SEBI Navigates F&O Market Complexity: Balancing Retail Oversight with HFT Relief

India's market regulator, the Securities and Exchange Board of India (SEBI), is closely scrutinising activity in the options market while simultaneously considering regulatory adjustments that could offer relief to high-frequency traders (HFTs). This comes amidst a backdrop of persistently high retail participation in the futures and options (F&O) segment, despite previous attempts to curb it.

The regulator may also look to modify the market-wide position limit (MWPL) across exchanges, potentially linking it to delivery volumes of stocks. This measure is aimed at preventing manipulation and the cornering of stocks by any single entity. MWPL defines the total number of stock options and futures contracts an entity can trade across exchanges.

Persistent Glare on Retail Activity

Retail participation in index options remains a key concern for SEBI, with activity staying elevated despite regulatory steps introduced in October and February. The regulator is expected to continue monitoring retail behaviour in this segment, as India leads globally in index options trading relative to its cash equity market size.

In October, SEBI increased the lot size of index options to 75 shares from 25 and restricted exchanges to a single weekly index expiry. These measures aimed to curb retail losses, with SEBI data revealing individual investors lost ₹1.89 trillion during FY22-24, mainly on expiry days, while high-frequency traders (HFTs) booked gains.

Analysts link the surge in options trading volumes to SEBI's 2019 mandate requiring upfront margin collection for intraday cash market trades. This move reduced leverage access and pushed retail traders toward index options, skewing volumes. Meanwhile, SEBI is expected to withdraw a February proposal to impose intraday monitoring of a ₹1,500 crore gross limit on index options positions. The proposal was aimed at curbing large exposures by HFTs.

However, following significant opposition from market participants, the regulator has now decided to substantially raise these limits. The gross limit is set to increase to ₹ 10,000 crore from ₹ 1,500 crore, and the net limit will rise to ₹ 1,500 crore from ₹500 crore, with the crucial change being the removal of the intra-day monitoring requirement. Clients will now only need to adhere to the ₹1,500 crore net limit and not exceed the ₹ 10,000 crore gross limit by the end of the trading day. This adjustment has been described by one broker as a "major relief" from the earlier proposal, which was feared to result in rising impact costs and a drain on market liquidity.

Tweaks to Market-Wide Position Limits and FPIs

Beyond index options, SEBI has already reduced market-wide position limits to 15% of a stock's free float from the previous 20%. Exchanges have the discretion to stipulate the lower of 15% of a stock's free float or 65 times the average daily delivery volumes (ADDV), subject to a floor of 10%.

For Foreign Portfolio Investors (FPIs), the limit for index options has been increased to a net ₹ 1,500 crore. Previously, FPIs could hold positions of ₹ 500 crore each in index options and futures contracts over and above their underlying exposure, a limit introduced post-Covid to prevent market meltdowns from excessive derivatives trading. For index futures, SEBI is likely to stipulate the higher of 15% of the futures open position or ₹ 500 crore. Trading members (covering both proprietary and client positions) face a limit that is the higher of 15% of open interest or ₹7,500 crore. Furthermore, SEBI has proposed calculating the open interest of index options based on delta, a measure reflecting the change in option price relative to the underlying asset. This move has been largely welcomed by market participants.

The proposed changes signal SEBI's nuanced approach to market regulation, attempting to balance concerns over potentially excessive retail speculation with the need to provide sufficient operational flexibility and liquidity for sophisticated market participants like HFTs and FPIs. 

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