Why legal restrictions are not enough to curb F&O retailing

Financial derivatives play a vital role in the growth and expansion of the securities market by providing investors with cost-effective risk management tools, investment diversification opportunities and by improving the overall information and pricing efficiency of the markets. High liquidity, volatility and market capitalization of the underlying asset contribute positively to the success of derivative contracts.

Financial derivatives play a vital role in the growth and expansion of the securities market by providing investors with cost-effective risk management tools, investment diversification opportunities and by improving the overall information and pricing efficiency of the markets. High liquidity, volatility and market capitalization of the underlying asset contribute positively to the success of derivative contracts.

In recent years, the number of individual traders in the derivatives segment has surged from 710,000 in 2018-19 to 4.52 million in 2021-22 and 9.57 million in 2022-23, according to data from the Securities and Exchange Board of India ( sebi). Private participation in index options increased by 25.9% year-on-year in 2022-2023, with a turnover of 96.8 trillion, which represents 35% of the market share. However, retail involvement in index futures declined.

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In recent years, the number of individual traders in the derivatives segment has surged from 710,000 in 2018-19 to 4.52 million in 2021-22 and 9.57 million in 2022-23, according to data from the Securities and Exchange Board of India ( sebi). Private participation in index options increased by 25.9% year-on-year in 2022-2023, with a turnover of 96.8 trillion, which represents 35% of the market share. However, retail involvement in index futures declined.

This trend is also clearly visible in stock options compared to stock futures. Individual investor activity in stock options increased 40.6% year-on-year 8.2 lakh crore premium turnover, representing a share of 29.7%. (Source: NSE Market Pulse.)

This increase in retail participation is not unique to Indian derivatives markets. Globally, stock market leaders such as Nasdaq Chairman and Chief Executive Officer (CEO) Adena Friedman and Terry Duffy, Chairman and CEO of CME Group, are reporting increased participation from individual investors in derivatives markets who prefer to trade smaller contracts and shorter maturities. This trend of retail investors driving derivatives volumes is also seen on major US exchanges dominated by institutional investors and hedgers.

Cause for concern

In India, the critical factor contributing to the attractiveness of options is “the built-in leverage that allows traders to take big risks with a minimum of upfront cash.” (Reserve Bank of India Financial Stability Report, December 2023), causing the majority of intraday cash players to switch to index option products. The other factors contributing to this increase could be the democratization of market access and low-cost access to analytics, tools and information for retail investors and brokers. Constructive use of technological advances, supported by artificial intelligence, has to some extent helped level the playing field for retail investors.

From a regulatory perspective, this unprecedented increase in retail participation is welcome, but at the same time it is a cause for concern. The concerns relate to whether a derivative product is suitable for retail investors, whether it is adequately protected and whether it will bear the risks/potential losses that may be associated with it.

Union Finance Minister Nirmala Sitharaman recently raised these concerns at an event on the BSE. She pointed out that an uncontrolled boom in retail futures and options (F&O) could create future challenges for markets, investor sentiment and also for household finances.

Protection of private investors

In recent years, the Indian derivatives market has witnessed many regulatory changes to enhance investor confidence, balance market development and prevent market abuse. Initiatives such as aligning margins with volatility, offering margin benefits to traders, rationalizing and introducing short maturities and small lot sizes for derivatives products, and spreading the expiration date for index derivatives over different weekdays support market development. They will help reduce capital requirements, improve the hedging effectiveness of trades and lower risk as lot size is low.

Recently, the National Stock Exchange (NSE) reduced the lot size of three index derivatives and some equity derivatives. The introduction of mandatory physical settlement for equity derivatives, revision of market-wide position limits, collection of upfront margins from clients for positions created and enhanced supervisory measures aim to manage systemic risk, protect markets against price manipulation, prevent excessive speculation and preventing excessive speculation. detecting and preventing market abuse.

From the perspective of investor protection, Sebi studied the profits and losses of individual traders in the equity derivatives market. The study concluded that nine out of ten derivatives traders suffer losses, and that the average loss per active trader 50,000 in 2020-2021. To alert uninformed investors, Sebi directed all brokers to display these results on the trading terminal to increase awareness and encourage retail investors to take risks with sufficient product knowledge. Despite these warnings, private participation in derivatives has remained the same.

Regulatory measures that restrict retail participation or a strict product suitability framework may not be the way forward. Actively campaigning and educating retail investors about the risks associated with derivatives and warning against disproportionate exposure to derivatives, similar to campaigns in investment funds, can help. More importantly, to ensure that the markets receive equal participation from private, institutional and foreign participants, investing in resources and technology that can provide unbiased, low-cost education to all investors is essential.

As Indian markets are now moving towards a level playing field for retail participants, it is necessary to provide adequate financial literacy to all. It is important to protect investors from reckless, deceptive financiers and to lay the foundation for creating a diverse fabric of informed investors and market participants.

Latha Chari and Rasmeet Kohli are professor and assistant managing director, respectively, at the National Institute of Securities Markets. Pradiptarathi Panda is an Assistant Professor at the Indian Institute of Management, Raipur. The opinions expressed are personal.

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