Regulatory Zeal Risks Choking India’s Market Engine

Another day… another regulation. This has become a part of the operating procedure for equity market participants of all spots and stripes. The Securities and Exchange Board of India is coming on fast and furious, and participants have been left gasping for breath to comply.

Consider the bewildering plethora of changes in official regulations pertaining to just equity derivatives in the last several months. Changes in lot size. Changes in expiry dates. Prevention of weekly expiries in several underlying indices. Changes in calendar spread-related margins. Changes to premium collection timing. Changes in tail risk-related margins. 

Then consider the “unofficial” regulations that can be inferred from reading the Jane Street tea leaves.

Traders need to only execute near the first bid/ask in the trade book for fear of being labelled “aggressive”. Arbitrage trades cannot be executed in size for fear of being labelled as manipulative, when it is only in large size that arbitrage is helpful in correcting mis-pricings for improved market efficiency. 

Traders have to hazard guesses as to whether retail traders are on the opposite side en masse or not, as losses to them may incur wrath.

Hedges cannot be unwound near the end of the day on expiry days, given the allegedly manipulative market impact they may have, regardless of what happens to the option positions set to expire.

Traders have to watch the P&L on all legs of arbitrage trades to ensure that they are all positive – gains on options and losses on hedges now signal manipulation, in contrast to fundamental tenets of hedge accounting. This all but renders arbitrage as a business all but impossible and ultimately impotent.

Now consider regulations on the anvil.

The closing auctions are now being implemented first in securities where derivatives exist. So now, derivatives traders are exposed to potentially unknown risks with respect to settlement on expiry day. Yes, the SEBI has performed some analysis of what happens in other markets, but prudence demands that this be tried first on securities where there is no impact on the much larger derivatives market.

Intraday monitoring limits are set to be instituted from December. Stock Exchanges are to monitor delta equivalent positions four times a day, but the model to be used to compute delta, especially on expiration day, remains unclear.  Option risks such as gamma and delta decay cannot thus be appropriately accounted for in trading, as models used may not match the regulators, leading to allegations of excessively large positions.

There is now talk about getting rid of weekly expirations entirely. Entire strategies and businesses in the trading arena now have to be reworked to comply with this. This is being done in the name of protecting retail traders in options, but should caveat emptor not be a fundamental principle in regulation? Why kill market efficiency and legitimate business for those who understand these instruments to protect those who do not? 

Maturity extension of options is now being suggested as a replacement. As others have pointed out, longer dated options have very different characteristics from shorter dated ones and cannot be a replacement. In addition, the general experience with longer-dated options in India has not been good. Even today, there is almost no liquidity in the longer-dated options that already exist. Is swapping out an instrument with high liquidity for another that has no liquidity sensible?

Now consider a key question regarding the premise on which much of this regulation is based — most retail traders only lose money. SEBI’s research publishes separate analyses with respect to retail traders’ losses in derivatives and in equity shares, without any reference to the fact that both types of securities, in fact, deal with the same underlying risks and may be used to hedge and offset risks pertaining to each other.  Several simple strategies, such as covered calls or protective puts that are popular with retail traders, rely on profits in one, possible concomitant losses in the other, but with overall gains. By looking at only the losses in the options leg, can one judge whether the overall strategy is profitable or not? Are equity securities and equity derivatives entirely separate markets in which profits must therefore be made independently of each other?  Regulatory decisions appear to be made based on the impossible requirement that both legs need to make money independently, ignoring the inherent connectedness of the two markets.

In addition to such explicit and implicit regulations for equity derivatives, there are several others for equities, mutual funds and bonds. Stepping back and looking at these in toto, there appears to be far too much tinkering from a regulatory standpoint in some markets, while really important issues in others are being ignored entirely – for instance instead of fixing the issue of embedded options in agricultural commodity derivatives to improve their usefulness and performance, the blunt solution of entirely banning such derivatives has been implemented, essentially killing the primary means of hedging price risk in these markets.

While the intent in equity derivatives to protect retail investors deserves plaudits, the plethora of actions now risks falling into micro-management territory rather than being macro prudential regulation that leaves room for innovation for markets. A coherent market development strategy appears missing, and suggests a siloed and fragmented approach to regulation, frittering away the gains made in liquidity and volume that have propelled Indian equity derivative markets to preeminence globally.

Instead of looking at capital markets as a source for driving economic activity and employment, potentially transforming Mumbai into a regional or even global financial centre, this extent of over-reach risks stymying such an objective. Capital Markets are a cornerstone of the economy, stumbles will prove very expensive.