Explosion in Derivatives Trading: Regulatory Measures to Shield Retail Investors 

Introduction

Indian stocks have been on a remarkable upward trajectory. The Sensex (30 stock index) and Nifty (50 stock index) have repeatedly touched new highs, propelling the Indian stock market to become the third most expensive globally, trailing only the United States and Japan. This unprecedented bull run has sparked a Fear of Missing Out (FOMO)^[1] among investors, who are increasingly concerned about losing opportunities for quick profits if they don’t participate.  A growing number of investors/ traders view the stock market as a shortcut to exponential wealth. This perception has led to a surge in speculative trading, particularly using complex instruments like Futures and Options (F&O). Millions of users are now engaging in such trades, creating a frenzy that has caught the attention of the Securities and Exchange Board of India (SEBI), which is the apex regulatory body for the Indian securities market.

The Indian derivatives market has experienced unprecedented growth in last five years, particularly in the F&O segment. This expansion, driven by technological advancements, increased retail investor participation, and favourable economic conditions, has raised significant concerns about market stability and investor protection.^[2]

A snapshot of the growth in last 7 years is depicted in the table below:

The above data has been taken from the SEBI Consultation Paper on “measures to strengthen index derivatives framework for increased investor protection and market stability” (Index Derivative Consultation Paper)^[3]

To understand the real concern, it is crucial to delve into the nature of derivative trading. Unlike traditional stock buying, where investors purchase shares based on their current market value, derivative trading essentially involves betting on a stock’s future performance. Investors buy contracts based on their predictions of how a stock might perform. If their prediction is correct, they profit; if not, they lose. This high-risk approach to investing prompted a SEBI board member to caution, “If you want to gamble, if you need diabetes and high blood pressure, then go into this market.”^[4]

The ratio of F&O turnover to cash market turnover escalated from 19.8 in FY18 to an extraordinary 367.8 in FY24, underscoring the magnitude of this shift. Concurrently, the number of demat accounts surged to 15.8 crore (i.e. 158 mn) as of May 2024, with 12.2 crore (i.e. 122 mn) accounts opened since April 2020, indicating a substantial influx of new market participants, especially retail investors/ traders.

However, this rapid expansion has not translated into widespread profits for retail investors. A SEBI study revealed that 89% of individual traders in the equity F&O segment incurred losses in FY 2021-22.^[5] More recent data for FY 2023-24 shows that approximately 85% of the 92.50 lakh (9.25 mn) unique individuals and proprietorship firms trading in the National Stock Exchange’s (NSE) index derivatives segment made net trading losses. The cumulative trading loss for retail investors in this segment amounted to Rs 51,689 crore (~USD 6.20 bn), exceeding 32% of the net inflows into Growth and Equity oriented schemes of all Mutual Funds during the same period.

These alarming trends have raised concerns among various regulatory bodies and government officials. SEBI’s chairman has warned about household savings being diverted into speculation, while the Reserve Bank of India (RBI) has expressed worry about people borrowing money for speculative trading.^[6]  India’s Finance Minister has also cautioned that unchecked explosions in retail trading of F&O could create future challenges for markets, investor sentiment, and household finances.^[7]

Measures

SEBI has introduced several regulatory measures aimed at enhancing the safety and stability of the derivatives market, particularly concerning F&O trading through Index Derivative Consultation Paper dated 30 July 2024.^[8]

The key proposals are:

1. Increasing the minimum contract size for index derivatives

It is proposed to increase the threshold from ₹5 lakhs (~USD 6,100) to between ₹20 lakhs (~USD 24,000) and ₹30 lakhs (~USD 36,200) in a phased manner. By increasing the threshold, SEBI intends to ensure that only traders with significant financial resources can participate in these markets. This rationale is designed to protect smaller retail investors from engaging in high-risk trades that could lead to substantial losses, effectively creating a safer environment by limiting participation to those with the financial capacity to absorb potential losses.

• Upfront collection of premiums

In F&O trading, premium is the cost of buying an option. Prior to the issuance of Index Derivative Consultation Paper, no regulation mandated upfront payment of premium by options buyers, a situation that facilitated high-risk trading practices due to the volatile nature of options prices. To mitigate risks and discourage traders from assuming positions exceeding their financial capacity, the proposal suggests that brokers should secure the complete options premium from buyers before executing any trades.

SEBI’s proposal reinforces the requirement that this amount be paid in full at the time of executing the transaction. This is an attempt to reduce the risk of defaults and adding an additional layer of security to the market.

• Increasing the margin requirements

Margin money refers to the quantum of funds that a trader must deposit with their broker to initiate and maintain a position in F&O trading. It also serves as a financial safety net.

Under the present regulations, margin requirements do not increase as contracts approach expiry, despite increased trading activity and volatility. This situation poses major risk, particularly for options traders. To address this concern, it’s proposed to adjust the margins near the expiry date.

Increasing the margin requirements closer to the expiry ensures that traders are better equipped to handle any sudden market fluctuations. This adjustment is particularly important as contracts near expiry are more prone to sharp price movements. By requiring higher margins, SEBI aims to mitigate the risks associated with these fluctuations, thereby protecting both individual traders and the broader market from potential instability from any defaults on account of significant price movements resulting in greater losses.

• Rationalizing weekly options

This proposal seeks to limit the number of weekly expiries that exchanges can offer. Currently, there are multiple expiries within a week. For instance, the NSE offers four distinct contracts with weekly options expiries in the Indian markets which are MIDCAP NIFTY, FINNIFTY, BANKNIFTY, and NIFTY expiring on Monday, Tuesday, Wednesday and Thursday, respectively leading to increased market activity and volatility, making the market unpredictable. By restricting exchanges to a single weekly expiry, SEBI aims to reduce this volatility, fostering a more stable trading environment.

Our thoughts

Several factors have contributed to the surge in derivative trading. The proliferation of user-friendly stock trading apps and complex derivative platforms has democratized access to financial markets. These apps often feature low or zero-commission models and are integrated with digital payment systems, making it easier than ever for new participants to access the market. Additionally, the emergence of financial influencers (finfluencers) on social media platforms has further fuelled this trend.

While these developments have attracted millions of new participants, they have also introduced significant challenges. Many platforms lack robust risk management tools and safeguards, leaving inexperienced investors vulnerable to high-risk products they may not fully understand. To mitigate these risks, SEBI is considering developing clear guidelines for financial advice on social media, implementing verification systems for qualified advisors, and enhancing its monitoring capabilities.

The surge in retail participation in derivatives trading is not just a result of regulatory gaps but also a symptom of broader economic and social factors. A shortage of attractive investment alternatives beyond traditional options, coupled with retail investors’ behaviour which views derivates as a quick path to financial success, leads to emotions led decision-making resulting in cycle of losses creating systemic risks. 

Therefore, while the Indian stock market’s bull run has created opportunities for wealth generation, it has also exposed retail investors to significant risks, particularly in the derivatives market. The challenge for regulators and policymakers is to strike a balance between fostering market growth and protecting investors from excessive speculation. As the market continues to evolve, it will be crucial to educate investors about the risks involved and implement robust safeguards to prevent widespread financial losses.

[1] John Jenning, “Investors, Don’t Succumb To The Fear Of Missing Out” https://www.forbes.com/sites/johnjennings/2021/02/17/investors-dont-succumb-to-the-fear-of-missing-out/

[2] Economic Survey 2023-24, “Monetary Management and Financial Intermediation: Stability is the Watchword” https://www.indiabudget.gov.in/economicsurvey/doc/eschapter/echap02.pdf

[3] SEBI, ‘Consultation Paper on Measures to strengthen index derivatives framework for increased Investor protection and Market stability” https://www.sebi.gov.in/reports-and-statistics/reports/jul-2024/consultation-paper-on-measures-to-strengthen-index-derivatives-framework-for-increased-investor-protection-and-market-stability_85279.html

[4] Economic Times, “India’s options trading boom hides billions of losses for retail traders”, https://economictimes.indiatimes.com/markets/options/indias-options-trading-boom-hides-billions-of-losses-for-retail-traders/articleshow/107653413.cms?from=mdr

[5]SEBI, “Study – Analysis of Profit and Loss of Individual Traders dealing in Equity F&O Segment”, https://www.sebi.gov.in/reports-and-statistics/research/jan-2023/study-analysis-of-profit-and-loss-of-individual-traders-dealing-in-equity-fando-segment_67525.html

[6] Times of India, “Finance Sector governance needs highest priority says RBI Governor” https://timesofindia.indiatimes.com/business/india-business/finance-sector-governance-needs-highest-priority-says-rbi-governor/articleshow/111329043.cms

[7] The Hindu, “Unchecked explosion in retail F&O trading can create challenges”, https://www.thehindu.com/business/unchecked-explosion-in-retail-fo-trading-can-create-challenges-fm/article68175441.ece

[8] Id at 3