Sebi’s right about the derivatives boom: The market’s tail mustn’t wag the dog (2024)

The slew of measures it has proposed include an increase in the minimum contract size from ₹5 lakh to ₹15-20 lakh, higher upfront margins to be paid for trades, allowing only one weekly expiry per exchange (as opposed to daily), and the intraday monitoring of position limits.

These and other steps would be in addition to the action it took earlier. On its part, the Centre’s budget has doubled the securities transaction tax on futures and options. The broader message is clear. Authorities are going all out to tighten screws on speculative trading, which is seen as having gone out of hand.

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“The tail had grown bigger than the dog," Sebi chairperson Madhabi Puri Buch told Mint, referring to an exponential rise in derivatives trading. “Yes, it does look, as someone said, that the tail is wagging the dog, because, ultimately, [the use of futures and options] was meant to be a way of risk management, hedging, etc," she added.

The data has been dropping jaws. Index options volumes on NSE surged almost 13-fold from ₹10.8 trillion in 2019-20 to ₹138 trillion in 2023-24. Meanwhile, cash market turnover during the same period rose a modest 2.25 times from ₹89 trillion to ₹201 trillion.

Though cash-segment trading is still considerably higher, the gap is closing fast. On current trends, it may not be long before derivative trades match their underlying segment of assets, which would be a conceptual anomaly. But what’s behind this boom?

As conceived, equity derivatives derive their value from stocks, with contracts designed for genuine risks to be hedged by sophisticated participants in capital markets. Since their market values move up and down, they also attract punters who find that outsized bets can be placed with relatively small sums.

Little margin money to be paid upfront—for the difference to be settled at the end of the transaction cycle—has resulted in investments by people who may prove unable to fully pay up what they owe should their game go wrong. For all their enthusiasm, market surveys show that retail investors rarely end up winners.

Also read: Mint Explainer: Impact of Sebi's planned measures for index derivative framework

About 70% of intraday traders made losses in 2022-23, according to a recent Sebi study. A previous Sebi survey had found that nine out of 10 individuals in the equity derivatives segment were making losses. Clearly, the odds are stacked against them, no matter how highly they fancy their chances.

In an economy that lets markets be shaped by free interactions of demand and supply, state intervention to curb any kind of trading can be controversial. In general, investors should be at liberty to take the risks they deem fit. If losses arise, it would serve them a lesson and the resultant caution ought to keep hazards in check.

Yet, reckless behaviour can overpower and outlast corrective forces. Derivatives cater to the “gambling instincts" of humans, as noted by this year’s Economic Survey, and instability in this segment could have negative spillovers across capital markets.

So, while it’s helpful to educate participants on what’s best for their own safety, ample signs of naive investing in this segment also make a case for exceptional curbs on behalf of others who may suffer the fallout of a crash. Derivatives do serve a useful purpose, but only in an adjunct role. We must not let the market’s tail wag the dog.

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