Taxmann's Analysis | SEBI's Tightened Controls – A Safer Approach to Equity Index Derivatives
1. Introduction
The derivatives market plays a crucial role in facilitating price discovery, enhancing liquidity, and enabling risk management for investors. Stock Exchanges and Clearing Corporations are pivotal in providing a robust trading platform, ensuring meticulous real-time risk management, effective surveillance, and seamless settlement processes. Their contribution is particularly significant in light of recent market evolutions, including a surge in retail participation, the introduction of short-duration index options, and heightened speculative activities on expiry days.
Earlier, the Securities and Exchange Board of India (SEBI) established an Expert Working Group (EWG) to evaluate regulatory frameworks to safeguard investors and foster the growth of the equity derivatives market. Following the EWG’s insights and consultations with the Secondary Market Advisory Committee (SMAC), SEBI released a consultation paper on July 30, 2024. After gathering and analysing stakeholder feedback and conducting further dialogues with stock exchanges and clearing corporations, SEBI has resolved to introduce strategic enhancements to the equity index derivatives sector. These measures are designed to fortify investor protection and ensure greater market stability.
Key Insights on Strengthening the Equity Index Derivatives Framework for Improved Investor Protection and Market Stability:
2. Upfront Collection of Options Premium and Margin Verification for Enhanced Risk Management
Currently, both futures positions (long and short) and options positions (with short options requiring margins) necessitate the upfront collection of margins. For long options positions, buyers are only required to pay the options premium; however, there hasn’t been a requirement for Trading Members (TM) and Clearing Members (CM) to collect this premium upfront from buyers.
2.1. Upfront Collection of Options Premium
Due to the non-linear nature of option prices and their significant leverage potential, which can lead to rapid price fluctuations, SEBI has now mandated that TMs and CMs collect the options premium upfront from buyers. This new regulation aims to mitigate undue intraday leverage by clients and discourage them from holding positions that exceed their available collateral. With this
measure, better risk management at the client level will be ensured. Additionally, the upfront margin requirement will now encompass the net options premium payable by the client. Compliance will be monitored through intraday snapshots by Clearing Corporations, and penalties will be imposed for any non-compliance.
2.2. Implementation Timeline
To provide market participants with sufficient time to adjust to these changes, the new requirement for the upfront collection of options premiums in the equity derivatives segment will be implemented starting February 1, 2025.
Comments
The requirement for Trading Members (TM) and Clearing Members (CM) to collect options premiums upfront from buyers marks a significant advancement in risk management within the derivatives market. This measure is designed to curb excessive intraday leverage by clients and prevent the maintenance of positions that exceed their collateral limits. By tackling these critical issues, the amendment promotes a more stable and transparent trading environment, enhancing both market integrity and investor protection.
3. Margin Framework and Calendar Spread Adjustments for Derivatives
Currently, the margin requirement for a Futures and Options (F&O) position is significantly reduced when an offsetting position on a future expiry is taken, as the calendar spread margin applies instead of the standard margin for both positions.
3.1. Withdrawal of Calendar Spread Benefits
Due to the considerable basis risk present on the expiry day—when the values of contracts expiring can diverge sharply from those of future contracts—SEBI has decided to revoke the calendar spread benefit for offsetting positions across different expiries on contracts expiring on that particular day. This decision comes in response to the heightened trading volumes and associated basis risks observed on expiry days.
3.2. Calculation of Worst-Case Loss and Extreme Loss Margin on Expiry Day
On the day of expiry, the worst-case loss will be calculated distinctly for contracts due to expire and those continuing beyond that day. Consequently, the calendar spread benefit will not apply to contracts expiring on the same day, eliminating the need for an additional calendar spread margin for these contracts. Additionally, the Extreme Loss Margin (ELM) for calendar spread positions will be assessed without considering offsetting futures positions if one leg of the trade expires on the same day.
3.3. Clarification on Margin Calculations for Calendar Spread Positions Across Expiries
SEBI has further clarified that the established margin calculations—including worst-case loss, calendar spread margin, and ELM—will remain the same for all expiries, except for those involving contracts that expire on the same day. For example, if the expiries are set for the 29th (current month), 30th (next month), and 31st (far month), any calendar spread positions between the 29th and 30th, or the 29th and 31st will not be treated as calendar spreads on the 29th. However, positions expiring on the 30th and 31st will still be eligible for calendar spread benefits on the 29th.
3.4. Implementation Timeline
These modifications concerning calendar spread positions in equity index derivatives will be implemented starting February 1, 2025.
Comments
The existing margin benefits for calendar spreads are reasonable under normal circumstances. However, the situation is markedly different on expiry days, when the values of expiring contracts can exhibit substantial fluctuations in comparison to contracts expiring in subsequent months. This variance is compounded by increased trading activity on expiry days, which exacerbates basis risk. Additionally, liquidity risks are elevated as options expiring in the following month often do not have adequate liquidity. This scenario can make closing both legs of calendar spread positions challenging and potentially result in net losses, underscoring the importance of robust risk management strategies.
4. Strengthening Oversight of Position Limits for Equity Index Derivatives
Stock Exchanges and Clearing Corporations are tasked with monitoring the position limits for index derivatives contracts, as established by SEBI, at the close of each trading day.
4.1.
Enhanced Monitoring of Position Limits for Index Derivatives
Recognising the potential for intraday positions to exceed permissible limits without detection, particularly on high-volume expiry days, SEBI has now mandated that exchanges also conduct intraday monitoring of existing position limits for equity index derivatives.
4.2. Implementation of Intraday Position Snapshots
To support this enhanced monitoring, stock exchanges will be required to capture a minimum of four position snapshots throughout the trading day. While exchanges may determine the specific timing of these snapshots, they must ensure that at least four are taken at random intervals within predetermined time windows.
4.3. Implementation Timeline
This new monitoring framework will become effective for equity index derivatives contracts starting April 1, 2025, allowing exchanges ample time to adapt. Moreover, the current penalty structure for breaches of end-of-day position limits will also apply to any intraday position limit violations.
Comments
On expiry days, there is a heightened risk that intraday positions may exceed the permissible limits undetected, especially since positions might close at zero by day’s end. Maintaining market integrity requires strict adherence to position limits at all times by all market participants. The implementation of real-time checks for breaches will significantly strengthen oversight and mitigate risks associated with excessive positions during periods of high trading volume.
5.
Update on Minimum Contract Size for Index Derivatives
The SEBI Master Circular for Stock Exchanges and Clearing Corporations, dated October 16, 2023, specifies the contract size for index futures and index options. Since 2015, these contracts have been required to maintain a value ranging between ₹5 lakhs and ₹10 lakhs.
5.1. Revised Minimum Contract Size for Index Derivatives
In response to the approximately threefold increase in market values and prices since the last adjustment, SEBI has revised the minimum value of derivative contracts to no less than ₹15 lakhs at the time of their introduction to the market. Furthermore, during the review period, the lot size will be adjusted to ensure that the contract value remains within the range of ₹15 lakhs to ₹20 lakhs. All other regulations concerning the contract size of index derivatives, as detailed in the aforementioned Master Circular, will continue without change.
5.2. Implementation Timeline
This updated requirement will apply to all new index derivatives contracts introduced from November 20, 2024, onward.
Comments
Given the inherent leverage and heightened risk associated with derivatives trading, this adjustment to the minimum contract size is in line with overall market growth. It aims to ensure that the suitability and appropriateness criteria for market participants are rigorously maintained, contributing to a more stable and reliable trading environment.
6. Rationalisation of Weekly Expiry Index Derivatives to Enhance Market Stability
Index options trading on expiry days, especially when premiums are low, is predominantly speculative. Stock exchanges offer short-duration options contracts on indices that expire daily, leading to intensive trading activities. The SEBI consultation paper observed that the average duration for holding such positions is just minutes, causing pronounced volatility in the index values both throughout the trading day and at expiry. This pattern raises concerns about the potential risks to investor protection and market stability, with minimal benefit to long-term capital formation.
6.1. Rationalisation of Weekly Expiry Index Derivatives Products
In response to these concerns, SEBI has decided to streamline the offerings of index derivatives that expire weekly. Under the new regulations, exchanges will only be allowed to offer derivatives contracts for one benchmark index with a weekly expiry, aiming to curb the excesses of trading behaviours on expiry days.
6.2. Implementation Timeline
This new policy will be implemented from November 20, 2024. From this date forward, exchanges will be restricted to offering weekly derivatives contracts solely on one benchmark index.
Comments
The rapid depreciation of option premiums as they near expiry heightens financial risks by encouraging participants to take highly leveraged positions with scant time value. Moreover, intense trading activity around expiry can destabilise the market, particularly during periods of unexpected volatility. By limiting weekly options contracts to a single benchmark index per exchange, SEBI seeks to reduce these risks and improve overall market stability and investor protection.
7. Enhanced Margin Measures for Expiry Day Trading in Options Contracts
As options contracts approach their expiry, trading activity, open positions, and volatility typically increase. Despite this, current margin requirements do not adequately adjust to reflect the elevated risks, leaving the market vulnerable to excessive speculation and insufficiently buffered against sudden price shocks or unpredictable market events. The Extreme Loss Margin (ELM) is designed to address these tail risks that extend beyond standard risk scenarios.
7.1. Enhanced Extreme Loss Margin (ELM) for Short Options Contracts on Expiry Days
Recognising the increased speculative activity on expiry days, SEBI has decided to introduce an enhanced ELM of an additional 2% specifically for short options contracts. This adjustment is intended to improve coverage for tail risks on these high-stakes trading days.
7.2. Application of Additional ELM on Expiry Days
This augmented margin will be applicable to all open short options positions at the start of the day, as well as any new short options contracts that are opened during the day and are due to expire on the same day. For instance, if the weekly expiry for an index contract is scheduled for the 7th of the month, while other expiries are set for the 14th, 21st, and 28th, an additional 2% ELM will be imposed on all options contracts expiring on the 7th.
7.3. Implementation Timeline
This new margin policy will be effective starting November 20, 2024.
Comments
The increase in margin requirements on and before the expiry day is aimed at mitigating the risks associated with the near-expiration trading of options contracts. This strategic adjustment is designed not only to curb excessive speculative activities but also to fortify market defences against potential price volatilities or unforeseen market disturbances.
8. Implications for Brokers in Compliance, Operations, and Market Strategy
The recent amendments by SEBI in the derivatives market bring several increased compliance requirements for brokers, which include:
(a) Upfront Collection of Premiums – Brokers are now required to ensure the upfront collection of premiums for long options positions. This process involves real-time monitoring and margin verification, necessitating system upgrades to handle intraday snapshots and ensure compliance, with penalties in place for non-adherence.
(b) Operational Adjustments – Significant adjustments will be needed within operational workflows and client-facing systems. Brokers will also need to educate their clients about these changes, especially concerning the heightened margin requirements on expiry days and the removal of calendar spread benefits.
(c) Complex Risk Management – With the imposition of stricter margin requirements, particularly around expiry days, brokers will face additional complexities in risk management. They will need to work closely with clients to mitigate impacts and navigate the new regulatory landscape effectively.
(d) Product Offering Limitations – The rationalisation of weekly expiry index derivatives to a single benchmark index per exchange may restrict the range of products brokers can offer. This could impact both liquidity and revenue streams, necessitating a strategic re-evaluation of market offerings.
9. Conclusion
In conclusion, the latest measures introduced by SEBI are designed to fortify the equity index derivatives framework, addressing the key risks associated with trading on expiry days. By mandating the upfront collection of options premiums, rationalising product offerings, and enforcing stricter margin requirements, these initiatives aim to enhance market stability, protect investors, and curb excessive speculative activity. Collectively, these steps are expected to foster a more resilient and transparent derivatives market, contributing positively to the broader financial ecosystem.
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