India’s market regulator has put forward a proposal to reduce position limits for equity stock derivatives while also introducing stricter regulations for index derivatives. This move is aimed at minimizing the accumulation of excessive risk within these markets. By lowering the permissible limits for holding positions in equity derivatives, the regulator seeks to curb speculative trading and ensure greater market stability. Additionally, the tighter rules for index derivatives are expected to enhance oversight and reduce the likelihood of market volatility triggered by large, concentrated bets. These measures are part of a broader effort to strengthen the overall risk management framework and promote a more balanced and resilient financial market environment.
The latest proposals from the Securities and Exchange Board of India (SEBI) build upon regulatory changes introduced in October. In those earlier reforms, SEBI raised the entry requirements for participating in derivatives trading, effectively making it more challenging for individuals to access these markets. Additionally, the cost of trading derivatives was increased, with the primary objective of offering greater protection to retail investors by reducing their exposure to high-risk financial instruments.
The new set of proposed measures comes amid growing concerns that heightened volatility in the futures and options (F&O) segment is beginning to affect the broader stock market. This concern has gained urgency as the overall market, after reaching record highs in September 2024, has since experienced sharp declines. By tightening regulations further, SEBI aims to curb excessive speculation, stabilize market conditions, and prevent any potential spillover effects from the derivatives market that could destabilize the larger equity market.
In a consultation paper released late on Monday, the Securities and Exchange Board of India (SEBI) put forward a proposal suggesting that the market-wide position limit for single-stock derivatives be directly linked to activity in the cash market. This means that the maximum allowable positions traders can hold in single-stock derivatives would be tied to the trading volume and liquidity of the underlying stocks in the cash market. By aligning derivative limits with the cash market, SEBI aims to ensure that trading in derivatives remains proportionate to actual market activity, thereby reducing the risk of excessive speculation and promoting market stability. This measure is intended to create a more balanced relationship between the derivatives and cash segments of the market.
SEBI has proposed setting the position limit for single-stock derivatives based on a threshold determined by two factors. The limit would be set at the lower value between 15% of a stock’s free-float market capitalization or 60 times the average daily delivery value of that stock.
The free-float market capitalization refers to the total market value of a company’s shares that are available for public trading, excluding shares held by promoters or other strategic investors. By tying the position limit to this metric, SEBI aims to ensure that the size of positions in derivatives remains proportionate to the actual market value of shares available for trading.
Alternatively, linking the limit to 60 times the stock’s average daily delivery value ensures that trading volumes in the derivatives market remain in line with the stock’s liquidity in the cash market.
According to SEBI, this dual approach is designed to minimize the risk of market manipulation and align the exposure in derivatives more closely with the underlying stock’s liquidity. This, in turn, would help maintain market stability and reduce the potential for speculative excesses that could disrupt the broader market.
The market regulator has also suggested introducing stricter eligibility criteria for offering derivatives on stock indices other than the two primary benchmarks, the BSE Sensex and the NSE Nifty 50. Under this proposal, derivatives on alternative indices would only be permitted if the respective index meets specific predefined conditions set by SEBI.
These criteria are likely aimed at ensuring that only indices with sufficient market depth, liquidity, and representation of the broader market are eligible for derivative trading. By imposing these requirements, SEBI seeks to maintain the integrity and stability of the derivatives market, preventing the introduction of products based on less liquid or narrowly focused indices, which could pose higher risks for investors and contribute to market volatility.
SEBI noted that although index derivatives are settled in cash rather than through the physical delivery of underlying assets, there remains a strong connection between the cash market and the derivatives market. This linkage exists because the prices of index derivatives are inherently based on the movements of the underlying stocks that make up the index in the cash market.
As a result, fluctuations or trends in the cash market can directly influence the value of derivatives contracts, and vice versa. SEBI’s observation highlights the importance of maintaining regulatory oversight across both markets to ensure that trading activities in derivatives remain aligned with the actual performance and liquidity of the underlying assets in the cash market.
SEBI highlighted a potential risk associated with index derivatives, noting that if a significant portion of an index’s overall weight is concentrated in just a few stocks, traders could indirectly accumulate large, unmonitored positions in those individual stocks. This could lead to concerns about possible market manipulation or contribute to heightened market volatility, as substantial trading activity in a small number of influential stocks could disproportionately affect the broader market.
To address this issue, SEBI has proposed a safeguard: derivative contracts should only be introduced on indices that consist of at least 14 constituent stocks. By ensuring a broader distribution of weight across a larger number of stocks, this measure aims to reduce the concentration risk and minimize the chances of excessive influence from a few heavily weighted stocks. This would help create a more balanced and stable trading environment, aligning derivative activity more closely with the overall health and diversity of the market.
SEBI has further recommended setting limits on how much influence individual stocks can have within an index to prevent excessive concentration of market power. According to the proposal, the combined weight of the top three constituent stocks in any index should be capped at less than 45% of the total index value. Additionally, no single stock should carry a weight exceeding 20% of the index. These measures are designed to promote diversification within indices and reduce the risk of market manipulation or undue volatility caused by a small number of heavily weighted stocks.
In addition to these guidelines, SEBI has proposed introducing a pre-open session for the futures market, similar to the one currently used in the cash market. This pre-open session would initially apply to current-month futures contracts on both single stocks and indices. The goal of this initiative is to facilitate more orderly price discovery and reduce volatility at the market’s opening, providing participants with a clearer sense of market direction before regular trading begins.
SEBI has invited feedback from market participants on these proposed regulatory changes, allowing stakeholders an opportunity to share their views, suggestions, and concerns. The regulator has set a deadline of March 17 for submitting responses. This consultation process is intended to ensure that the final regulations are well-informed by the perspectives of various market participants, including investors, brokers, financial institutions, and other stakeholders. By seeking input from those directly affected by these changes, SEBI aims to create a balanced regulatory framework that addresses market risks while supporting healthy market growth and participation.