India’s stock market activity has grown by leaps and bounds since 2018, when the Securities Exchange Board of India (SEBI) last set its eligibility criteria for the inclusion of new stocks into the derivatives segment. Between May 2018 and May 2024, NSE market capitalisation is up nearly three-fold, while daily average cash turnover is up nearly four-fold. Therefore, SEBI’s recent consultation paper to revise the metrics on the basis of which the exchanges choose stocks for the futures and options (F&O) segment, is timely. The new eligibility criteria rightly set a high bar on the liquidity and activity parameters that stocks would need to meet, to be eligible for F&O trading.
A stock would now need to have a market-wise position limit (a limit set by exchanges on open positions) of ₹1,250-1,750 crore as against the current norm of ₹500 crore. The average daily delivery value in cash market should be ₹30-40 crore instead of ₹10 crore. It should also have a median quarter sigma order size (the order size needed to move prices by one-fourth of standard deviation) of ₹75-100 lakh instead of the present ₹25 lakh. The new criteria are likely to lead to significant churn in the F&O segment, if implemented. About 25 of the 182 F&O stocks are expected to fail these tests and exit, while 70-odd new stocks may be added.
This disruption is positive for market integrity; it is desirable that only the most liquid and actively traded stocks, with the ability to absorb large volumes without undue price volatility, feature in F&O. F&O participants take on significant leverage to punt on small price moves in the underlying security. Therefore, stocks with poor liquidity or high impact cost may be prone to easy manipulation by operators. Such protective mechanisms for F&O traders have become quite necessary in India because of the high retail interest in equity derivatives, with individuals accounting for 35 per cent of equity options and 20 per cent of equity futures turnover.
However, for the healthy evolution of the F&O market in India, SEBI would need to do much more. The world over, the primary purpose of the derivatives markets is to facilitate efficient price discovery and hedging for long-term investors. In India, there seems to be a disconnect between the indices and stocks which hog F&O volumes, and those which are widely held by institutions such as mutual funds and pension funds. To ensure that domestic institutions are able to participate as hedgers and arbitrageurs in equity derivatives, the criteria for inclusion of stocks and indices into F&O should factor in qualitative metrics such as institutional ownership, passive assets tracking them and fundamental/governance metrics (in the case of individual stocks). Subjecting retail investors to eligibility criteria to participate in F&O, in terms of their underlying holdings in the cash market and investing experience, may not be a bad idea.