Why regulatory restraints are not enough to contain retail trading in F&O

Retail participation in index options rose 25.9% year-on-year in 2022-23, with a turnover of  ₹96.8 trillion, representing 35% of the market share.
Retail participation in index options rose 25.9% year-on-year in 2022-23, with a turnover of 96.8 trillion, representing 35% of the market share.

Summary

  • The number of individual traders in the derivative segment has surged from 710,000 in 2018-19 to 4.52 million in 2021-22 and 9.57 million in 2022-23

Financial derivatives play an essential role in the growth and expansion of the securities market by providing investors with cost-effective risk management tools, opportunities for investment diversification, and improving the markets’ overall informational and pricing efficiency. High liquidity, volatility and market capitalization of the underlying asset contribute positively to the success of derivative contracts.

In recent years, the number of individual traders in the derivative segment has surged—from 710,000 in 2018-19 to 4.52 million in 2021-22 and 9.57 million in 2022-23, as per data from the Securities and Exchange Board of India (Sebi). Retail participation in index options rose 25.9% year-on-year in 2022-23, with a turnover of 96.8 trillion, representing 35% of the market share. However, retail involvement in index futures dropped.

This trend is also evident in stock options compared to stock futures. Individual investor activity in stock options surged 40.6% year-over-year to 8.2 lakh crore premium turnover, representing a 29.7% share. (Source: NSE Market Pulse.)

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This surge in retail participation is not unique to Indian derivatives markets. Globally, exchange leaders like Nasdaq chair and chief executive officer (CEO) Adena Friedman and Terry Duffy, chair and CEO of the CME Group, report heightened participation of individual investors in derivative markets who prefer to deal in more minor contracts and shorter durations. This trend of retail investors driving derivative volumes is also seen in large US exchanges dominated by institutional investors and hedgers.

Cause for concern

In India, the critical factor contributing to the attractiveness of options is “the embedded leverage that allows traders to take large exposures with minimum upfront cash" (Reserve Bank of India’s Financial Stability Report, December 2023), resulting in the bulk of intraday cash players moving to index option products. The other factors contributing to this increase may be the democratization of market access and low-cost access to analytics, tools and information for retail investors and brokers. Constructive use of technological advancements supported by artificial intelligence has helped, to some extent, level the playing field for retail investors.

From a regulatory perspective, this unprecedented surge in retail participation is welcome, but at the same time it is a cause for concern. The concerns relate to whether a derivative as a product is suitable for retail investors, whether it is adequately protected, and whether it will sustain the risks/potential losses that may accrue to it.

Union finance minister Nirmala Sitharaman recently echoed this concern during an event at the BSE. She pointed out that an unchecked explosion in retail trading in futures and options (F&O) can create future challenges for the markets, investor sentiment and also for household finances.

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Safeguarding retail investors

In the last few years, the Indian derivatives market has witnessed many regulatory changes to bolster investor confidence, balance market development and prevent market abuse. Initiatives like aligning margin levels to volatility, providing cross-margin benefits to traders, rationalizing and introducing short maturities and small lot sizes across derivative products, and spreading the expiry day for index derivatives across different weekdays, support market development. They will help reduce capital requirements, improve the hedging effectiveness of trades, and lower risk as the lot size is low.

Recently, the National Stock Exchange (NSE) reduced the lot size of three index derivatives and some stock derivatives. The introduction of mandatory physical settlement for stock derivatives, revision in market-wide position limits, collection of upfront client margins for positions created, and enhanced surveillance measures are aimed at managing systemic risk, protecting the markets from price manipulation, preventing excessive speculation, and detecting and preventing market abuse.

From an investor protection perspective, Sebi studied the profit and loss of individual traders in the equity derivatives market. The study concluded that 9 out of 10 derivative traders are incurring losses, and the average loss per active trader was 50,000 in 2020-21. To warn uninformed investors, Sebi mandated all brokers to display these results on the trading terminal to increase awareness and encourage retail investors to take risks with adequate product knowledge. Despite these warnings, retail participation in derivative products has remained the same.

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Regulatory measures restraining retail participation or a stringent product suitability framework may not be the right way forward. Actively campaigning and educating small investors about the risks related to derivative products and warning against disproportionate exposures in derivatives similar to mutual fund campaigns may help. More importantly, to ensure that the markets have equal participation from retail, institutional and foreign participants, investing in resources and technology that may provide unbiased, low-cost education to all investors is essential.

While the Indian markets are now moving towards providing a level playing field for retail participants, it is necessary to provide adequate financial knowledge for all. It is important to protect investors from reckless misguiding finfluencers and lay the foundations for creating a diverse fabric of informed investors and market participants.

Latha Chari and Rasmeet Kohli are, respectively, professor and assistant general manager at the National Institute of Securities Markets. Pradiptarathi Panda is assistant professor at the Indian Institute of Management, Raipur. The views expressed are personal.

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