Risk adjustments: Change on derivatives mkt must be well considered

A consultation paper released on February 24 by the Securities and Exchange Board of India (Sebi) — titled “On Enhancing Trading Convenience and Strengthening Risk Monitoring in Equity Derivatives” — has triggered strong reactions from the Futures Industry Association (FIA). The FIA is a global body that represents many foreign portfolio investors. Sebi proposes to change the methodology for open interest (OI) calculation as well as to revise the position limits on derivatives. It also proposes introducing pre-opening and post-closing sessions for derivatives and outlines eligibility criteria for offering derivatives on indices, which are not benchmark. The FIA claims the Sebi proposals could increase risks of price manipulation, reduce liquidity, and raise trading costs.

 

The mathematical complexity of calculations would increase with the proposed method. OI is defined as the number of outstanding derivatives contracts. At present, OI in single-stock derivatives is measured by adding the notional OI in positions on futures and options. The regulator proposes to aggregate the delta of options positions with futures OI to calculate OI on a given underlying asset. Sebi also proposes using delta as the benchmark for calculating position limits. Delta is a theoretical estimate of how much an option’s value will change for a move of ₹1 up or down in the underlying asset’s price. Delta values range from minus 1 to plus 1, with zero representing options where the premium doesn’t move relative to price changes in the underlying. Sebi believes this delta-methodology is a better representation of the price sensitivity of OI. The FIA’s view is that such calculations are uncommon in global markets, due to the complexities of implementing delta-adjusted thresholds. It requires multiple layers of calculation, monitoring, and dissemination across the trading ecosystem, adding to operational burdens. Due to fluctuating delta (every price change triggers a delta change), there is additional volatility as the limits constantly shift. This complexity makes delta calculations more error-prone.

 

Using delta to define limits on options positions as proposed also has issues. Long options positions with full premium paid (which carry no additional risk by definition, since the entire premium at risk has been paid) would exceed delta limits if there’s a big swing in delta. Other common strategies (such as trading an index along with a component of the index) could also be affected since delta calculations may overstate the risk. The use-cases cited by the FIA are very common. As a result, participants may be forced out even though risk doesn’t increase. This, in turn, may lead to reduced liquidity and higher volatility. The FIA response also cites calculation methods and risk-management measures followed in large markets like Hong Kong and the Chicago Mercantile Exchange, which may be considered as alternatives.

 

If these changes in calculation are introduced, Sebi also proposes to increase the end of day (EoD) limit for entities to ₹1,500 crore (from the current ₹500 crore). While the FIA advocates not opting for this method, if at all Sebi decides to implement delta-based calculations, it wants the EoD limit to be enhanced to ₹7,500 crore.  While the intention of the proposal is laudable, the FIA response does show delta calculation could be inefficient in many common situations. There have actually been no serious defaults under the current methodology and Sebi should consider the FIA suggestions carefully and consider implementing alternative methodologies if it does decide to change the current practice.