SEBI Proposes New Criteria to Broaden Non-Benchmark Indices

The market regulator has put forward a proposal to introduce additional criteria aimed at diversifying thematic and sectoral indices, in an effort to mitigate concerns regarding potential market manipulation.

One of the key recommendations is to cap the weightage of the largest constituent at 20 percent, while ensuring that the combined weight of the top three constituents does not exceed 45 percent. These measures are expected to enhance the stability of such indices, making them less susceptible to manipulation by large investors or institutional entities.

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SEBI’s Consultation Paper and Key Proposals

In a consultation paper published on February 24, the Securities and Exchange Board of India (SEBI) outlined several measures intended to enhance trading efficiency and strengthen risk oversight in equity derivatives. This move comes amid growing concerns that certain sectoral and thematic indices have become increasingly concentrated, with a few stocks disproportionately influencing overall movements.

Among the proposals is the introduction of supplementary criteria for launching derivatives linked to non-benchmark indices. Currently, benchmark indices such as the Nifty 50 and Sensex are widely used for trading in derivatives, as they include a broad mix of companies. However, thematic or sectoral indices, which focus on specific industries such as IT, banking, or pharmaceuticals, can sometimes be heavily skewed toward a few major players.

The paper highlights that while benchmark indices are typically broad-based, thematic and sectoral indices tend to be more concentrated, with a few key constituents exerting significant influence. If the top-weighted stocks in such indices are not regulated, it can lead to excessive speculation and price distortions.

It further states, "Although index derivatives are cash-settled, there remains a connection between cash and derivative markets. When a small number of stocks account for a substantial portion of an index’s weightage, market participants may effectively accumulate large, unmonitored positions in those stocks, raising concerns over potential market manipulation and heightened volatility."

Measures to Reduce Market Risks

In addition to restricting the weightage of top constituents, SEBI has proposed maintaining a minimum of 14 constituents per index and ensuring a descending weight structure, where all lower-weighted stocks have individual weights below that of the more heavily weighted constituents. These measures are aimed at preventing undue influence from a handful of stocks, thereby promoting a more balanced and representative index composition.

Another noteworthy recommendation pertains to measuring open interest (OI) in equity derivatives. The proposed approach aims to prevent unnecessary trading bans while also curbing attempts to obscure excessive risk in index-derivative holdings.

The paper explains, "Currently, in the case of index options, the monitoring system aggregates both long and short notional positions to determine a net value. This setup enables entities to hold substantial long and short notional positions that technically cancel each other out but still carry significant net Delta risk. For instance, a long at-the-money call option combined with a short out-of-the-money call option may not reflect notable net notional utilization, yet it implies a substantial net (long) delta risk."

Impact on Market Participants

SEBI’s proposed reforms could significantly impact various market participants, including institutional investors, retail traders, and fund managers. Mutual funds and alternative investment funds (AIFs) that actively invest in derivatives will need to adjust their strategies in response to the new exposure limit calculations.

By restructuring market-wide position limits (MWPL), SEBI aims to create a more transparent and fair trading environment. The revised method for computing exposure limits will ensure that large market players cannot bypass regulations by holding synthetic positions in derivatives that do not appear in traditional risk calculations.

Moreover, these changes are expected to encourage a more diverse range of stocks in thematic and sectoral indices, fostering a healthier and more competitive market landscape. With a minimum constituent requirement and a balanced weighting structure, these indices will likely become more reflective of broader industry trends rather than being disproportionately influenced by a few major stocks.

The Road Ahead

The proposed reforms indicate SEBI’s commitment to enhancing market stability and protecting investors from undue risks. While some investors may initially find it challenging to adapt to the new guidelines, the long-term benefits of a more diversified and transparent market structure outweigh the short-term adjustments.

SEBI has invited feedback from market participants on these proposals before finalizing the regulations. If implemented, these changes could mark a significant shift in how sectoral and thematic indices are structured and traded, reinforcing India’s financial markets' resilience and integrity.