Change is for Good

Last week SEBI came out with certain changes in the way derivatives market functions in India. The idea behind it is to bring about more transparency, efficiency, curbing volatility and investor protection. SEBI is the apex body regulating the financial markets in India. Their focus always has been protection of small investors and regulating financial markets in such a way that it controls manipulation. Derivatives, for some reason is seen with higher caution in India, due to its capacity to create leverage, excesses, attract weak hands, price volatility and price manipulation. But it is the best way to create liquidity and price discovery.

A gist of these changes and the likely impact are:

• F&O list: over time new criteria will reduce existing list; smaller stocks which are generally in ban will exit the list.
• New scrips in F&O: tougher entry norms
• Arb Funds: VWAP risk on expiry ceases if stock in delivery mode.
• Arb funds: can now look @ rolling till last min
• SLB: SLB opportunity likely to increase mainly in 2nd line names.

So, what are the changes and why the changes?

To facilitate greater alignment of the cash and derivative market, physical settlement for all stock derivatives shall be carried out in a phased and calibrated manner. Average rollovers in Indian markets is around 85%, rest get unwind which creates volatility on last half hour of expiry day. This rule will take of this problem. Physical settlement will be only incase one wants to expire his position and roll it over. So, the expiration will be spread over few days and expiry day volatility will be curbed.

• To update and strengthen the existing entry criteria for introduction of stocks into the derivative segment in line with the increase in market capitalization since the last revision of the criteria in 2012. Accordingly, existing criteria like market wide position limit and median quarter-sigma order size shall be revised upward from current level of INR 300 crore and INR 10 lakh respectively to INR 500 crore and INR 25 lakh respectively.
• An additional criterion, of average daily ‘deliverable’ value in the cash market of INR 10 Crore, has also been prescribed. This regulation is the most interesting one, as it removes all the illiquid names in cash market out of the derivatives regime. The enhanced criteria are to be met for a continuous period of six months.
• To begin with, stocks which are currently in derivatives but fail to meet any of the enhanced criteria, would be physically settled. Such stocks would exit the derivative segment if they fail to meet any of the enhanced criteria within a period of one year from the specified date or fail to meet any of the current existing criteria for a continuous period of three months.
• Stocks which are currently in derivatives and meet the enhanced criteria shall be cash settled. Such stocks if they fail to meet any one of the enhanced criteria for a continuous period of three months shall move from cash settlement to physical settlement. After moving to physical settlement if such stock does not meet any of the current existing criteria for a continuous period of three months, then it would exit out of derivatives. After a period of one year from the specified date, only those stocks which meet the enhanced criteria would remain in derivatives.
• To reflect global initiatives on product suitability, a framework has been approved. Individual investors may freely take exposure in the market (cash and derivatives) upto a computed exposure based on their disclosed income as per their Income Tax Return (ITR) over a period of time. For exposure beyond the computed exposure, the intermediary would be required to undertake rigorous due diligence and take appropriate documentation from the investor. This is to remove weak hands who tend to over leverage create excesses in the system.

Few stocks will be impacted due to this and one needs to take cognizance of that. They would be initially put in physical settlement and then can be removed from derivatives segment.

But like always, change is for good and it would improve efficiency in the financial markets.

Happy Trading.

Cheers!!!