THE POLICY LAB (TPL) - 51
SEPTEMBER 10, 2024

By J B Mohapatra

A: A SEBI report of January 2023 - "Analysis of Profit and Loss of Individual Traders in Equity F&O Segment"- presented data to illustrate that 89% of individual traders in equity F&O segment incurred losses with an average loss of Rs 1.1 lakhs during FY 22, whereas 90% of active traders incurred average loss of Rs 1.25 lakhs during the same period. That over and above the trading loss, an additional 28% was expended by way of transaction costs.

B: In July 2024, SEBI's consultation paper -"Measures to Strengthen Index Derivatives Framework for Increased Investor Protection and Market Stability" -- specifically targeted index options within the F&O segment as an area of concern and invited suggestions for tightening its own investor protection measures and for ensuring a comforting level of systemic stability. Data released alongside the consultation paper showed : (a) increase in notional turnover in F&O segment from Rs 1,650 lakh Cr in FY 2018 to Rs 79,927 lakh Cr in FY 2024 (b) increase in ratio of F&O notional turnover to cash market turnover from 19.8 in FY 2018 to 367.8 in FY 2024 (c) 85% of the 92.50 lakh individual and firms who traded in index derivatives in FY 23-24 having made a net trading loss in addition to loss due to transaction costs (d) contrarily, larger non-institutional players that are 'high frequency algo based proprietary traders and/or FPI' in general having made profits in index options.

C: Draft containment measures as suggested by SEBI in its consultation paper included (a) limiting the number of strikes and strike interval to be uniform near prevailing index price (b) upfront collection of options premium (c) denying margin benefit for calendar spread positions involving any contract expiring on the same day (d) weekly options contract to be provided on a single benchmark index of an exchange (e) position limits for index derivative contract to be monitored on intra-day basis and not the prevailing practice of end-of-the-day (f) extreme loss margin (ELM) to be increased by 3% at the start of the day before the day of expiry and by 5% at the start of the expiry day (g) increase the minimum value of the derivatives contract at the time of introduction to Rs 15-20 lakhs range and further increase it to Rs 20- 30 lakhs range in 6 months.

D: While it is apparent that 'hyper activity' as SEBI terms the volumes growth in index options as one segment of F&O trading that needed an augmented level of monitoring through newer forms of regulation, some extracts from the consultation paper containing some data and a prima facie position of SEBI are worth quoting.

At para 3.6.3 the report says : "Also in many cases, the expiry day trading in options constitutes as high as 80-90% of overall notional turnover of the weekly index option contracts in expiry week."

At para 2.3.6 of the report, it says : "This lower premium on expiry day likely makes the F&O trading on that day an accessible, cheap and enticing lottery ticket for some individuals to purchase, sell, and speculate on, irrespective of low the odds of success may be. It is very difficult to attribute any kind of benefit to the overall securities market ecosystem and capital formation from such concentrated hyper activity in derivatives on expiry date."

At para 3.6.2 of the report, it says : "Expiry day trading is almost entirely speculative. Given there is an expiry of weekly contracts on all five trading days of the week combined with previous findings on increased volatility during closing time, speculative activity created near contract expiry and poor profitability outcome for individual investors in F&O segment, rationalisation is warranted in the product offering."

E: Further, data from SEBI's Current Statistics for FY 22-23 below with regard to the explosive pace of growth of the derivatives market buttresses the position that SEBI has taken up in the consultation paper of 2024:

i) Distribution of turnover on Cash Segments of NSE was Rs 133 lakh Cr. Distribution of notional turnover at NSE in Stock Futures on the other hand was Rs 190 lakh Cr, and in Stock Options the notional turnover was Rs 408 lakh Cr (call) and Rs 183 lakh Cr (put).

ii) Distribution of notional turnover in Index Futures at NSE was Rs 95 lakh Cr and notional turnover in Index Options was Rs 19,334 lakh Cr (call) and Rs 18,010 lakh Cr (put).

iii) 27.4% of turnover in cash segment came from proprietary concerns, whereas proprietary concerns accounted for 53.2% of turnover in equity derivative segment at NSE.

F: Derivatives, it may be noted, were neither defined nor included for the purposes of recognising them as 'securities' when the Securities Contracts (Regulation) Act, 1956 was originally enacted. It was through Securities Laws (Amendment) Act, 1999 that requisite amendments were made in section 2 of that Act as under:

In section 2(ac):

"derivative" includes-

(A) a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;

(B) a contract which derives its value from the prices, or index of prices, of underlying securities;

In section 2(h):

(h) "securities" include-

(i) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate;

(ia) derivative;

F: Currently, equity derivatives (stock and index futures and options), currency derivatives (futures and options), interest rate futures, and commodity derivatives confirm to the definition as provided in section 2(h) of SCRA, 1956 and allowed to be traded at the stock and commodity exchanges.

Derivatives as defined in the amendment to SCRA, 1956 provide for 'futures'- a form of contract for sale for delivery in future at a price determined today- and 'options'- essentially a 'future', where one party has the option to repudiate a contract. In both forms, the underlying asset at the foundation of the contract is neither delivered nor received, since the seller of the contract is neither expected to own the underlying asset nor the buyer is expected to have an intention of receiving the delivery of the underlying asset. What makes the derivative market appeal to the investing public is the low relative cost of holding an inventory compared to that in the cash market, since a derivative contract is settled on payment by one of the contracting parties of a 'premium' determined upfront by the occurrence or non-occurrence of a future event, unlike a trading transaction in the cash segment where the full value of the consideration is actually paid for or received. In the working of gross notional turnover of stock options contracts (call) at NSE for FY 22-23 for example, the premium component is Rs 6.32 lakh Cr against a notional turnover of Rs 408 lakh Cr. These 2 aspects - the low cost of holding and low entry barriers- are without a doubt the triggers for an exponential growth in investments in derivatives sector and now the subject for policy deliberation at the level of the regulator.

G: SEBI's consultation paper of July 2024 in that context contains the essential and standard risk containment measures including the calendar spread, margining requirements, position limits and periodic reporting as further attempts at regulating the derivatives market. On areas of taxation as a measure for regulation, the increase in STT on F&O in the Budget 2024 should have an impact.

H: An area deliberated in SEBI's consultation paper is the poorly understood level of technicalities of trading and speculative impulse of sizeable section of investors in derivatives market. When the paper says that 'concentrated hyperactivity' in derivatives market may not be benefiting the overall securities market ecosystem or assist in capital formation, the oblique implications are the derivatives market neither brings liquidity nor aids in accuracy in price discovery, and on the contrary the social costs might be outweighing its benefits.

I: While draft risk containment measures in the consultation paper are definitely intended to subdue the overly speculative impulse in the derivatives market, the amendments made through Finance Act 2005 to exclude an eligible transaction in respect of trading in derivatives in a recognised stock exchange, and through Finance Act, 2013 to exclude an eligible transaction in respect of trading in commodity derivatives in a recognised association from being deemed as a 'speculative transaction' within the meaning of section 43(5) of the Income Tax Act are worth a fresh appraisal. It is a zero sum game for the revenue to impose taxes on profit from derivative trading in 11-12% of overall cases who have reported a profit, while foregoing equal amount of taxes claimed by 88-89% of overall cases who claim to have incurred a loss.

While India's derivative market at this stage of development must not go back to the common law contract rules and start honouring only those transactions contracted for hedging purposes as advocated by some theorists, it is equally important that a concerted effort to effectively quell the speculative impulse of a sizeable section of investors and bridge the knowledge asymmetry among the many classes of investors in the derivatives market is made through meaningful law and regulation not just at the level of SEBI but across all stakeholders.