SEBI to tighten derivatives rules amid high retail participation

In a sweeping move poised to impact thousands of retail traders in the equity derivatives market, the Securities and Exchange Board of India (SEBI) proposed seven new regulatory measures in its consultation paper released on Tuesday. These measures aim to protect small retail investors and promote stability in the derivatives market, ensuring sustained capital formation.

The tighter derivatives rules include increasing minimum contract sizes by up to four times, collecting options premiums on an upfront basis, and reducing the number of weekly contracts.

As the paper highlights, retail participation in the F&O segment has significantly increased in recent years with over 92.50 lakh unique individuals and proprietorship firms trading in the NSE index derivatives segment in FY 2023-24. With a meagre 14.22 lakh making a net profit in the derivatives market, almost 85 out of 100 traders have incurred losses that when calculated cumulatively amount to a trading loss of ₹51,689 crore, excluding transaction costs.

At an event organised by the NSE, SEBI Chairperson Madhabi Puri Buch stated that when individual households lose ₹60,000 crore in the F&O segment in a year - an amount that could be more productively invested in other financial products - the issue takes on macroeconomic significance.

To curb retail losses, both SEBI and the government have been seen taking stringent measures in recent days. This paper was released just over a week after the Union Budget announced a doubling of the Securities Transaction Tax (STT) on futures and options (F&O) from October 1, 2024.

The seven proposals given in the consultation paper include

Minimum Contract Size

The proposal plans to revise the minimum value of derivatives contracts in a phased manner, creating an entry barrier for small investors. At the time of introduction, the minimum contract size must be between ₹15 lakh and ₹20 lakh. After six months, this will rise to between ₹20 lakh and ₹30 lakh. Currently, the minimum contract size ranges from ₹5 lakh to ₹10 lakh.

Rationalisation of Weekly Index Products

Under the proposed framework, exchanges will offer weekly options contracts for a single benchmark index. Currently, the NSE provides contracts on Nifty, Bank Nifty, Midcap, and FinNifty, while the BSE offers contracts on Sensex and Bankex. The new rules will require each exchange to select just one index for their weekly options contracts. As a result, a higher volume traction and faster market-share gains may be seen for the BSE, again limiting the trade volumes.

Increase in Margin Near Contract Expiry

The proposal includes raising margins on the day before and the expiry day of contracts. The Extreme Loss Margin (ELM), an additional margin to cover risks beyond VAR model predictions, will be adjusted to address high implicit leverage in options contracts near expiry. Specifically, the ELM will increase by 3% at the start of the day before expiry and by an additional 5% at the start of expiry day.

Upfront option premium

The paper suggests collection of option premiums on an upfront basis.

Removal of expiry day calendar spread benefit

To address the skewed trade volumes observed on expiry days compared to non-expiry days and the associated liquidity risks, the margin benefit for calendar spread positions will no longer apply to contracts expiring on the same day.

Rationalisation of strike price for options

Currently, exchanges introduce options strikes at uniform price intervals around the prevailing index value. For example, NIFTY contracts have 35 In the Money (ITM) and 35 Out of the Money (OTM) strikes. This setup covers approximately 7% to 8% of index movement around the prevailing price. A large number of strikes, however, especially for short-tenure contracts, can lead to sudden price movements.

To avoid this SEBI proposes the strike intervals be made uniform near the prevailing index price (within a 4% range) and increase these intervals as the strikes move further (up to an 8% range). Additionally, it places a limit of no more than 50 strikes that can be introduced per index derivatives contract at launch. New strikes may be added daily to meet the 4%-8% interval requirement.

Intraday monitoring of position limits

Position limits for index derivative contracts will be monitored intraday by clearing corporations and stock exchanges, with the implementation of short-term fixes and a gradual implementation plan for full implementation, considering the necessary technology upgrades.

The Board has invited public comments on the paper via an online platform until August 20, 2024.