On October 1, 2024, the Securities and Exchange Board of India (SEBI) issued a circular (SEBI/HO/MRD/TPD-1/P/CIR/2024/132) introducing key reforms to enhance investor protection and ensure market stability in equity index derivatives. The measures aim to address the growing retail participation, short-tenure index options, and speculative trading volumes on expiry days. SEBI's changes, driven by its regulatory mandate, stem from recommendations by an Expert Working Group (EWG) and subsequent discussions with the Secondary Market Advisory Committee (SMAC). Below is an overview of the significant updates.
The Importance of the Derivatives Market
Derivatives play a crucial role in price discovery, liquidity improvement, and risk management for investors. Stock Exchanges and Clearing Corporations provide platforms for trading while managing risks, surveillance, and trade settlement. SEBI emphasizes that product development, risk management, and surveillance are core functions for these entities, as defined under the Securities Contracts (Regulation) (Stock Exchanges and Clearing Corporations) Regulations, 2018 (SECC Regulations, 2018).
Key Measures to Strengthen the Framework
1. Upfront Collection of Option Premiums
Starting February 1, 2025, Trading Members (TM) and Clearing Members (CM) must collect the full option premium upfront from buyers. This is aimed at preventing undue intraday leverage and ensuring that positions are backed by sufficient collateral.
2. Removal of Calendar Spread Benefits on Expiry Day
From February 1, 2025, SEBI will remove the calendar spread benefit for contracts expiring on the same day. Calendar spread benefits allow the offsetting of positions across different expiry dates, but SEBI highlights the risk of significant price fluctuations on expiry days. The removal aligns the treatment of such positions with SEBI's cross-margin framework for correlated indices.
3. Intraday Monitoring of Position Limits
Beginning April 1, 2025, Stock Exchanges will monitor position limits intraday, with a minimum of four random snapshots taken throughout the day. This addresses the risk of exceeding permissible position limits, especially on expiry days when volumes peak. Current penalties for breaches of end-of-day limits will be extended to include intraday violations.
4. Recalibration of Contract Size
To align with the growing market and mitigate leverage risks, SEBI has recalibrated the contract size for index derivatives. As of November 20, 2024, the value of new index derivatives contracts must be at least ₹15 lakhs, with a permissible range of ₹15 lakhs to ₹20 lakhs at the time of review.
5. Rationalization of Weekly Expiry Index Derivatives
SEBI has observed increased speculative activity on expiry days, leading to heightened volatility. To address this, effective November 20, 2024, each exchange can only offer weekly expiry derivatives on one benchmark index, reducing the concentration of speculative trading activity.
6. Increase in Tail Risk Coverage on Expiry Day
On options expiry days, SEBI will increase the additional Extreme Loss Margin (ELM) by 2% for short positions, starting November 20, 2024. This measure aims to address heightened speculative risks associated with short options positions, especially on expiry days when volatility spikes.
Impact and Applicability
The reforms outlined above will come into effect on different dates, ensuring that stock exchanges and clearing corporations have sufficient time to adjust their systems and amend relevant rules. The schedule of implementation is as follows:
- Upfront collection of option premiums: February 1, 2025
- Removal of calendar spread benefits on expiry day: February 1, 2025
- Intraday monitoring of position limits: April 1, 2025
- Recalibration of contract size: November 20, 2024
- Rationalization of weekly index derivatives: November 20, 2024
- Increase in tail risk coverage on expiry day: November 20, 2024
Conclusion
SEBI's circular underscores its commitment to safeguarding investor interests while promoting the orderly growth of the equity derivatives market. By introducing these reforms, SEBI seeks to mitigate risks associated with speculative trading, particularly on expiry days, and ensure that market practices remain transparent and fair. These measures aim to create a more stable and secure market environment, fostering investor confidence in India’s rapidly evolving derivatives ecosystem.
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