‘Gamification’ of Indian equities poses macro and market threats
India’s staggeringly large retail participation in high-risk derivatives trading calls for the use of risk-curbing disincentives
is chief investment officer at Axis AMC.
Indian equity market capitalization has more than doubled to $4.7 trillion in the past five years (as on 26 February 2024). Market depth has increased, with cash-market volumes now averaging $14.9 billion daily. Domestic investors have participated in this, with 80 million investors now directly accessing this market, some 40 million of them through equity mutual funds. Indian retail investors have participated in this wealth creation journey of half a decade, having gained an estimated ₹16 trillion in their investments in mutual funds and ₹20 trillion from direct equity investments. The combined value of their investments in mutual funds and equity is now placed at over ₹67 trillion.
Another equally remarkable transformation has been the emergence and now dominance of derivatives trading. The equity derivatives market in India is about 400 times bigger than the underlying cash-market in terms of traded volumes, by far the largest multiple globally. In most markets, derivative volumes accounts for 5-15 times their cash-market volumes. Derivatives in India account for a staggering 99.8% of market volumes, trading a notional turnover of over $5.9 trillion per day.
This ‘gamification’ of the derivatives market has led to a 20-times jump in trading volumes from pre-covid levels, led by a proliferation of short tenure options, and increased ease of onboarding as well as an easy-to-use interface offered by trading apps. The number of active derivatives traders has increased 8 times to about 4 million from less than half a million in 2019. In comparison, in the cash market, the number has grown 3 times—from about 3 million in 2019 to 11 million.
The availability of shorter-duration options (expiry day options are now 64% of total volumes) has led to ‘sachetization’ of the derivatives market, with the average ticket size of contracts now down to ₹1,500, compared to ₹3,600 in 2020. This trend is visible in the US as well, with zero-day-to-expiry options (contracts that expire on the same day as they are traded) constituting 55% of S&P 500 volumes in August 2023.
High embedded leverage in shorter tenor deals (up to 500 times) and the lure of lottery-like returns are attracting a growing number of traders to these. Retail traders have an average holding period of less than 30 minutes. The demographic profile of these traders is also getting younger and nearly 90% of additions are now from India’s Tier 2 cities and beyond.
While retail investors in the cash market and mutual funds have gained significantly in the past five years, a report by the Securities and Exchange Board of India (Sebi) highlights that nine out of 10 traders lose money in the derivatives market. The aggregate loss, as per the study, was ₹372 billion in 2021-22. Approximately ₹448 billion was lost in total by 90% of this market’s participants, while 10% made money, earning a collective ₹76 billion.
Regulators have instituted several measures to curb the build-up of risk at a systemic level, such as imposing higher margin requirements. In addition, the large risk in options trading is being highlighted to investors by Sebi, which has mandated the display of its study’s results every time an investor logs in to a trading account. The government also increased the securities transaction tax (STT) on derivatives by 25% in 2023.
Does this deter investors? Only a few, as seen from the continued strong growth in derivative volumes. Derivatives do have a useful economic function, as they let risks be transferred from participants who do not want to bear them to those who are ready to (for probable returns). They also provide liquidity to supplement what is available in the cash market. An outsized derivatives market, though, can itself be a source of macroeconomic and market risks. We have seen this in global cases with credit default swaps (CDS) and derivative contracts. Black-swan events and resultant spikes in volatility can drive exaggerated moves in stock prices and thereby lead to market dislocation.
At an individual level as well, buying options can lead to a significant loss of capital. If one is dealing with futures or selling/writing options, the loss can be several times greater than the initial capital.
Derivatives are sophisticated products that carry an asymmetric risk-return profile, given the largeembedded leverage. Access to portfolio management services (PMS) and alternative Investment funds (AIFs) is limited only to investors whose net worth is above a certain threshold. This leaves large numbers who practise retail trading on their own. In general, to curb risk, the sachetization of derivatives can be tempered by setting up minimum floors for contract premia, going beyond just limits on lot size based on notional value. Similarly, the government could consider levying the STT on notional value instead of the premium of an option, which will act as a disincentive for shorter-duration contracts.
Retail investors should remember that just as Rome was not built in a day, they should not expect overnight success stories. They must invest in markets for the right reasons, with appropriate expectations based on their risk profile and goals, instead of chasing daily returns in a risky market.