Sebi proposals seek orderly conduct in F&O market amid volatility

Even as its proposed measures and those announced last year have helped, Sebi will need to be fleet-footed in its regulation and supervision of this market

Indian equity markets witnessed an unprecedented surge in derivatives trading over the past five years, becoming the world’s largest derivatives market with a notional turnover of $6.4 trillion a day and annual option premiums of $2.2 trillion in 2024. The proportion of derivatives to cash market volumes in India is also the highest globally.

 

Market regulator Securities and Exchange Board of India (Sebi) in July 2024 proposed the first set of measures to contain this unfettered growth of derivatives, particularly among retail participants who were incurring high losses (90 per cent, according to a Sebi study). These measures included: (1) Limiting the number of weekly expiries to one per exchange, (2) Raising the minimum contract size, (3) Upfront collection of premium, and (4) Removal of calendar spread benefits on expiry day.

 

These measures started to come into effect from November 2024, and moderation in some of the excesses is visible.

 

1. The number of expiries in a month is down from 20 to eight.

 

2. The sachetisation of index options has been arrested, with the average premium per index option increasing to Rs 3,000 in February 2025 from Rs 1,300 in November 2024. This has come about due to an increase in the minimum lot size and, more importantly, a reduction in the share of expiry day options The share of zero-day-to-expiry options trades is now at 50 per cent of volumes compared to 70 per cent earlier, and 20 per cent of total premiums versus 40 per cent in November 2024.

 

This has resulted in the notional daily traded value of options dropping by 35 per cent, from $5 trillion in November to $3.2 trillion last month. As options volumes have spread out by reducing the share of zero-day options, the impact on a premium-traded basis is lower, at only 15 per cent. The fall in derivative volume also reflects the correction in the equity markets over the past few months. Cash market volumes in February were 12 per cent lower compared to November, not too dissimilar from the 15 per cent decline in option premium turnover. With cash market activity picking up this month, average daily derivative volumes are also up 20 per cent month-on-month in March.  

 

The option premium turnover to cash market turnover ratio remains high at Rs 0.54x in February 2025, similar to the 0.5-0.6x range through last year, still among the highest globally. On a notional basis as well, derivatives to cash market volumes continue to be high at 300x vs 400x in November. After looking to address the froth in the derivatives market, Sebi’s consultation paper last month appears to seek more orderly conduct in the derivatives market.

 

It has proposed (1) Transition to future equivalent (Delta-based) calculation for market-wide position limits for both stock and index derivatives (2) Linking derivative position limits on single stocks to their underlying cash market delivery volumes and (3) Enhancing individual entity-wise derivative position limits while introducing intraday limits rather than just end-of-day limits.

 

As future equivalent limits are more representative of “price sensitivity” or value at risk of the derivatives contract, it is a more appropriate measure. Many regulators globally as well monitor the derivative market using delta-based exposures for the same reason. This limit, pegged at 15 per cent of free float for single stocks, is now significantly more liberal than the 20 per cent calculated on the notional basis stipulated earlier. Back testing in the Sebi discussion paper indicates that the number of stocks going into a derivatives ban will consequently drop by 90 per cent (at 27 vs 366 under current system).

 

At the individual stock level, linking limits to underlying cash delivery volumes will also help ensure that derivative position build-up is not uncorrelated to underlying cash market liquidity, allowing for arbitrage between the two markets.

 

Sebi has effectively enhanced individual entity-wise end-of-day limits on options by retaining it at Rs 500 crore on a future equivalent basis, instead of a notional basis earlier. This change in methodology effectively triples the net end-of-day limit. Gross entity-wise limit has been set even higher at Rs 1,500 crore.

 

It, however, has also introduced intraday limits for individual entities to place guardrails and help prevent domination by a few players. Intraday monitoring of limits will ensure that no single entity, even if deep-pocketed, will be able to trigger intraday volatility by building outsized positions. It has similarly proposed diversification characteristics for benchmarks to reduce the potential for index manipulation by managing the price of a few stocks.

 

India’s option market continues to garner large interest from global as well as domestic investors. The number of retail traders in the derivatives segment increased from 700,000 to 3.7 million over the past five years. Moreover, given its scale now dwarfs the cash market, its orderly conduct is essential for the health of the Indian equity markets and their development. Therefore, even as these proposed measures and those announced last year help, Sebi will need to be fleet-footed in its regulation and supervision of this market and its players.

The author is CIO, Axis Mutual Fund. The views are personal