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Understanding SEBI's New Measures to Strengthen the Index Derivatives Framework

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The Securities and Exchange Board of India (SEBI) has introduced a series of measures aimed at enhancing investor protection and promoting market stability within the index derivatives segment. These changes are designed to address the evolving market dynamics, particularly the increase in retail participation and the speculative trading volumes on expiry dates. This blog will explain these measures in detail, provide context on the current practices, and outline both the short-term and long-term impacts on traders, especially retail investors.

Introduction to Derivatives and SEBI's Role

Objective:

The derivatives market aids in better price discovery, improves market liquidity, and allows investors to manage their risks. However, excessive speculative activity can endanger investor protection and market stability. SEBI's new measures aim to address these concerns.

Simplified:

Derivatives help investors manage risks but can become too speculative. SEBI wants to protect investors and keep the market stable.

Changing Market Dynamics

Background:

The equity derivatives segment has seen increased retail participation and the introduction of short-tenure index options contracts. This has led to heightened speculative trading volumes, especially on expiry dates.

Market Dynamics:

Weekly Options Contracts: Introduced in May 2016 on sectoral indices and later benchmark indices. Initially, these contracts expired on a single day of the week, but now they expire on all five trading days.

Trading Turnover: Derivatives market turnover in India has significantly surpassed cash market turnover. Retail investors' participation has surged post-COVID-19, with a notable shift towards index options contracts.

Simplified:

Retail investors are now more involved in short-term trading, especially on options that expire every week. This has led to more trading in derivatives than in regular stocks.

SEBI's Proposed Measures

1. Rationalization of Strike Prices:

Current Practice:

Options strikes are introduced at uniform intervals around the prevailing index value. This can scatter trading activity and create sudden price movements.

Proposed Change:

Strikes will have a uniform interval around 4% of the prevailing price, increasing as strikes move away from prevailing price (around 4% to 8%).

No more than 50 strikes will be introduced initially, with new strikes added daily as needed.

Simplified:

SEBI will limit the number of options available for trading to reduce sudden price changes and make trading more stable.

Simplified:

Too many options can lead to excessive speculative trading. SEBI wants to reduce this by limiting the options available.

2. Upfront Collection of Options Premium:

Current Practice:

Only short options require margin; long options require payment of the premium by buyers, but there's no stipulation for upfront collection.

Proposed Change:

Members must collect option premiums upfront from clients.

Simplified:

Buyers will now have to pay the full price of options upfront to prevent over-leveraging and risky trading.

3. Removal of Calendar Spread Benefit on Expiry Day:

Current Practice:

Margin benefits are given for offsetting positions on futures expiry.

Proposed Change:

No margin benefit will be provided for calendar spread positions involving contracts expiring on the same day.

Simplified:

To prevent risky trading strategies, SEBI will remove certain margin benefits on the day of contract expiry.

4. Intraday Monitoring of Position Limits:

Current Practice:

Position limits are monitored end-of-day.

Proposed Change:

Position limits will be monitored intraday by clearing corporations/stock exchanges.

Simplified:

SEBI will keep a closer watch on how much trading happens during the day to prevent any breaches in limits.

5. Minimum Contract Size:

Current Practice:

Last set in 2015, the minimum contract size ranges from ₹5 lakhs to ₹10 lakhs. SEBI points out that the indices have gone up 3 times in these 9 years.

Proposed Change:

Phase 1: Minimum contract size increased to ₹15 lakhs to ₹20 lakhs.

Phase 2: After six months, increased to ₹20 lakhs to ₹30 lakhs.

Simplified:

To reduce risk, SEBI will increase the minimum size of contracts traded in the market.

Impact on Retail Investors:

This change will make it more challenging for small investors to participate in derivatives trading, potentially reducing their risk exposure.

6. Rationalization of Weekly Index Products:

Current Practice:

Weekly expiry index derivatives are offered by exchanges on all five trading days.

Proposed Change:

Weekly options contracts will be limited to a single benchmark index of an exchange.

Simplified:

SEBI will limit weekly options to reduce speculative trading across multiple days.

7. Increase in Margin Near Contract Expiry:

Current Practice:

Margins do not account for increased risk near expiry.

Proposed Change:

Extreme Loss Margins or ELM will increase by 3% at the start of the day before expiry and the ELM will be further increased by 5% at the start of the expiry day.

Simplified:

To protect the market, SEBI will require higher margins for trading near contract expiry.

Short-Term Impact on Traders

For Retail Traders:

Increased Costs: Upfront premium payments and higher margins on expiry days will increase trading costs.

Reduced Speculation: Limiting the number of strikes and monitoring position limits intraday will reduce speculative trading opportunities.

For Institutional Traders:

Enhanced Risk Management: Changes will necessitate more stringent risk management practices, especially around expiry days.

Liquidity Adjustments: Rationalization of weekly index products might impact liquidity in specific contracts.

Long-Term Impact on Traders

For Retail Traders:

Improved Investor Protection: Reduced speculative opportunities will protect retail investors from significant losses.

Market Stability: More stable market conditions will benefit long-term retail investors by reducing volatility.

For Institutional Traders:

Better Market Practices: The changes will promote healthier trading practices and reduce systemic risks.

Enhanced Transparency: Intraday monitoring of position limits and rationalized strike prices will improve market transparency.

When will it be Applicable?

These changes will take effect from a date specified in the final circular (yet to be determined). Public comments on these measures are invited until August 20, 2024.

Conclusion:

SEBI's new measures aim to create a more stable and investor-friendly environment in the index derivatives market. By addressing speculative trading and enhancing risk management, SEBI seeks to protect retail investors and ensure long-term market stability. While these changes may increase trading costs in the short term, the long-term benefits of a more stable and transparent market will outweigh these initial challenges.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing. This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

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