Last Thursday, speaking at a press conference, the chairperson of the Securities and Exchange Board of India (SEBI), Madhabi Puri Buch, expressed concerns over massive speculative volumes in derivatives trading. Trading volumes in derivatives have, indeed, exploded (mainly in stock options) over the past few years, leading to fears of speculative excesses.
Nithin Kamath, founder of stock broking firm Zerodha said on X: “We are in the middle of a period of excess in options trading. Volumes in index options have gone up from Rs4.6 lakh crore in 2018 to Rs138 lakh crore in 2024, and, more importantly, the share of retail has gone up from 2% to 41%.”
Unfortunately, SEBI’s concern seems rather late and also misdirected. Here is why.
Speculation vs Hedging
SEBI is worried that a lot of options trading is only speculative and not in the nature of hedging. SEBI is right about this but, on a lighter note, it reminded me of something that a third-generation stockbroker told me 25 years ago. At a meeting with brokers in the 1970s, a finance ministry official complained that there was too much speculation on the Bombay Stock Exchange. One of those present muttered in Gujarati, “Market ma satto na thai toh su thai?” (If not speculation, what on earth should happen on the stock market?).
SEBI is also concerned about the absence of a link between the cash market and the futures & options (F&O) market. But the majority of option traders have never traded options to take or give delivery. In fact, I could not find data for how many option contracts result in physical delivery; but the amount is likely to be minuscule.
If an option trade does result in delivery, it would be incidental, perhaps an oversight by the trader, but not a part of any hedging strategy. This has been the case ever since stock options were introduced. For index options, delivery is irrelevant anyway.
Ms Buch also said, from a larger macroeconomic perspective, “A large amount of money is going from household savings into what is essentially not productive economic activity. This is speculative activity”. The money is “not going into any capital formation in the economy,” she said.
This is, indeed, true, but stock trading (whether in cash or the derivatives market) by itself has never been a productive activity anywhere in the world, right since the first stock market was set up in Amsterdam in 1602.
From a macroeconomic standpoint, stock trading in the secondary market is a necessary evil to allow the primary market to function. It is the primary market that channels savings into enterprises, but it cannot survive on its own; it needs a secondary market to create confidence among primary market investors about adequate trading liquidity that will allow them to exit when they want to. This confidence is important so that enterprises can keep attracting savings through equity issues.
Incidentally, commodity markets do not even perform the function of channelling savings to enterprises nor is it offering serious hedging to manufacturers or farmers.
Now, if there are serious concerns about extreme speculation in derivatives, how has this excess come about? After all, options were introduced by stock exchanges under SEBI approval. Exchanges are now ‘for-profit’ entities but SEBI has complete ultimate control over all aspects of the market including approving the appointment of heads of exchanges and key management personnel.
Under a SEBI mandate, when traders log on to a trading portal, they are forced to read a pop-up of a SEBI study that says ‘9 out of 10 individual traders in the equity futures and options segment, incurred net losses. Over and above the net trading losses incurred, loss makers expended an additional 28% of net trading losses a transaction costs. Those making net trading profits, incurred between 15% to 50% of such profits as transaction costs’.
Who is on the other side of these transaction costs? Five entities: brokers (brokerage fees), exchanges (fees), SEBI (fees), the state government (stamp duty) and the Central government (securities transaction tax-STT). Are these entities prepared to forego the bumper revenues they earn in order to reduce speculation?
Indeed, there is a lack of clarity even among policymakers on how to tax derivatives income. Derivatives are, indeed, speculative products. But strangely, gains from derivative trading are not treated as speculative income but as business income for income-tax (I-T)!
There was a difference in views when derivatives were launched. In 2001, the doyen of modern capital markets, the late Dr RH Patil, said in a speech: “The original plan of bringing futures to the country in place of badla was to introduce index futures, index options and stock options. The SEBI Committee that went into the whole issue of equity-based futures was not in favour of stock futures. In most of the countries where equity futures are traded the individual stock futures either do not find any place or even if they are grudgingly allowed, not much trade takes place in them.”
But Dr Patil’s views were discarded and 'speculation' took off. The second big boost to speculation came when SEBI allowed exchanges to introduce weekly expiries in 2019. The fact is, SEBI had no problem with derivatives until trading exploded post-COVID.
But now, having built a dangerous road, from which different entities, mainly the government, are extracting a heavy toll, SEBI is concerned that people are driving on it in much greater numbers.
While SEBI has set up a committee to examine the issue, if it is interested in saving speculators from themselves, SEBI could start by scrapping the weekly expiry of options.
(This article first appeared in Business Standard newspaper)
