Sebi’s new approach to keeping markets under watch should help reduce distortions

The proposal will not only help retail investors, but also institutions such as mutual funds that manage retail money. The existing method of measuring OI by adding the notional value of futures and options makes limited sense. It inadvertently leaves the door open for market risk guard-rails to be bypassed.

Also Read: F&O action: Can new Sebi rules tame wild bulls of the derivatives market?

Regulatory independence: Indian regulators have at times adopted global best practices and at others charted their own path. For example, Reserve Bank of India (RBI) guidelines that predate the West’s 2008 subprime-loan crisis had restrained securitization structures which had a weak economic rationale. But in hindsight, these worked out well.

Take another example. The London Interbank Offered Rate (Libor), once a global lending benchmark, was determined by a process called ‘fixing,’ and had the same executional shortcomings that its name cued. But India’s benchmark, the Mumbai Interbank Offered Rate (Mibor), did not follow what was seen as a ‘best practice’ before it was phased out in 2023.

While the future-equivalent (or Delta) way of calculating OI proposed by Sebi may not be present in major markets, the concept is sound. So, there is no reason why India should not implement it. South Korea and America’s Commodity Futures Trading Commission have already adopted the Delta approach. Sebi’s proposal hits a sweet spot that balances economic correctness with ease of implementation.

Also Read: Sebi’s options plan that spooked many could be in for a review

How easy is it to implement? ‘Delta’ represents the ratio of change in the derivative’s price to the change in the underlying stock price or index value. A futures price tends to have a one-on-one link with the price of its underlying asset. If both prices move in perfect sync, the Delta would be 1. For options, the absolute value of Delta ranges between 1.0 and 0.0, with extreme values observed only when an option is almost surely making money (an in-the-money option) or almost surely not doing so (out-of-the-money).

In the proposed approach, the Delta of futures will be added with the Delta of options, with long positions given a positive Delta and short ones negative. This enables the measurement of risk for the aggregate market portfolio for any given set of changes in market prices.

Of course, this does not cover all types of risks, such as the rate of change of Delta as the underlying asset’s price moves, or what is called Gamma, and other risk measures such as Vega or Theta. In derivatives trading, the risks are regularly calculated and hedged, or traded. Even small trading outfits have the capability to track and monitor these so-called Greeks. Sebi has been sharing daily Delta data for some time. So, the introduction of a Delta-based measure for OI may not surprise traders (influencers, we can excuse).

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The long and short of it: The existing OI measures allow participants to show zero net exposure, which grossly under-represents the actual market risk position. A notional exposure of ₹100 in long futures does not necessarily cancel out the exposure to an out-of-money put option of notional value of ₹100. Still, today’s OI metric will read 0. This gap lets participants game the system and push a stock into a futures and options (F&O) trading ban at very minimal outlay (since out-of-money options are cheap). Such a temporary ban often leads to a fall in its spot price and provides an illicit opportunity to make money to those very participants whose actions triggered the ban. The proposed rule draws a curtain on such gaming.

With respect to the gross value versus net value of Delta-based positions, the debate is more nuanced. Recall the London Whale episode of JP Morgan where $2 billion was lost. That the risk of derivatives exposure was measured on a net-exposure basis, which failed to raise a timely red flag, contributed to it. Net exposure measurement works best when long positions move in perfect unison with short ones, but in opposite direction—theoretically, a perfect hedge.

This, however, never happens. So, Sebi’s proposal of tracking both gross and net positions (and set separate limits) is pragmatic. In the current regime, one may have a huge Delta or Gamma exposure even as OI remains below the ₹500 crore limit. But the proposed method will make it hard to have large hidden risk exposures. It is hoped that exposure limits will balance the need for liquidity, given the growth of India’s market and the risk of single trading outfits bearing large exposures.

Also Read: How futures and options became India’s favourite game: Lessons from the Soviet Union

Long journey ahead: The proposed method will make it more expensive and hard to manipulate F&Os. But Sebi should consider providing a floor for the value of Delta, as opposed to letting it go anywhere near 0. This would prevent any big build-up in deep out-of-money option positions for manipulation. That said, rules alone cannot eliminate market manipulation. The regulator and exchanges must also enhance surveillance. AI-led real-time pattern recognition could further help keep that malpractice in check.

The author is a quantitative risk management professional and member of the visiting faculty at IIM Calcutta and IIM Ahmedabad.