he Securities and Exchange Board of India (Sebi) has introduced a comprehensive six-step plan aimed at reducing retail participation in speculative index derivatives. These reforms are designed to curb rampant speculation, particularly in the futures and options (F&O) segment, which has seen daily turnovers reach a staggering Rs 500 trillion. This has raised concerns as retail investors, in many cases, find themselves at the losing end of trades. The new rules are expected to have a significant impact on trading volumes, which could drop by as much as 30-40%.
Sebi’s plan includes a set of robust measures, the most important of which involves increasing the minimum contract size, raising margin requirements, and enforcing the upfront collection of option premiums. Additionally, there will be tighter controls over weekly expiries, intraday position limits, and the treatment of calendar spreads during expiry days. This move is part of Sebi’s effort to ensure that retail investors, who often engage in high-risk speculative trades, face stricter controls that reduce their exposure to potentially catastrophic financial losses.
Key Elements of Sebi’s Six-Step Plan
Sebi’s new plan includes a number of crucial regulatory changes, most of which are designed to limit the ability of retail investors to engage in speculative trading with minimal capital. One of the most notable changes is the increase in the minimum contract size for trading in index derivatives from Rs 5 lakh to Rs 15 lakh. This move significantly raises the financial threshold for participation in these markets, thereby making it more difficult for small retail investors to take speculative positions.
Additionally, Sebi has mandated higher margin requirements, meaning that traders will need to deposit more money upfront to enter trades. This, coupled with the requirement for the upfront collection of option premiums from buyers, will further reduce the leverage available to retail investors. By enforcing these measures, Sebi is aiming to create a trading environment that is less speculative and more grounded in genuine financial strategies, as opposed to quick profit-seeking behavior that often leads to substantial losses for retail participants.
Other key changes include limiting weekly expiries to just one benchmark per exchange, which is aimed at reducing the frequency of speculative trading opportunities. Sebi will also tighten its monitoring of intraday position limits, ensuring that retail traders cannot exceed prescribed exposure limits within a single trading day. Moreover, the regulator has decided to eliminate calendar spread treatments on expiry days, a move that will prevent traders from benefiting from the typically lower margin requirements associated with these positions.
Impact on Trading Volumes and Market Activity
These regulatory actions are expected to have a profound impact on trading volumes, especially on the National Stock Exchange (NSE). Market analysts estimate that trading volumes could decline by nearly one-third as a result of these changes. In September alone, the average daily trading volume in the NSE’s cash market segment was Rs 394 trillion, while the BSE’s volume was Rs 144 trillion. Given the high levels of retail participation in index derivatives, the introduction of stricter rules could significantly reduce overall market activity.
The new restrictions are likely to affect futures trading in particular, which has already come under pressure due to a rise in the securities transaction tax (STT) that came into effect earlier this week. With the combination of higher transaction costs and increased margin requirements, many traders may look for alternative venues to continue their speculative activities. One such venue is Gujarat International Finance Tec-City (GIFT City), where trading volumes in index derivatives could potentially increase.
At present, GIFT City’s market share remains small, with approximately 2 million contracts traded per month. This represents less than 1% of the NSE’s overall volume, which averages 10.8 billion equity derivatives contracts monthly. However, analysts believe that GIFT City’s appeal could grow, especially among foreign portfolio investors, as it offers a wider range of weekly options than the onshore exchanges. The success of GIFT City in capturing this shift will depend heavily on its ability to build market liquidity and depth, both of which are critical for attracting large volumes of speculative trading.
The Role of Brokers and Stock Exchanges
The new regulations will also have a significant impact on stockbrokers and exchanges, many of which derive a large portion of their revenue from the F&O segment. For instance, Zerodha, India’s most profitable brokerage firm, anticipates a revenue decline of between 30-50% as a direct result of Sebi’s changes. This is because index derivatives trading accounts for a significant share of brokers’ income, and the reduction in retail participation will directly hit their bottom line.
In the first quarter of 2024-25, the NSE earned Rs 3,623 crore from transaction charges, while the BSE earned Rs 366 crore. A substantial portion of these revenues came from the F&O segment, where high trading activity generated significant transaction fees. With the expected drop in volumes, both exchanges will likely see a reduction in transaction charges, which will ultimately impact their profitability.
To mitigate the impact of these changes, many brokers are already looking to diversify their revenue streams. Some are exploring opportunities in wealth management, mutual funds, and other financial products that are less dependent on speculative trading. For stock exchanges, the challenge will be to maintain trading volumes while adhering to the new regulatory framework. The BSE, which is less reliant on weekly index options than the NSE, may see a smaller impact, but it too will need to adjust to the new market dynamics.
Long-Term Market Outlook and Risks
While the initial impact of Sebi’s reforms is expected to be negative for trading volumes, the long-term outlook remains uncertain. Some market participants believe that the higher entry barriers could push retail investors to take on even greater risks, as those who remain in the market may feel the need to engage in more aggressive trading strategies to compensate for the increased costs. This could potentially lead to higher volatility and increased financial instability, particularly in times of market stress.
The Futures Industry Association, a global trade body, has expressed concerns that the new rules could lead to wider bid/ask spreads, making it more expensive for retail traders to enter and exit positions. Liquidity providers, who facilitate trading by buying and selling securities, will face higher margin costs, which could ultimately be passed on to end users in the form of wider spreads. This, in turn, could lead to market distortions and increased costs for both retail and institutional investors.
In its submission to Sebi’s consultation paper on derivatives curbs, the association emphasized the importance of balancing regulation with market efficiency. While it acknowledged the need to protect retail investors from excessive speculation, it also warned that overly restrictive measures could harm market liquidity and create unintended consequences. Sebi, for its part, has indicated that it will closely monitor the impact of its reforms and make further adjustments if necessary.
Conclusion
Sebi’s six-step plan to reduce retail participation in speculative index derivatives represents a significant shift in the regulatory landscape for India’s financial markets. By raising the minimum contract size, increasing margin requirements, and enforcing the upfront collection of option premiums, the regulator aims to curb excessive speculation and protect retail investors from financial losses. However, these measures are expected to lead to a substantial reduction in trading volumes, particularly on the NSE, which could see volumes drop by as much as 30-40%.
The impact of these changes will be felt across the industry, from stockbrokers who rely on F&O trading for their revenues, to liquidity providers who will face higher costs. While the long-term effects remain to be seen, the immediate consequence will likely be a more cautious and risk-averse market environment, with fewer retail investors willing to engage in speculative trading.
As Sebi continues to refine its regulatory approach, it will be important to strike a balance between protecting investors and maintaining market efficiency. Only time will tell whether these new rules will achieve their intended goals without causing undue harm to India’s financial markets.
