Indian financial markets have been vibrant, driven by retail participation and growing interest in Futures and Options (FnO) trading. The growth has been significant over the last decade, attracting both seasoned investors and newcomers. However, there are emerging concerns that this exuberance may lead to a turbulent phase. A comparison is being drawn with South Korea’s experience, where stringent regulations curbed a once-flourishing derivatives market, leading to a sharp decline in trading volumes and investor interest. The question now looms: Is India facing a similar scenario?
South Korea's derivatives market was once the largest by trading volume globally. Retail investors played a pivotal role, particularly in equity-linked derivatives such as options and futures. This fueled rapid growth, turning the Kospi 200 derivatives market into a global powerhouse. However, things changed drastically after regulators introduced a series of stringent measures, as per FT’s report. These included raising the minimum trading unit for index-linked options and increasing the collateral requirements for forex margin trading.
The result? A steep 70% drop in trading volumes, pushed South Korea out of the global top 10 in derivatives trading by 2013. This sharp decline followed efforts to curb excessive speculation and reduce retail investor losses in the highly speculative derivatives market. However, these regulations also discouraged participation, reducing liquidity and pushing traders to markets in China and Japan.
Could India be heading in the same direction?
India’s Securities and Exchange Board (SEBI) has introduced new rules aimed at making FnO trading more secure and less speculative. While these regulations are designed to protect retail investors and bring more stability to the market, they also raise concerns about reduced participation, especially from smaller investors.
1. Increased Contract Size for Index Derivatives: SEBI has increased the contract size from ₹5-10 lakh to ₹15-20 lakh. This raises the bar for entry into the FnO market, effectively pushing smaller retail investors out of the game. Larger contracts demand higher capital, making it difficult for smaller participants to engage in speculative trades.
2. Rationalization of Weekly Expiry Index Derivatives Products: SEBI has reduced the number of weekly expiry options for index derivatives. This is expected to limit speculative trading while promoting a more stable market. Exchanges like NSE and BSE are now allowed to offer weekly derivatives contracts for only one benchmark index, which reduces the range of options available to traders.
3. Upfront Collection of Option Premium: Starting in February 2025, brokers must collect the full premium upfront from option buyers. Previously, some brokers allowed traders to enter positions using leverage, reducing the initial cost. The new rule effectively eliminates this practice, further restricting speculative participation.
4. Intraday Monitoring of Position Limits: Another critical change is the introduction of intraday monitoring of position limits. This will be conducted at random intervals throughout the trading day. Traders must now constantly monitor their positions to avoid exceeding the new limits, adding complexity to their strategies.
5. Increase in Tail Risk Coverage on Expiry Days: To manage volatility during expiry days, SEBI has introduced an extra margin requirement, known as the "extreme loss margin." This will increase margin requirements for option sellers by 2% on the day of options expiry, aiming to cushion against sharp price movements.
6. Removal of Calendar Spread Treatment on Expiry Days: Calendar spreads involve holding both long and short positions in contracts with different expiry dates. SEBI has removed the margin benefit for these positions on expiry days, making it more expensive to hold these positions.
The introduction of these new regulations is seen as a move toward stabilizing the Indian market. However, there are valid concerns that these measures could stifle the retail investor-driven boom in FnO trading, just as similar steps did in South Korea.
The most immediate impact is likely to be felt by retail investors. By raising the contract size and increasing the upfront cost of entry, SEBI is effectively filtering out smaller traders. While this reduces the risk of speculative losses, it also limits the number of participants, which could lead to reduced liquidity in the market.
Retail investors play a significant role in the Indian FnO market, much like they did in South Korea. A significant reduction in retail participation could lead to a sharp drop in trading volumes, affecting market liquidity and pricing efficiency. Reduced participation also impacts the discovery of fair prices in the market, potentially leading to larger bid-ask spreads and increased volatility.
With fewer options available for speculative trades, traders will need to adapt their strategies. The reduced number of weekly expiries for index derivatives forces traders to shift toward longer-term strategies or look for opportunities in other segments of the market. This could lead to a focus on more sustainable trading practices, but it also reduces the quick-turnaround opportunities that many retail traders seek.
The requirement to collect the full option premium upfront increases the capital required to trade in the FnO market. This makes the market less attractive to smaller traders who often rely on leverage to maximize their returns. The higher costs, combined with the increased margin requirements on expiry days, could further drive away speculative participants.
For brokers, this means adjusting their margin policies and compliance mechanisms to accommodate the new rules. Brokers will need to invest in better technology and real-time monitoring systems, increasing their operational costs. These costs could be passed on to traders, making the market even more expensive to participate in.
While SEBI's new rules aim to promote market stability and protect retail investors, they also raise concerns about curbing market growth. The South Korean experience demonstrates that stringent regulations can lead to a sharp decline in market participation and liquidity. As trading volumes drop, the market becomes less efficient, potentially leading to greater volatility, which could destabilize the broader financial system.
The Indian market has seen phenomenal growth in FnO trading, fueled by a combination of retail enthusiasm and relatively lenient entry requirements. By tightening these rules, SEBI is walking a fine line between promoting long-term stability and risking a sharp contraction in the market.
South Korea's derivatives market saw an abrupt downturn when retail investors began to desert the market after regulations raised the barriers to entry. The once-dominant Kospi 200 market, which had thrived on retail speculation, lost its global standing as trading volumes fell sharply.
India is now at a crossroads. Like South Korea, India's FnO market has been driven by retail investors who have thrived in a relatively liberal regulatory environment. SEBI’s new rules may discourage speculative activity, but they also risk alienating the very participants who have fueled the market’s growth.
One of the key lessons from South Korea’s experience is the impact of reduced liquidity on the broader market. As retail investors left, the South Korean derivatives market struggled with lower trading volumes, which had a ripple effect on the stock market. The average daily turnover of South Korea’s 200 largest stocks fell by 13% in the first half of 2013, as investors had fewer tools to hedge their positions through derivatives.
If India follows a similar path, the broader stock market could also suffer from reduced liquidity. The FnO market plays a crucial role in providing hedging opportunities for large investors and institutional players. Reduced participation in the FnO segment could lead to less efficient risk management in the broader market, amplifying volatility.
While retail investors are a significant part of the Indian FnO market, institutional investors also play a crucial role. The new regulations could lead to a shift in market dynamics, with institutions taking a more dominant position as retail participation declines. This could make the market more stable in the long run, but it may also lead to reduced competition and innovation.
Institutional investors typically engage in more conservative strategies, focusing on hedging and long-term risk management rather than speculative trades. As they take a more prominent role, the market could become more predictable, but also less dynamic.
India's FnO market is at a critical juncture. The new SEBI regulations aim to bring more stability and protect retail investors, but they also risk reducing participation and liquidity. The lessons from South Korea's experience should not be ignored. Striking the right balance between regulation and market growth is essential for ensuring the long-term health of the Indian financial markets.
Market participants, including brokers, traders, and institutional investors, will need to adapt to the new regulatory environment. The key to navigating this period of transition will be flexibility and a focus on long-term strategies. While the short-term impacts of the new rules may lead to reduced participation and liquidity, a well-regulated market could pave the way for more sustainable growth in the long run.
The Indian market may not be on the verge of a Korean-style fall, but the risks are real. Ensuring that the regulatory framework supports both stability and growth will be crucial for avoiding the mistakes of the past and maintaining India’s position as one of the world’s fastest-growing financial markets.