SEBI: Stop Playing With Fire 🔥

Welcome to this week’s Altsights!

₹51,689 crore is more than the annual profit (FY24) of India’s largest IT services firm TCS which stood at around ₹46,000 crore.

Playing with Fire 🔥

Warren Buffet has famously said - Derivatives are weapons of financial mass destruction. 

But Indians seem to think otherwise. Just look at the breakneck pace at which the derivatives market volume has grown since COVID-19.

SEBI’s 3-Point Agenda 📝

In its 30 July, 2024 consultation paper, SEBI has said that it wants to do 3 things:

1. Protect the average retail trader

2. Increase the stability of the markets

3. Promote sustained capital formation

While the first 2 are straightforward, let’s understand what capital formation is and why it is important.

You see, as an economy we produce and consume goods and services. But merely producing and consuming does not help the economy grow in size - we need capital formation to grow.

Capital formation refers to investing money into new ventures like starting a new company, building a new factory etc. These ventures need money, often large amounts of public money.

So, when you invest in stocks, you promote capital formation while attempting to create wealth for yourself.

But when most savings are redirected into speculative activities like options trading, capital formation takes a backseat which is a negative for economic growth.

How Did We Get Here? 💭

In this story, there are 4 major players:

1. Retail traders: Speculators looking to make some quick money

2. Sophisticated trading firms: Profit makers, often at the expense of retail traders

3. Enablers like stock exchanges (NSE and BSE) and brokers: The casinos - they make money no matter what

4. Market regulator SEBI: Promoter of sanity

If you look at how I have described the players, you’ll realise that everyone except the market regulator desires a more active derivatives market.

While retail investors desire it despite making losses, trading firms and enablers like stock exchanges and brokers desire it to increase their profits. But only stock exchanges can truly increase the activity in the derivatives market unless it is prohibited by the regulator.

In recent years, stock exchanges have done 3 things that has led to promote derivatives trading:

1. Increased the number of indices in FnO segment

For the longest time, speculation through FnO was restricted to a few select indices like NIFTY 50 and Bank NIFTY. Even today, most FnO contracts traded are based on these.

However, over time, the NSE has consistently included more indices in the FnO segment. Here are some examples:

➡️ Finnifty was added in Jan 2021

➡️ 13 new ‘Option on Futures’ commodity derivatives contracts were launched in October 2023 

➡️ Nifty Next 50 (AKA Junior Nifty) was added in April 2024. The transaction costs for this are also waived off until October 2024 to encourage more participation

2. Increased the number of expiry days

Retail and institutional traders rush to close positions or roll them over thereby spiking the trading volumes on expiry days.

In other words: Profits of the stock exchanges (as well as brokers) spike on expiry days.

Previously, most traded contracts would expire on Thursday but that changed about a year ago when the stock exchanges decided to spread out the expiry days throughout the week (Mon-Fri).

3. Decreased the lot sizes

When you engage in options trading, you have to buy or sell in lots which have different sizes.

A simple way to increase participation and activity in the derivatives market is to decrease the lot sizes which, unsurprisingly, the NSE has implemented. 

Here are the new lot sizes implemented in 2023/2024:

7 Proposals to Reduce FnO Speculation 📝

In its consultation paper, the SEBI has made a total of 7 proposals like:

1. Limiting weekly expiries to just 2 (one each for BSE and NSE)

2. Increasing the minimum contract size to make trading less accessible to small trader

3. Increasing the margin requirement near expiry days to manage risk

There are 4 more proposals made by the SEBI - all directed towards reducing the speculative nature of the FnO segment and making it less accessible to small traders.

If you have ever been curious about derivatives trading and/or thought of trying it out, please don’t. Instead donate some money to your favourite charity - at least it will go to the needful.

Cheers,
Madhu,
Founder, Altcase