Implications of SEBI’s New Framework for Equity Derivatives

What’s in today’s article?

• Why in News?
• What are Equity Derivatives?
• Changes Effective from November 20, 2024
• Changes to be Effective in 2025
• Conclusion

Why in News?

• The Securities and Exchange Board of India (SEBI) has introduced six key reforms to enhance the framework for equity derivatives, commonly referred to as equity futures and options (F&O).
• While three measures take effect on November 20, 2024, the remaining will be implemented in 2025.

What are Equity Derivatives?

• Meaning:
  • Equity derivatives are financial instruments that derive their value from the price movements of an underlying asset, like a stock.
  • These instruments serve as essential tools for risk management, speculation, and portfolio optimisation, allowing traders to engage with equity markets without directly owning the underlying assets.
• Types:
  • Futures contracts:
    • Definition: Agreements obligating buyers and sellers to transact an underlying equity asset at a predetermined price and date.
    • Example: Popular contracts include BSE S&P futures and Nifty IT futures.
  • Options: Contracts giving the holder the right (not obligation) to buy (call option) or sell (put option) an asset at a specific price before or on an expiration date.
  • Swaps: Contracts where parties exchange cash flows based on the return of an underlying equity asset. Used for hedging or investment purposes.
  • Forwards: Similar to futures but non-standardised and traded over the counter (OTC), making them more flexible yet riskier.
• Difference between equity and index derivatives:

• Changes Effective from November 20, 2024:
• Recalibration of contract size for Index derivatives:
  • New rule: The minimum contract size for index futures will increase to ₹15–20 lakh from the current range of ₹5–10 lakh.
  • Objective: Ensure participants take on manageable risks while trading in derivatives.
  • Impact:
    • Retail traders, who account for 40% of F&O trades, may face challenges due to higher capital requirements.
    • Institutional players, contributing 60% of turnover, are expected to fill the liquidity gap.

Smaller investors will benefit from reduced risk exposure, minimising potential losses.

• Rationalisation of weekly Index derivatives products:
  • New rule: Each stock exchange can now offer weekly expiry derivatives for only one benchmark index.
  • Objective: Limit speculative trading, particularly around expiry days, where options premiums are low.
  • Impact:
    • Reduces opportunities for uncovered or naked options selling.
    • Helps curb speculative trading, which accounts for approximately 70% of index derivatives volume.
    • Shields retail investors from high-risk trades that historically lead to significant losses.
• Increased tail-risk coverage on expiry days:
  • New rule: An additional 2% Extreme Loss Margin (ELM) will be levied for short-options contracts on expiry days.
  • Objective: Mitigate risks associated with heightened speculative activities and sharp price movements.
  • Impact:
    • Higher margin requirements may discourage aggressive trading.
    • Expected to reduce extreme volatility, historically responsible for significant losses exceeding ₹1,000 crore in retail accounts on peak expiry days.

Changes to be Effective in 2025:

• Upfront collection of options premium (Effective Feb 1, 2025):
  • New rule: Options premium must be collected upfront by trading members or clearing members to prevent undue leverage.
  • Objective: Discourage positions beyond available collateral and ensure responsible trading practices.
• Intraday monitoring of position limits (Effective April 1, 2025):
  • New rule: Exchanges must monitor permissible position limits intraday to prevent excessive trading volumes.
  • Objective: Curb risk from undetected intraday positions exceeding regulatory limits.
• Removal of calendar spread treatment on expiry day (Effective February 1, 2025):
  • New rule: Calendar spread benefits will no longer apply to contracts expiring on expiry day.
  • Objective: Reduce basis risk and prevent price distortions caused by rollovers and speculative trading.

Conclusion:

• SEBI’s revised framework for equity derivatives focuses on reducing speculative trading, protecting retail investors, and enhancing market stability.
• While higher margin requirements and rationalised contracts may temporarily affect retail participation, these measures aim to foster a more sustainable and secure trading environment in the long run.

Q.1. What are Index derivatives?

Index derivatives are financial contracts that allow investors to trade in a group of assets represented by an index without buying each individual asset. They are made up of futures and options.

Q.2. How the Securities and Exchange Board of India (SEBI) regulates the exchange-traded equity derivatives market in India?

The SEBI regulates the exchange-traded equity derivatives market by setting eligibility conditions for derivatives exchanges and clearing corporations. These conditions are designed to ensure that trading is transparent, safe, and secure, and that investors can resolve grievances.

News: Here’s what changes for retail investors from today as Sebi’s new F&O rules kick in