Analysis: Mixed signals from regulators confuse derivative traders in India

India's F&O market has seen huge surge in trading volumes

India's derivatives or futures and options (F&O) market is currently navigating through uncertainty as conflicting signals from regulators have left investors confused even as the balance between regulating speculative activities and maintaining market vibrancy remains a delicate challenge for policymakers.

The surge in trading volumes has sparked concerns among authorities and market participants alike, triggering a debate on how best to address the risks associated with derivatives trading. During recent pre-budget consultations, asset management firms are said to have advocated an increase in the Securities Transaction Tax (STT) on derivative trades, especially those carried out by algo-based funds. Their argument is that higher taxes could deter excessive speculation, which they fear could destabilize the market.

Meanwhile, the Securities and Exchange Board of India (SEBI) has been cautioning retail investors against speculative trades for the past two years. SEBI's warnings are based on data showing that up to 90% of retail traders fail to profit from derivative trading, underscoring the risks associated with F&O trading. The rapid growth in retail participation in derivatives has raised significant concerns about market stability. F&O contracts derive their value from underlying equities, making them susceptible to volatility that could spill over into broader equity markets.

Experts have also questioned some recent moves by exchanges, maintaining that these actions have contributed to speculative activity. Questions are being raised regarding the decision the decision of stock exchanges in 2019 to introduce weekly expiries for indices. Some experts believe that the shift from monthly expiries has increased volatility. They argue that the previous monthly expiry schedule helped maintain market stability.

Industry experts are divided on  decision  of stock exchanges to reduce the lot size for Nifty contracts in March this year, which has made derivatives more accessible to small traders. Some experts believe increasing the lot size could effectively create a barrier to entry for retail traders, thereby reducing speculative activities.

Critics argue that the introduction of STT was originally intended to address the absence of a Long-Term Capital Gains (LTCG) tax. Increasing STT rates could disproportionately affect traders and discourage participation in the market. Higher STT rates could deter speculative trading but might also reduce market liquidity and drive away participants. Similarly, increasing lot size aims to raise entry barriers and reduce speculative activities could impact accessibility for small traders and potentially increase transaction costs.

Reverting to monthly expiry schedules might stabilize market activities by reducing trading frequency, but this could face resistance from exchanges and brokers who benefit from increased trading volumes.