beyond tier 1 cities in the past 3-4 years.
To curb such challenges and protect individual investors from such grave losses, the Expert Working Group came up with certain measures, which, after the recommendation of the Securities Market Advisory Committee, were released as the consultation paper for public comments on 30 July 2024. Consequently, after the Board Meeting of SEBI on 1 October 2024, SEBI released a circular with measures to strengthen the equity index derivatives framework.
This article explores the implications of these regulatory measures on the derivatives market, focusing on their potential to curb volatility and ensure a stable trading environment.
Understanding the Regulatory Changes in the Circular
Mitigating risks and ensuring investor protection and market stability are at the forefront of these regulatory changes. "Derivatives should be used for hedging exposures and not for pure gambling by speculators with little knowledge, training or experience in them. Overall a welcome step in protecting small investors and safeguarding market integrity," said Ajay Bagga, a market veteran.
This section will examine provisions introduced by SEBI and analyze their implications on both market participants and the broader financial ecosystem.
Upfront collection of option premiums
One of the most significant changes mandated by the circular is the requirement for an upfront collection of options premiums from the buyers. In the erstwhile framework, there was no explicit stipulation of upfront collection of premiums from the options buyers by the members.
This led to undue intraday leverage to the end client, and the traders could hold larger positions beyond the collateral at their level. This creates a bubble in the market, provides a way for speculative trading, and also sets up the investor for heavier losses.
This measure is hence designed to prevent the build-up of leveraged position, which could result in significant market disruptions, especially during volatile hours like on the expiry day. By enforcing upfront collection, SEBI aims to curb excessive speculative trading and align trading practices with sound risk management principles.
Removal of calendar spread treatment on expiry day
The previous framework allowed traders to take positions in two contracts with different expiry dates and has traditionally provided margin relief by offsetting the risk of holding contracts in opposing directions. However, expiry day can see significant basis risk, where the value of a contract expiring on the day can move very differently from the value of similar contracts expiring in future, and hence, the benefit of offsetting positions shall not be available on the expiry day.
On the day of expiry, the worst scenario loss, as specified in Clause 14.3 of Chapter 5 of SEBI Master Circular for Stock Exchanges and Clearing Corporations dated 16 October 2023, shall be calculated separately for contracts expiring on the given day and for the rest of the contracts. Given that the worst scenario loss is calculated separately, and hence, calendar spread benefit is not available for contracts on the day of expiry, an additional calendar spread margin will not be applicable for contracts expiring on a given day.
SEBI aims to reduce expiry day volatility by eliminating calendar spread benefits. Expiry day has become a hotspot for speculation, resulting in unpredictable price swings due to high trading volumes.
This measure, while beneficial for market stability, may also lead to a shift in trading behaviour, with some traders choosing to reduce their exposure or move to longer-duration contracts to avoid the heightened risk and margin requirements on expiry day.
Intraday monitoring of position limits
Traditionally, position limits were monitored only at the end of the day, leaving room for potential violations to go undetected during peak trading hours. Considering the high trading volumes, especially on the expiry day, traders could exceed their permitted limits and close positions before the end of the day without triggering any penalties.
The stock exchanges shall consider a minimum of four random intraday snapshots of position limits. With this, SEBI has tightened its oversight, ensuring that the violations are detected and penalized in real time.
This measure is expected to limit the ability of traders to manipulate their positions during intraday volatility. While this could lead to reduced liquidity, it also enhances the overall stability of the market by preventing sudden position unwinds that could exacerbate volatility.
Rationalization of weekly index derivatives products
Expiry-day trading in index options, at a time when option premiums are low, is largely speculative. Different stock exchanges offer short-tenure options contracts on indices, which expire every day of the week.
The SEBI consultation paper has noted that there is hyperactive trading in index options on expiry day, with average position holding periods in minutes, accompanied by increased volatility in the value of the index through the day and at expiry. All this has implications for investor protection and market stability, with no discernable benefit towards sustained capital formation. To address this, SEBI has limited each exchange to offering weekly expiry contracts on only one benchmark index.
This move is expected to significantly reduce the volume of speculative trading on expiry days, as traders will no longer have the option of rotating between multiple indices. The concentration of liquidity in a single index per exchange should also enhance price discovery and reduce the risk of market manipulation.
Contract size recalibration
In the previous framework, the stipulation for Index options and futures contracts to have a value between INR 5 lakhs and INR 10 lakhs. This limit was set in 2015. This range is no longer reflective of current market conditions, as broad market values have risen significantly over the past decade.
The minimum contract size has now been increased to 15 lakhs at the time of introduction, and the lot size is fixed in such a manner that the contract size comes within INR 15-20 lakhs on the review day.
With this, SEBI aims to ensure that derivatives trading remains suitable and appropriate for participants with adequate risk tolerance. The result could be a shift towards more institutional participation in the derivatives market, which tends to be more sophisticated and better equipped to manage risks associated with these products.
Increase in tail risk coverage on the day of options expiry
Extreme loss margin is levied with the view to cover tail risk outside the scanning risk. The volume traded on the expiry day increases, leading to heightened speculative activity and risk, which tends to increase price volatility on such days. In this view, SEBI has imposed an additional 2% extreme loss margin on short options contracts during expiry days.
By requiring an additional margin, SEBI ensures that traders maintain sufficient reserves to cover potential sharp market movements. This will protect against defaults and stabilize the market during periods of increased risk. It also discourages excessive speculative behaviour, particularly among traders in short positions, promoting long-term market confidence and resilience.
Conclusion
The recent trend in F&O trading with increasing retail participation was concerning. This was not just limited to risk hedging for investors or businesses, but much of it was speculation. This led the regulator to come up with this circular, which will help curb the speculative behaviour of this trade and improve market stability.
SEBI’s circular introduces vital reforms which are aimed at stabilizing the equity index market. By mandating the upfront premium collection and removing calendar spread benefits on the margin, SEBI aims to decrease the leverage and volatility in the market.
The rationalization of weekly index derivatives, as well as stricter monitoring of the position limits, indicate a shift towards more structured trading and fewer opportunities for market abuse.
These reforms, while potentially curbing the short-term speculative volumes and reducing retail participation, will be beneficial in the long term. SEBI by focusing on risk management and investor protection is paving the way towards a more stable and resilient derivatives market.
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