SEBI Cracks Down on Derivative Trading Regulations

Just as derivative traders were beginning to recover, the market regulator introduced yet another challenge, making trading even more difficult.

The Securities and Exchange Board of India (SEBI) has proposed changes to gross and net position limits for intraday and end-of-day trading in index futures and options. This move is expected to impact market liquidity, particularly affecting foreign portfolio investors (FPIs), high-net-worth individuals, and proprietary trading desks of stockbrokers, potentially reducing their exposure.

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SEBI’s decision on derivative trading appears to be counterproductive. Instead of supporting liquidity providers, it is imposing stricter restrictions on them. Under the proposed rules, intraday position limits for index options will be set at ₹1,000 crore on a net basis and ₹2,500 crore on a gross basis, while end-of-day limits will be capped at ₹500 crore and ₹1,500 crore, respectively.

Following the reduction in expiration dates, many traders now have idle capital, leading to lower returns and a decline in trading volumes on exchanges. Executing large orders has already become a challenge.

Adib Noorani, Founder of Market Wizard and Academic Head of HoGrowth Academy, expressed concern over the proposed margin limits, stating that these restrictions would hinder liquidity providers' trading capacity. He warned that SEBI's decision could drive traders to more stable and consistently regulated markets.

According to media reports, if these new measures are implemented, trading volumes could drop by 60-70%. In response, traders are actively seeking alternative markets with lower costs and more stable regulatory environments.

Rising Compliance Costs and Market Instability

Tanmay Kurtkoti, founder of QC Alpha and Trisha Capital, highlighted the challenges posed by frequent regulatory changes. Adjustments such as revised Market Wide Position Limits (MWPL), position limits, and index criteria force firms to frequently alter their strategies, creating instability. Between 2021 and 2023, SEBI introduced over 14 reforms in the equity derivatives space, making long-term planning increasingly difficult.

As a result, India risks being seen as a complex "regulatory maze" compared to more stable Asian markets like Singapore and Vietnam. While FPIs can adapt to reforms, frequent changes disrupt their cost-benefit assessments, making India a less attractive destination for investment.

Stricter regulations are also affecting proprietary trading firms, which must constantly upgrade their technology and software to comply with new rules. These adjustments require significant financial investments, forcing firms to allocate resources toward compliance rather than market innovation.

Regarding the latest changes, Kurtkoti noted that tighter gross limits might lead to premature unwinding of positions, ultimately reducing returns. While FPIs are unlikely to completely exit India's high-growth market, they may allocate less capital due to increasing compliance burdens.

Impact on Indian Exchanges and Market Sentiment

Brokerage firms and exchanges are already feeling the impact, with research firms downgrading their ratings. Goldman Sachs, for instance, reduced its target price for the Bombay Stock Exchange (BSE), citing that 70% of its daily turnover comes from proprietary traders. A decline in trading volumes could significantly impact BSE’s revenue, further exacerbating concerns about India’s market competitiveness.

The cost of trading has risen considerably, making it less attractive for institutional traders. Previously, India was one of the largest derivative markets globally, but with these continuous changes, it is now being compared to much smaller Asian exchanges.

Some analysts argue that SEBI’s focus on protecting retail investors is misdirected, as the proposed regulations may inadvertently reduce overall liquidity. A highly liquid derivatives market benefits all participants, including retail traders, by ensuring efficient price discovery and trade execution. Restricting the participation of large institutional players could lead to wider bid-ask spreads and increased volatility.

Kurtkoti emphasized that SEBI needs to strike a balance between transparency and regulatory predictability to keep India competitive. Noorani cautioned that these regulatory changes could backfire, ultimately discouraging participation rather than protecting retail traders.

Looking Ahead: What Traders Expect from SEBI

It is crucial that SEBI takes market participants' concerns into account before implementing these rules. The industry had anticipated regulatory relief under SEBI’s new chairman, Tuhin Kanta Pandey, but the latest proposals indicate a move toward significantly tightening the derivatives market.

Traders are now hoping for a more measured approach that fosters market growth rather than restricting it. While regulatory oversight is essential, excessive intervention could drive investors and traders toward more stable markets in other countries. India has the potential to remain a dominant player in the global derivatives space, but only if the regulatory environment encourages participation rather than discouraging it.

The coming months will be critical in determining the future of India’s derivative market. If SEBI proceeds with these changes without addressing industry concerns, the impact on liquidity, trading volumes, and overall market sentiment could be severe.