For some time now, the Securities and Exchange Board of India (SEBI) and government officials have been dropping hints about the untrammelled rise in retail derivatives trading in stock markets doing more harm than good to the economy. SEBI’s latest consultation paper on the subject points to its willingness to act on this score. To those who ask why regulators should worry if individuals choose to punt on derivatives, the paper offers data showing that this is a macro concern.
Globally, the primary purpose of derivatives is to allow investors to hedge price risk on assets they own. In India though, new investors joining the stock market since Covid have been skipping shares and mutual funds to make a beeline for derivatives. About 12.2 crore new demat accounts were opened between FY20 and FY24. In this period, retail turnover in the derivatives market doubled from ₹35 lakh crore to ₹71 lakh crore; likewise, futures and options (F&O) turnover almost doubled from ₹63 lakh crore to ₹117 lakh crore. Volumes are now concentrated (62-96 per cent) on expiries in weekly index options, where individuals punt on contracts at risk of dwindling to zero. In FY24 alone, the 92.5 lakh retail investors who traded index derivatives on the NSE made collective losses of ₹51,689 crore — household savings that could have been more productively used. These punts result in flight of capital too, as the counter-parties are often global algo-trading and high frequency shops.
In this light, SEBI’s proposals to rein in retail participation in derivatives do not seem excessive. Rather than completely ban contracts with weekly expiry, SEBI proposes to allow one index contract with weekly expiry from each exchange. It plans to raise the minimum lot size on contracts from the current ₹5-10 lakh to ₹15-20 lakh and then to ₹20-30 lakh, in phases. Brokers will be required to collect higher margins on expiry day and the day before. Exchanges will be asked to reduce the number of strike prices offered on each index contract to 50, so that there are fewer out-of-the-money strikes to bet on. Of these measures, increased lot size is likely to have the maximum deterrent effect. Derivatives trading, like gambling, is an addictive activity. Therefore, these retail traders may well crowd into weekly contracts and out-of-the-money strikes that remain open to them, or migrate to other risky segments such as SME platforms, penny stocks or commodity derivatives. In fact, individuals who are really hooked may even get around bigger lot sizes by borrowing to trade, exposing them to financial ruin.
SEBI must consider strict screening criteria for admitting investors into derivatives. Derivatives trading can be made conditional on holdings of equities/mutual funds and minimum years of experience. If these measures do work, though, stock exchanges, depositories and discount brokers will feel the heat on their revenues, profits and valuations. SEBI must resist pushback from this ecosystem.