SEBI’s proposed F&O measures: Derivatives volumes, cash market could be potential collateral damage

The proposed measures by the Securities and Exchange Board of India (SEBI) to regulate Futures & Options (F&O) are likely to have a cascading impact, from reducing volumes in the derivatives segment to even affecting the cash market. A similar situation unfolded in South Korea a decade ago when the regulator raised minimum deposits and mandated education for F&O trading to protect retail investors, which resulted in a significant drop in volumes. Later, the South Korean regulator had to partially relax the rules.

According to industry experts, the market serves as a transmission mechanism and requires a variety of participants. If there is a higher threshold for entry, retail investors may be unable to enter the market for hedging. “Implementing such measures could decrease activity from market makers and liquidity providers. If market makers, who profit from options, reduce their activity, this reduction could extend to the cash market as well,” they suggest. 

“Even as a normal retail investor, if I want to hedge using Rs 5,000 or Rs 10,000, why should I be restricted? If that activity reduces, then market makers also reduce their activity, which can unintentionally affect the cash equity side. Suddenly, impact costs might increase, and even long-only, long-term funds might see reduced returns or lower activity due to the increased market impact,” explains Rishi Kohli, CIO of Hedge Fund Strategies at InCred Asset Management.

The government earns Rs 60,000 crore annually in taxes from equity market with no cost to collect, no leaks, and no administrative expenses. “This is the easiest money for the government. It is almost two and a half percent of direct tax collection,” says Jimeet Modi, founder of SAMCO Securities. According to data, only a third of this money comes from retail investors, while the rest comes from institutions and high-net-worth individuals. Any restrictions could reduce tax revenue and increase liquidity and impact costs. In a highly liquid market with lots of buyers and sellers like in NSE, impact costs are typically lower. In less liquid markets like BSE, the impact cost is higher because each trade has a greater effect on the price. For example, removing just a few participants could push up the costs of trading, creating risks related to both liquidity and market impact. “By curbing trading, you will actually give rise to larger risks. The lack of liquidity causes systemic risk,” warns Modi. 

“Imposing charges is not the right option, as imposing charges will increase the cost, resulting in losses. More so, an increase in charges will not significantly impact the market dynamics, market movements, volume, and other key parameters,” says Atul Parakh of Bigul. 

Zerodha’s founder and Chief Executive Officer Nithin Kamath said in X that the  suggested changes, even with the STT increase, won’t really change options volumes. But on the flipside, they will reduce futures volumes. “From what I’ve seen at Zerodha, futures traders have higher odds of making money than option buyers. On a gross basis, futures traders are profitable about 50% of the time as  opposed to options traders, who are only profitable about 10 per cent of the time. This is because options come with almost unlimited leverage, whereas leverage on futures is capped at 6 times (15 per cent for index),” he said. 

Kamath  suggested that if the intent is to reduce speculation, then the solution is maybe to make it harder for non-serious people to trade by having a product suitability framework. Are we focusing on the wrong issue? The real factors behind the decline in household savings are higher inflation and rising interest rates, which are eroding people’s savings.

Experts suggest that India should aim to be a developed country by embracing free markets rather than constrained ones. The more restrictions imposed, the less likely a nation is to achieve developed status. 

“You must allow the power and economics of free markets to operate independently,” says the head of a domestic brokerage house. Modi of SAMCO Securities, advocates learning from the US markets. “The US markets do not interfere; they regulate the market and create awareness. But the market and the collective wisdom of its players are supreme,” says Modi while adding, “You will never become a developed or supreme nation if you do not allow the power and economics of free markets to operate and exist.”