Moneycontrol Pro Panorama | Regulatory overreach puts capital market growth at risk

Market depth and India's appeal to foreign investors

Dear Reader,

The Reserve Bank of India sent shockwaves through India's capital markets with sweeping new regulations that could fundamentally alter the trading landscape. The central bank's decision to tighten liquidity rules for market intermediaries threatens to disrupt one of the world's most vibrant derivative markets, potentially affecting employment, market depth and India's appeal to foreign investors.

The immediate impact was visible on February 16, when shares of capital market entities plummeted by close to 10 percent following the announcement. The new framework mandates that brokers provide full collateral—including substantial cash components—against loans for proprietary trading, while effectively barring bank funding for securities acquisition on a broker's own account. This represents a dramatic departure from previous norms and strikes at the heart of how Indian markets have functioned for years.

Proprietary trading firms, which accounted for over 50 percent of equity options turnover on the exchanges last year and nearly 30 percent of cash equities trading, face the most severe consequences. These firms have been instrumental in creating jobs across broking and trading operations, providing a new employment avenue in the financial sector.

Under the old system, brokers could obtain bank guarantees for a modest fee of 1-2 percent, requiring their own contribution of just Rs 10-20 crore for a Rs 1,000 crore exposure. The new rules demand at least 50 percent cash collateral, exponentially increasing the cost of operations.

The ripple effects extend far beyond proprietary desks. High-frequency traders and arbitrageurs—who perform critical functions like cash-futures arbitrage and options market-making—will find their business models severely compromised. These low-margin, high-volume strategies help narrow spreads and improve price discovery, essential functions for a healthy market. Industry veterans warn that forcing near-100 percent collateralisation could render many arbitrage strategies commercially unviable, not merely more conservative.

There is little logic in asking brokers seeking bank funding to provide full collateral when they must already provide equivalent collateral, suggesting they might as well deploy those funds directly with clearing corporations.

The margin trading funding business, currently worth Rs 1,00,000 crore, also falls victim to the new regime. While technically permitted, the requirement for cash or government securities as collateral makes it practically useless for brokers, as they would have little incentive to borrow against assets they already possess, especially since exchanges set these margins to provide limits.

Tightening margins, making trading costlier through taxes, and now squeezing liquidity from the system give market participants the impression that the government is not keen on encouraging trading in Indian markets, both in the derivatives and cash markets. India's capital markets already operate under stringent oversight from SEBI and exchanges, with upfront margining, real-time risk monitoring, and tight collateral norms. The additional bank-level constraints could have unintended consequences.

The broader implications are concerning. Reduced liquidity could widen bid-ask spreads, increase impact costs, and make execution more expensive for institutional investors, including foreign portfolio investors who rely on tight spreads to trade efficiently. This could diminish India's attractiveness for global capital allocations and increase trading costs across the board.

In the months ahead, it remains to be seen whether India's highly liquid markets can adapt to these sweeping changes or suffer an extended period of subdued activity. Many traders have already begun exploring alternative markets abroad—such as global equities, cryptocurrencies, and forex—to sustain their operations. Imposing such restrictive measures may only accelerate this exodus.

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