Why Sebi’s reviewing the eligibility criteria for derivatives trading

The review comes after a gap of six years, during which the markets have grown phenomenally, including in terms of delivery volumes and market capitalisation. These factors have necessitated a review of the eligibility criteria for stock derivatives. To this end, Sebi has sought comments on a consultation paper by 19 June. 

Mint dives into the reasons for and implications of the market regulator’s latest decision.

 

What are the existing criteria for derivatives trading?

Derivatives, both futures and options contracts, on stocks can be traded on recognised exchanges only if they satisfy certain criteria that were previously reviewed in 2018. The eligibility criteria relate to average daily market capitalisation, average daily traded value, average daily delivery value, and market-wide position limit, or MWPL, on a rolling basis for a continuous period of six months. 

There are also criteria for frameworks related to index derivatives (such as Nifty, Bank Nifty futures, and options contracts). These stipulate that at least 15% of the trading members active in all stock derivatives, or 200 members, whichever is lower, shall have traded in any derivative contract on the stock, and the average daily turnover (option premium basis) would be a minimum ₹150 crore.

Only stocks from among the top 500 in terms of average daily market cap and average daily traded value on a rolling basis qualify. The average daily delivery volume on the cash market should not be less than ₹10 crore. 

Another criterion relates to a stock’s median quarter sigma order size not being less than ₹25 lakh over the previous six months on a rolling basis. 

This refers to the order size in value terms required to cause a change in the stock price equal to one quarter of a standard deviation, where standard deviation measures the dispersion of a dataset relative to its mean. The higher the quarter sigma order size, the more difficult it is to manipulate a stock. 

Why is there a need for a review now?

Following the review of the eligibility criteria in 2018, the number of stocks in the derivatives segment reduced to 144 in financial year 2019-20 and 156 in FY21, from 196 in FY19. It currently stands at 182. 

The parameters reflecting market cap and turnover in the capital markets segment, though, have surged, with the number of demat accounts rising to 158.05 million in the current fiscal year through May from 40.8 million in FY20. 

The capital markets and the derivatives segments make up the overall equities markets.

The surge in the capital markets segment has increased trading interest, which, in turn, has affected index values, delivery volumes, traded volumes, and market cap, to name a few. 

For comparison, the Nifty 50 has risen 110% from 10,736 points in May 2018 to 22,530.70 in May 2024. Stock market capitalisation has zoomed 178% to ₹408.8 trillion. The average daily turnover has increased 253% to ₹1.12 trillion, and the average daily delivery by 208% to ₹29,677 crore over the same period. 

This development in the cash segment has led Sebi to review the criteria for stock derivatives in the interest of investors. 

What’s the rationale for this review?

The stock exchanges have a capital market segment and a derivatives segment, which influence each other. The derivative gets its value from the stock traded in the capital market segment. Actual holders of stocks use the derivative counterpart to hedge against price risk volatility. 

Hedging is the act of taking contrary positions on the same asset in two different segments—in this case, the capital markets and the derivatives segments. If the cash share falls, the sell position in the futures segment helps offset the loss. If the cash share rises, the loss in the futures segment is offset. 

The counterparty to the hedger is the speculator, who takes on the risk that the former seeks to cover themself against. The speculator, typically an informed investor, takes a contra bet. If there are more speculators than hedgers, the market gets skewed.

Given the evolving situation in the cash market over the years, Sebi felt it needed to tweak the eligibility criteria for the stock derivatives segment to keep it aligned with the former. This will help in curbing manipulation, which is in investor interest. 

How will this affect stocks?

If the market turnover and delivery volumes in the cash segment are increased, new stocks could be included in the derivatives segment, and others could be excluded. 

Stocks that could face removal if Sebi’s proposals are implemented with base-case changes in any one of its laid out criteria include Abbott India, Atul, Bata India, Berger Paints, CanFin Homes, Mahanagar Gas, Gujarat Gas, and Dr Lal Path Labs, according to brokerage Nuvama. 

Those that could enter the derivatives segment include Zomato, Yes Bank, Jio Financial, Adani Green, and IRFC, it said. 

What are the proposed changes?

The rule on stocks having to be in the top 500 in terms of the average daily market cap and the average daily traded value has been left unchanged. The criterion of the median quarter sigma order size is proposed to be increased to ₹75 lakh-1 crore from ₹25 lakh presently. 

The rationale is that the average market turnover has grown 3.5 times the figure during the review in 2018. The increase in sigma order would therefore need to be increased proportionately. 

The market-wide position limit (the maximum number of outstanding futures and options contracts for a particular underlying stock), which was ₹500 crore, is proposed to be raised to ₹1,250-1,750 crore, as the average market cap is 2.8 times that in 2018, while the average turnover is more than 3.5 times higher. 

The average daily delivery value is proposed to be raised to ₹30-40 crore from ₹10 crore, as the delivery value on average has risen by three times. 

These changes will raise the bar and make it more difficult to manipulate stock derivatives as only those that meet the criteria of market cap and trade value, among other things, will ensure that broader represented constituents are listed on the derivatives segment.