While global as well as Indian institutions and proprietary trading houses account for a large part of F&O volumes, individual investors have taken to derivatives with gusto, accounting for a third of the volumes. The Securities and Exchange Board of India (Sebi) estimates a retail participant count of nearly 10 million.
Regulatory scrutiny has increased in lockstep with such retail ardour. Earlier this year, Sebi imposed additional margin requirements on certain F&O products. The Union budget imposed additional taxes on derivatives, increasing trading costs.
A Sebi paper estimated losses of ₹1.8 trillion for retail investors over the three years ended 2023-24, with ₹75,000 crore in 2023-24 alone. Such numbers have caused a minor storm, with political clamour growing to protect small investors.
Also read: Nine out of 10 individual F&O traders lost money in FY24, Sebi study reveals
The path to perdition is paved with good intentions, goes an old aphorism. It holds true for capital markets too. Take risks.
Macro-stability risks: India’s regulatory architecture tightly controls the single biggest macro risk of capital markets—leverage. This is contrary to popular lore about ‘high levels of leverage’ in markets. How?
For starters, total loans against shares in India extended by banks and non-banking financial companies are estimated to be less than ₹1 trillion, a tiny fraction of India’s aggregate market capitalization.
Second, margin requirements for stocks in India are among the most conservative in the world. A broker cannot fund a customer more than 80%, the funding it provides has to come primarily from its own capital, and it cannot use one customer’s margin to fund another.
Most pertinently, F&O contracts, which technically create leveraged positions, are skewed towards options in India. Globally, option volumes are around the same level as futures. In India, the trading volumes of options are more than 50 times those of futures.
Why is this important? Because option contracts represent far less risk of systemic liquidations than futures. Further, thanks to very large margin requirements on brokers, a significant proportion of F&O volumes in India are intraday trades that get squared before the market closes, thus minimizing overnight systemic risks (‘gamma’ for derivatives geeks).
Low levels of leverage have meant market volatility in India has been declining. It is at par with developed markets and significantly lower than in emerging markets overall. Over the last two years, the Nifty Vix (an index that tracks volatility) has regularly traded lower than the US Vix.
Investor-loss risks: The headline numbers of F&O losses for retail investors, as revealed by the Sebi study, are large but not eye-popping, given India’s size. To put it in context, mutual fund (MF) SIP flows alone are worth ₹23-24,000 crore every month. However, the headlines perhaps don’t capture the whole story.
One, they give only a partial view of investor balance sheets. They don’t take into account individual holdings in stocks (or MFs), which are positions likely to be sitting on significant profits (even if unrealized) over the same period.
A ₹1 lakh position in a Nifty 500 index fund would have made huge gains over the past year. For many investors, F&O trading positions are created on top of long-only cash market positions.
Two, F&O exposures could be for hedging purposes. Consider an investor with ₹1 lakh worth of Nifty who bought a one-year Nifty put option of ₹1 lakh notional value by paying a premium of, say, ₹6,000 a year ago.
Today, the option position would show a loss of ₹6,000, as the Nifty closed about 33% higher and the option expired worthless. But the investor’s aggregate net profit is ₹27,000 ( ₹33,000 unrealized gain on the Nifty minus the ₹6,000 put option loss).
The baby, bathwater and market development: F&O volumes engender market liquidity, which in turn dampens volatility and enables a larger pool of investors to participate without large friction costs. It has been a big reason for the explosion in India’s equity culture.
The number of unique MF investors today, at 45 million, is nearly five times the number of retail F&O traders. The total direct retail ownership of stocks is just under 8%.
Adding domestic institutional investors (mostly retail pools like MFs and insurance/provident funds), retail equity ownership in India, at 26%, is well above the foreign institutional investor ownership of 17%.
Creating conditions that constrict F&O volumes or reducing them by raising costs could significantly hurt overall market liquidity. That, in turn, can raise volatility and over time also tail-risks for India’s large pool of retail investors.
India’s financial regulators—the Reserve Bank of India and Sebi—have been on-the-button on risk, especially in the last two decades. They deserve credit for taking capital-market risks to near developed-market levels.
That confidence should be brought to bear while dealing with F&O risks. Responses should be Bayesian, dependent on aggregate data and the balance of risks, instead of a wholesale tamping down of F&O trades.
These are the author’s personal views.
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