How SEBI’s proposed regulation on derivatives will impact retail investors

April 24, 2018 12:37 PM

SEBI’s press release of their recent board meeting has revealed a new set of regulations for retail traders in the derivative markets.

sebi, derivative markets, retail investors, CFD platforms, Dabba trading , F&O trading,To rationalize and strengthen the framework of the equity derivatives market, SEBI has proposed to introduce some measures.

Market regulator SEBI’s press release of their board meeting on 28th March 2018 revealed a new set of regulations for retail traders in the derivative markets. Since 2017, there was discussion in the market that the regulator is seeking to reduce retail traders’ exposure in the derivative segment because they had published a discussion paper titled “Growth and Development of Equity Derivatives Market in India” and “Physical settlement in stock derivatives” in July 2017.

According to the report, India has the second highest derivative to equity turnover ratio in the world after South Korea at 15.59:1. However, it is very important to note that the turnover ratio overstates reality because NSE publishes notional turnover and not premium turnover. If premium turnover is calculated, the ratio reduces to 2.5:1. It makes a really huge difference. For instance, the data of top 20 derivatives contracts on NSE consistently shows that notional turnover reported by the exchange is a gross exaggeration of the actual premium paid/received by traders and portrays a completely wrong picture of the reality.

As shown on NSE’s website as on 9th April 2018, the premium turnover is a fraction of the reported notional turnover. On average the premium turnover of the top 20 derivative contracts is less than 0.5% of the notional turnover which means that notional turnover is a grossly overstated.

However, SEBI is concerned because the compounded annual growth rate for derivatives is much higher than equities 35.1% and 11.39% respectively since 2004-05. The increase in the turnover is mostly because of the rising index levels and notional turnover in the options segment. Up to 75% of the equity derivatives turnover comes from proprietary traders, FPIs, DIIs, corporates and others. Only 25% comes from retail participants. In fact, the reason why retail participation seems to be as high as mentioned is because most foreign investors prefer to trade the Nifty index in foreign exchanges such as Singapore Stock Exchange (SGX), London Stock Exchange (LSE) and Chicago Mercantile Exchange (CME) to avoid the high taxes imposed in India. If those volumes are accounted for, retail participation will be much smaller of the total pie.

To rationalize and strengthen the framework of the equity derivatives market, SEBI has proposed to introduce some measures. The most important of them are:

1. Physical settlement for all stock derivatives which shall be implemented in a phased manner.

2. The criteria for introduction of new stocks to derivative segment shall be tightened.

3. Individual investors shall take position in cash & derivatives up to a computed exposure based on their disclosed Income Tax Returns (ITR).

Of the above 3 points, the fact that SEBI wants to restrict retail traders’ exposure by imposing barriers based on ITR computation has already caused a lot of disappointment among the active retail trading community in India who already feel burdened by the multiple taxes & levies imposed on them (STT, GST, STCG, Stamp Duty, NSE Turnover charges) and now further restrictions to limit their participation in the derivative markets based on ITR declaration. For traders, trading is like a business and no other small business requires proof of previous income to undertake the venture. So the overwhelming feeling among them is, why should this be applicable for F&O trading? They also feel that if borrowing is allowed in business, it is only fair that it should be allowed for investing too.

The potential impacts of this regulation are:

# The retail traders will feel that their freedom to decide how to invest their own hard earned money will be further compromised despite having sufficient knowledge in derivatives simply because of income tax declaration. This will affect the price discovery mechanism if the limits are based on ITR as most traders declare income of less than Rs 10 lakh per annum. In the absence of these traders who are large in number, it can lead towards a lopsided market with lack of diversity.

# Liquidity will most likely dry up in the stock options segment to a large extent because they are already less liquid and account for only 6.47% of the total equity derivatives turnover. If you observe the next and far strike prices of stock options, there is barely any liquidity and the spread are really wide. Retail traders need to be encouraged to participate in this segment to make the markets more efficient, but the proposed regulation will further reduce the existing liquidity and potentially making the instruments non-tradeable.

# It will encourage traders to opt for Dabba trading rather than brokers who are members of the exchange to circumvent regulations. In the quest to trade as per their own limits rather than of ITR declaration, they will also end up evading taxes which is not a desirable outcome. It can give rise to many malpractices which can become a menace in the long-run.

# It discourages the risk taking culture that is inborn in traders. They will look for other alternatives to earn money where the risks are perhaps far greater than stock market investments. They may resort to high-risk lending, trading on illegal CFD platforms or even gambling.

# This may defeat the purpose of regulation and it will also dis-incentivize education because new participants may not want to learn about these derivatives as there are upper limits to exposure and the amount of money they can make is restricted. People who want to make money usually have a scarcity of it. An income based restriction can be understood as draconian by the new and existing traders which can potentially damage the long-term awareness about these instruments.

(By Tejas Khoday, Co-Founder & CEO, FYERS)

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