SEBI needs to find a fine balance between regulation and market development on index derivatives

SEBI should keep one eye firmly on efficient price discovery, which is the core staple of a well-regulated capital market.

The Securities and Exchange Board of India’s (SEBI’s) recent consultation paper proposing several amendments in the index derivatives framework has triggered a significant volume of strong opinions.

As the details get scrunitised with fine-tooth combs, a key nuance that, perhaps, has received a relatively underrated attention is the capital market watchdog’s multiple responsibilities straddling regulation, investor protection and market development.

Tension between regulation and market development

SEBI's proposed changes listed in the consultation paper owing to the increased participation in F&O (futures & options) trading, include increasing contract sizes by as much as four times, collecting options premium upfront and reducing the number of weekly contracts.

It has also suggested reducing weekly option contracts, increasing the contract size by multiple times, to make it harder for retail investors to participate in it or in a kind of "reverse sachetization". It has also favoured upfront collection of premiums from options buyers, eliminating margin benefits for calendar spread positions involving contracts expiring on the same day, implementing intraday monitoring of position limits, increasing the minimum contract size for index derivatives, limiting the weekly expiring index contracts to just one per exchange and increase in applicable margins for index option contracts prior to expiry.

There is no gainsaying the abundant emphasis that needs to be given on regulation, which remains SEBI’s primary responsibility. What, however, the latest consultation paper has set off is whether the regulator has unwittingly positioned this as some kind of a tug-of-war between regulation and market development.

Short of hedging options?

For instance, SEBI's proposal to allow introduction of options' strikes only up to four per cent around the prevailing index price with not more than 50 strikes at the time of introduction, can potentially spark erratic disruptions, particularly in a volatile market scenario.

A recent case in point can be seen in Japan’s Nikkei. It fell more than 13 percent on August 5 and rebounded sharply by 10.2 percent the next day on August 6.

It is par for the course that Indian markets can also be prone to such wild swings for a variety of known unknowns and unknown unknowns. A question that, however, arises now is whether SEBI’s proposals will leave the market participants without a reasonable hedging and risk management opportunity if Indian markets were to experience volatility of a similar magnitude.

Risks may increase

There is a view that SEBI’s proposals could significantly raise the risks pertaining to concentrated positions and, as a consequence considerably raise the risk of potential losses associated with sudden spikes and troughs.

There is also the proposal to increase the applicable margins, a tool used by regulators to control the risks associated with trading activities, near the contract expiry just to control market activity and volumes.

While SEBI has its rationale for suggesting changes in the existing system that has withstood volatility including during exogenous events such as the Covid pandemic, it should also be judged from the capital requirement point of view. Any upward increase in the applicable margins could lead to higher capital requirements during periods of heightened market activity and volatility This could force traders to keep their positions unhedged, potentially exacerbating volatility and market instability.

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A relevant question to ask is: to what extent will the plan to monitor position limits on intra-day basis serve as an additional risk management tool? This question will be particularly appropriate when the existing directives require deposit of upfront margins for creating any open position.

There is always the possibility that such a move will dissuade HNI clients from active participation in equity derivatives. This could potentially have a cascading and adverse bearing in both the market liquidity as well as volumes and eventually hurt the retail investors who cannot afford to breach prescribed open position limits.

Beware unintended consequences

In the final analysis, SEBI should keep one eye firmly on efficient price discovery, which is the core staple of a well-regulated capital market. This is a complex trade-off for SEBI to make.

The key constituent to watch out for is that the quest for creating a rigid regulatory architecture with appropriate checks and balances should not unintentionally end up leaving a potential for worsening market volatility, widen bid-ask spreads, discourage the use of common risk management strategies, increase transaction costs, cut down market participation, and erect barriers in development of the equity derivatives segment.