Problem of plenty

Derivatives volumes can increase risks

The Financial Stability and Development Council is reportedly considering setting up a panel to study the potential risks arising from a surge in derivatives (futures and options, or F&O) trading. The rapid growth in F&O volumes, coupled with an increase in retail participation, may have led to increased systemic risks and a possibility of contagion if there are high levels of volatility. Although details are sparse, the panel would possibly focus on retail derivatives traders and their possible sources of margin funding. It would examine the possibility that individuals are using personal loans to fund margins for this highly leveraged form of trading. India is an outlier when it comes to derivatives trading. Not only does it generate the highest volumes of F&O trades, it has alarmingly high ratios of derivatives volumes to cash equity volumes. The notional turnover of the Indian market is over 400 times that of the cash equity market. This is in contrast to other large financial markets which generally have ratios of 10 to 15 times.

The volumes are driven by a large and growing population of retail traders. This leads to the possible connection with unsecured loans underpinning trades. If true, that creates a larger amount of risk and the possibility of contagion in the broader financial sector. The F&O turnover doubled in 2023-24 compared to the previous year. According to a 2023 study by the Securities and Exchange Board of India (Sebi), nine out of 10 retail traders lost money, at an average of ~1.1 lakh per trader in FY22. Given that retail participation has increased and trading volumes have more than doubled since FY22, the per capita losses are likely to be even higher now. The regulator suspects that many retail traders take unsecured personal loans in order to put down the required margin on F&O trades, which are generally executed at high leverages. This practice may be especially prevalent among non-banking financial companies (NBFCS) that also have a brokerage arm and in many cases the NBFCS would be borrowing funds from the banking system. If this is the case, substantial risks could arise across the financial system if there is high volatility in the F&O segment.

While futures trading is a zero-sum game, options are not zero-sum. Losses for an option seller could be unlimited and it is likely that the average retail trader is not very skilled in hedging to minimise losses, given the statistics. If traders who borrow to fund margins at high interest rates (personal loans are obtained at high interest rates) do suffer high losses, there could certainly be a negative impact on the lenders. However, one of the suggestions that Sebi tried to implement to assess the level of risk was considered unworkable as well as a violation of privacy. The regulator considered trying to assess the net worth of retail derivatives traders to gauge the level of systemic risk and then set cutoff thresholds for individual traders based on those net-worth assessments. While this specific idea may be unworkable, the proposed panel could find more pragmatic ways to mitigate risks. It could also look for the root causes of the extraordinary trading volumes F&O generates. More data about the segment and a holistic analysis would certainly help. The regulator would also do well to conduct awareness programmes.