Sebi Plans Stricter Norms for Index Derivatives: What Investors Should Know

The Securities and Exchange Board of India (Sebi) has proposed tighter regulations on index derivatives and stock derivative position limits to reduce risks and curb excessive speculation in the financial markets. According to a Reuters report, Sebi aims to bring more stability to the market following a period of volatility that began after record-high stock market levels in September 2024.

In a consultation paper released on Monday, the market regulator outlined new limits on stock derivative positions, linking them directly to the cash market. Sebi is proposing a cap on market-wide position limits to the lower of 15% of a stock’s free-float market capitalization or 60 times its average daily delivery value.

Why is Sebi Tightening Derivatives Regulations?

Sebi’s concern stems from the fact that high speculation in futures and options (F&O) is spilling over into the broader market. This speculative activity, if left unchecked, could lead to market distortions and increase volatility, making the stock market more unstable for investors.

By aligning stock derivatives with cash market liquidity, Securities and Exchange Board of India (Sebi) hopes to reduce the chances of market manipulation and excessive speculation.

Key Changes Proposed by Sebi

1. Stricter Rules for Index Derivatives

Sebi has proposed stricter regulations to ensure that only indices with a diverse set of stocks are eligible for derivatives trading.

• Minimum 14 Stocks in an Index: Only indices comprising at least 14 stocks will be eligible for derivatives trading.

• Cap on Stock Weightage: The top three stocks in an index cannot collectively hold more than 45% weight, and no single stock can have more than 20% weight.

• Reasoning: This prevents traders from manipulating market prices by taking large unmonitored positions in a few heavily weighted stocks via index derivatives.

2. Position Limits for Stock Derivatives

• Sebi proposes that the market-wide position limit should be the lower of 15% of a stock’s free-float market cap or 60 times its average daily delivery value.

• The goal is to limit speculative positions and align derivatives trading with the liquidity available in the cash market.

3. Pre-Open Session for Futures Trading

• To improve price discovery and reduce volatility, Sebi is considering introducing a pre-open session for futures, similar to what exists in the cash market.

• Initially, this will apply to current-month futures on stocks and indices before expanding further.

Addressing Market Manipulation and Volatility

According to Sebi, index derivatives are cash-settled, but the connection between the cash and derivative markets still exists. The regulator pointed out that when a small number of stocks dominate an index, traders can exploit this concentration to take large, leveraged positions, raising concerns about market manipulation and volatility.

Sebi explained:

"If a high proportion of index weightage is attributable to a small number of stocks, participants could effectively replicate a large (and unmonitored) position in those constituents, giving rise to fears or risks of market manipulation and/ or excessive market volatility."

Impact on Retail and Institutional Investors

• For Retail Investors: The proposed changes will raise barriers for excessive speculation, making trading in derivatives safer but possibly less accessible.

• For Institutional Investors: The limits on index composition and stock derivatives could change trading strategies for funds and large investors who rely on derivatives for hedging.

Sebi's Ongoing Efforts to Regulate Derivatives

This isn't the first time Sebi has taken action to control excessive speculation in derivatives trading.

• In October 2024, the regulator introduced higher entry barriers and increased trading costs for retail investors in the derivatives segment.

• The new proposals are part of Sebi’s broader effort to ensure that market speculation does not lead to financial instability.

Feedback and Next Steps

Sebi has invited market participants to provide feedback on these proposed rules. The deadline for submitting comments is March 17, 2025. Once finalized, these regulations could significantly change how derivatives trading functions in India.

Conclusion

The Securities and Exchange Board of India (Sebi) is making a strong push to regulate derivatives trading, aiming to align speculative activities with cash market realities. By proposing stricter eligibility criteria for index derivatives, capping stock derivative positions, and introducing pre-open sessions for futures, Sebi is looking to curb market manipulation and excessive volatility.

While these measures could limit speculative trading, they are expected to create a more stable and transparent financial ecosystem. As investors and market participants analyze these new proposals, the coming months will reveal how these changes impact market liquidity, trading volumes, and overall investor sentiment.

With Sebi’s consultation period open until March 17, 2025, stakeholders will have a chance to voice their opinions before the rules are finalized. The future of India's derivatives market is set for significant transformation, and these proposed changes will shape the way traders and investors approach the market in the coming years.