SEBI’s Curbs on Derivatives: Can it Kill the Capital Market Powerhouse Ambitions?

Aditya Chhangani

(Legal Manager, Tata Capital Limited)

The Security and Exchange Board of India (SEBI) capped the trading frenzy in the last quarter of 2024, sighting investor protection, a move which can be well justified by looking at a staggering figure of INR 524 billion in losses in the Financial Year (FY) 2023-24. However, the move to cool off one market shifted the heat to another, resulting in investors moving towards other risky alternatives like small-cap cash markets. The hype in the derivatives market comes from the variety of investment options it provides across various asset classes. Reflecting on the Indian investor market potential, the volume of derivatives contracts rose to a whopping INR 8,737 trillion ($104.65 trillion) in March 2024, with ’India’s equity derivatives market earning the top spot globally and the National Stock Exchange (NSE) maintaining its position of being the world’s largest derivatives exchange market for the fifth year in a row. This article will focus on India’s unfettered derivatives market potential and how SEBI can aid the ambitious boom in this space while ensuring that restrictions do not lead to a shift.

What are Derivatives?

Derivatives are financial contracts involving a variety of underlying asset classes through which these contracts derive their value. The contracts in the derivative markets are usually in a hybrid form, including forward, futures and options. These can be as broad as to include interest rates to commodities and are majorly entered into to offset risk, through hedging and speculation which helps in maintaining a liquidity-positive market. The market can be divided into two broad categories, the exchange-traded (ET) derivative market with an intermediary involved, and the over-the-counter (OTC) derivative market which does not involve an intermediary and the parties directly negotiate the terms of the contracts usually through derivatives master agreements.

Since being traded in a regulated environment, ET derivatives have gained a lot of traction, offering a standardized form and default elimination of risk, with futures and options (F&O) being the preferred ET derivatives in the market. The major difference between the two being that contrary to a futures contract, an options contract provides the user with a right and not an obligation, to buy or sell something at a pre-determined price. These standard forms of contracts are tailored to determine crucial information like value, security amount, settlement date and process, etc. making it much easier for investors to understand the nuances of the transaction. The exchange in itself acts as a seller for a buyer and vice versa, eliminatingthe risks regarding the defaults on obligations.

Unlike the ET derivatives, the OTC derivatives mostly involve a forward contract type directly negotiated between parties, allowing the buy/sell of the underlined asset on a future date. One of the most popular traded contracts in such a market being the International Swaps and Derivatives Association Master Agreement (MA). This standard allows both parties to the contract to negotiate on each term to tailor fit their needs, which also increases and adds to the complexity of such MAs. This can also pose a high risk for investors without expertise.

SEBI and Derivatives Market Dynamics

SEBI oversees and regulates the capital market space in India, playing a crucial role in supervising, developing and promoting the market. As a part of the process, SEBI regularly releases circulars to keep up with the changing market dynamics and protect the investor’s interests. In 2019, the introduction of weekly expiring F&O contracts by the Bombay Stock Exchange (BSE) gave a huge push to the derivatives market, bringing in an influx of traders focusing on short term opportunities and providing more flexible options to diversify their portfolio. This move was made looking at the success of NSE’s weekly expiring contracts which were introduced in 2016. According to the Futures Industry Association data, around 36.8 billion equity F&Os were traded in the Q2 of 2024, which in itself accounted for more than two-thirds of all F&Os traded globally in 2023.

In the midst of the frenzy, the market caught up to its reputation of being highly dynamic. In FY 2024, Indian retail investors clocked a loss of 91.1%, while at the same time the proprietary traders made a gross profit of INR 330 billion. The data also suggested that the loss-making traders earned a median income of INR 500,000 or below annually.

Fast forward to Q4 2024, SEBI released its circular sighting the market frenzy in equity derivatives space, sighting investor protection and market stability, resulting in a farewell to the hotspot weekly expiring contracts from major indexes and limiting the same to only one benchmark index per exchange, leading to the derivatives volumes crashing down to a whopping 37% in December 2024. In brief the SEBI circular addresses, a stronger focus on the traditional monthly expiring contracts over weekly expiring contracts, sighting a less volatile segment along with a reduced frequency of contract expiration which can promote more market stability. The circular also increased the entry-level contract size for index F&Os from the previous range of 5-10 lakhs to 15 lakhs, making it tougher for small investors to add on to the already speculative market. Along with this, there have been other major changes like the upfront collection of premium for option contracts, intraday monitoring for limiting positions, limiting the weekly expiry contract to one per benchmark index on an exchange, increased extreme loss margin on short option contracts, and calendar spread treatment removal.

As of December 2024, the derivatives trading volume dipped to 37% month-on-month with an average daily turnover for the derivatives segment coming down to INR 280 trillion in just a month which was INR 442 trillion in November, recording the lowest hit since June 2023. However, post the circular came into effect, there has been a substantial increase in the premium derivatives market with bigger players and the value per contract has risen up to 50%.

Way Forward

As apparent from the foregoing discussion, it has become a tussle to strike the right balance, where on the one side, SEBI is meticulously keeping a watch and regulating the market, while on the other side, it has become a dooming scenario for small investors and an overall hit at the market. The regulations have reflected an intention to make the market more exclusive rather than keeping it more open and friendly for various players.

SEBI must come up with innovative solutions to not lead towards over-regulating the market. A similar decline trend can be noticed in the South Korean derivatives markets, once considered to be the global leader and among the most active derivatives markets. Regulators in South Korea introduced similar restrictions, citing financial stability risks, which led to a steep decline in trading volumes in South Korea in 2011. In 2015, the Chinese stock market also took a major hit resulting from over-regulations by the China Securities Regulatory Commission, the impact of which impacted the whole financial ecosystem and saw a major withdrawal of confidence among both domestic and international investors.

Ananth Narayan (a whole-time member of SEBI) in January 2025 affirmed that there will be no further curbs in the derivatives space by SEBI anytime soon and also highlighted that “What is very clear to us is the current way of measuring open interest as notional of futures and notional of options is simply not right. It gives a very, very wrong picture, and there is a need to debate how we move forward into a more meaningful metric”.

While the market presents a higher risk, it is equally rewarding and can aid the country’s economic trajectory. An investor-centric and equally open market in terms of catering to different classes of investors can give a push to the declining value of the rupee as well; this can be done by promoting rupee-focused forwards and increased circulation of domestic currency-focused trades in the small investors’ market. The restriction on the derivatives market may also be linked with the rupee decline panic and may force foreign investors to withdraw. While the current regulations by SEBI are receiving mixed reactions from the stakeholders, a phased implementation of regulations developed in consultation with investors and stakeholders can lead to better market adjustments.