Mint Explainer: Why Sebi and RBI want retail investors to stay away from derivatives

The Reserve Bank of India and the Securities and Exchange Board of India are closely watching the equity derivatives segment, where volumes have grown exponentially over the years. 

This is thanks to the increased participation of retail investors and proprietary traders, who account for 80% of the gross notional turnover on the National Stock Exchange of India.

Although there is no threat to financial stability, the regulators would prefer it if retail investors participated in the cash market and generated long-term wealth instead of using the derivatives segment (to the exclusion of the cash market) for punting, which exposes them to potential hefty losses. 

Mint explains why Sebi and RBI are increasingly concerned about retail investors trading in derivatives.

What are derivatives?

Derivatives are financial instruments that derive their value from underlying market indices, stocks, bonds, commodities, or currencies. Their utility is for price-discovery and transparency. These are also used as hedging tools by foreign and domestic institutional investors and by wealthy, or so-called high net-worth, individuals. 

Retail investors have been attracted to index options over the years because it is much cheaper than buying shares in the cash market or taking up futures contracts.

There are two types of derivatives: futures and options contracts. These facilitate the purchase or sale of an underlying asset, security, commodity or currency at a predetermined price for delivery on a future date.

Hedgers use derivatives to protect their stock portfolios against volatility, which is the price deviation from the mean. Speculators take on the risk that hedgers seek to cover themselves against losses. For liquid markets and efficient price discovery, hedgers, speculators, arbitrageurs and jobbers are needed.

How has the derivatives cult grown?

The notional turnover of derivatives on the NSE, the country's biggest exchange, jumped 23-fold from ₹3,445 trillion in FY20 to ₹79,928 trillion in FY24, as per the NSE. Index options (Nifty, Bank Nifty and Finnifty) accounted for 98.5% of the total turnover.

The NSE launched weekly options on the Bank Nifty index in May 2016, followed by weekly Nifty options in February 2019, the Nifty Financial Services (Finnifty) index in January 2021, and the Nifty Midcap Select Index in January of the following year. The BSE launched Sensex options in May last year.

Also read | Why Sebi’s reviewing the eligibility criteria for derivatives trading

The weekly options became a hit with retail and proprietary traders after the pandemic, which had confined people to their homes for two to three years. This was borne out by the growth in the number of dematerialised accounts, which investors need to trade in securities.

From 40.8 million demat accounts at the end of FY20, the count had swollen to 151.38 million at the end of FY24 and currently stands at 158.04 million, according to depository data. With so many new investors in the cash market, many have also been lured to the derivatives segment, especially options.

There is an option expiry on each day of the week, making the pull on investors habituated to speculating irresistible. On Mondays, you have the expiry of the Nifty Midcap Select, on Tuesday Finnifty, Wednesday Bank Nifty options, Thursday Nifty, and Friday Sensex options. 

What’s the attraction?

The cost. Buying a 23,500 Nifty call options contract expiring on 20 June costs a provisional ₹2,586. A Nifty futures contract expiring on 27 June, on the other hand, entails putting up a margin upwards of ₹1 lakh.

A call option allows you to buy and a put option allows you to sell an underlying asset at a future date in exchange for a premium (price) paid to the call and put option seller (writer). Though options can be exercised only upon expiry, they can be squared off during their contract life.

The maximum loss to the buyer is limited to the premium paid to the seller. However, the maximum loss of the seller is unlimited because of sudden and steep market moves, as seen on election results day on 4 June.

What are the regulatory concerns?

While the equity cash market turnover has grown to ₹201 trillion in FY24 from ₹89.98 trillion in FY20, index options' notional turnover swelled 25 times over the same period to ₹78,677 trillion on the NSE, as per exchange data. 

This means the derivatives market (notional basis) has become 391 times the size of the cash market from just 34 times in FY20. This indicates the interest in the derivatives market for retail investors and proprietary traders.

Sebi earns its regulatory fee on the notional turnover of options and not on the premium turnover, which at ₹138.19 trillion in FY24, is just 0.17% of the notional turnover of ₹78,677 trillion.

Securities transaction tax is on the premium turnover and not on the notional turnover. Likewise, exchange transaction charges are on premium turnover. The premium turnover of options has grown a more modest 12.8 times to ₹138.19 trillion in FY24 from ₹10.79 trillion in FY20.

That is probably why RBI governor Shaktikanta Das said at a media event recently that the financial market is not overheated.

Also read | Derivatives trade: Sebi is taking a pro-market approach

However, both Sebi and RBI feel that if part of the premium turnover were to flow into the cash market as long-term investments, it would help in wealth-creation rather than just be used to punt or speculate.

When shares are bought in an initial public offering, the proceeds that flow to the company are used to build and expand operations, which help in wealth creation as the value of the share will rise concomitantly with the company’s earnings and growth. This enables long-term investors to fund the education needs of their children, buy a car or home and add to economic activity.

However, if money is predominantly used to punt on options, no wealth is created. Money merely moves from the loser's pocket to the gainer. The gainer may deploy the earnings in speculating on real estate or gold, which spurs inflation and reduces national savings in the long term.

Another worry of the regulators is that with just a fraction of the funds that are deployed in options, one can influence prices or movements of the underlying indices - like the tail wagging the dog. Futures prices should be aligned with spot prices and they should not hugely deviate from each other. Then the market moves as per fundamentals rather than just on speculation.

What are the possible solutions to this?

Sebi could raise margins to trade or stipulate a minimum number of lots (contracts) that can be traded to rein in heavy retail speculation and the propensity for losses (it estimates that nine out of 10 retail investors lose money in derivatives trading).

The JR Varma Committee set up by Sebi in March 1998 recommended a Value at Risk (VAR) margining system to deal with market volatility and contain risk, just as the LC Gupta Committee, which laid the framework for derivatives trading two years ago, suggested keeping a minimum lot size to keep retail investors at bay from derivatives.

However, as the Nifty lot size has been halved in April to 25 shares from 50 shares to keep it within the ₹5-8 lakh price band, a minimum number of lots could be stipulated for a futures or options trade -- i.e. minimum 10 lots or so, rather than just one lot with 25 shares.

Risk disclosures put up by brokers on their trading applications about the pitfalls of derivatives trading haven't really reined in retail investors, so the workable solutions would be to increase margins to write or sell options or tinker with lot sizes.