India’s derivatives trading boom

Photo from Invest India

Retail-driven growth of derivatives trading in India raises concerns

India’s derivatives market is booming, driven by millions of small investors using new mobile technologies to trade on the country’s exchanges. It has ignited concern among Indian regulators about potential market instability.

According to the Futures Industry Association, the National Stock Exchange of India (NSE) was the world’s largest derivatives exchange for the fifth consecutive year in 2023 based on the number of contracts traded. And the World Federation of Exchanges ranked the bourse third globally by the number of equity trades.

It “demonstrates the strong capabilities of Indian capital market ecosystem on the global map”, Shri Sriram Krishnan, the NSE’s chief business development officer, said in a statement in January. “This will help attract new investors as well as fund flows to Indian markets, thereby aiding capital formation,” he added.

The growth has been driven by sustained domestic mutual fund inflows, increasing foreign investment, a surge in the number of investors, robust macroeconomic growth, and steady corporate earnings. A shortened T+1 settlement for Indian securities instituted in January last year has also improved efficiency and liquidity.

In 2023, the number of individual investors on the (NSE) register surpassed 85 million, with the last ten million added within just eight months. Foreign portfolio investors have also been growing, with at least one new account opened every three days over the past year.

The Nifty index tracking the 50 largest stocks on the NSE surged over 20% last year and the Sensex index of the top 30 companies on the Bombay Stock Exchange (BSE) jumped nearly 19%. It was the best year for the benchmarks since 2021 and the second best since 2017.

Alongside the bullish stock market, a frenzy for derivatives trading saw a remarkable 153% surge in stock index options to 84.3 billion contracts traded on the NSE in 2023. Globally, equity-related derivatives trading hit 112.4 billion contracts, with the NSE accounting for 75% share of the global equity option market.

The NSE’s total futures and options turnover, including equity, currency, commodity, and interest rate-based products, surpassed US$5 trillion in daily value, equivalent to the bourse’s market capitalisation, underscoring the magnitude of the activities.

Speculative trades

The derivatives boom shows no signs of slowing down in 2024. In March, monthly notional value of derivatives traded on Indian exchanges skyrocketed to almost $105 trillion, more than doubling from twelve months ago. Both the NSE and BSE are actively launching new products and cutting fees to attract investors and compete for a share of the growing derivatives market.

A research report by India’s Axis Mutual Fund last October noted that the notional value of derivatives traded on Indian markets was 400 times that of cash equity, the highest ratio in the world, and 900 times delivery-based trading volumes. In most markets, derivatives volumes are typically five to 15 times that of cash market volumes.

Weekly expiry stock index options are the most popular choice for Indian retail investors, accounting for 95% of trades. These options are particularly attractive due to their embedded leverage, allowing investors to gain exposure to full notional value by paying only 0.5%-5% of the underlying asset, significantly lower than the premium for monthly contracts.

To further attract investors, the NSE and BSE have synchronised weekly expiries of their option products for various indices, ensuring different derivative contracts are available for trading every day of the week. This has significantly boosted trading volumes.

Zero-day-to-expiry option contracts on indices have been introduced recently, allowing traders to bet on a short-term index price movement without an underlying exposure. The contracts expire on the same day they are traded.

“The introduction of shorter duration in options has effectively ‘sachet-ised’ trading, reducing the capital needed to take on similar risks,” the Axis report said.

Most of these derivatives trades are speculative. Only 1% of daily traded volumes, or one out of 100 contracts, are carried forward to the next day. Retail investors hold these options for only 30 minutes on average, according to Axis.

Young investors

Ease of onboarding and convenience offered by the new-generation trading apps, investors’ tech-savviness and widespread Internet use have contributed to the surge in derivatives trading. India’s unique biometric identity system, Aadhaar, covering 1.3 billion people, facilitates seamless transfer of money and authentication for third-party services.

The average age of an equity retail investor is 35 years, and the average of those using digital discount brokers is 29 years. Over 80% of them are male. Notably, half of new customers are below 25 years old.

While the trading boom is generating strong revenues for brokerages, banks, stock exchanges and the overall financial ecosystem, the influx of young and inexperienced investors participating in the speculative frenzy has raised concerns.

The Securities and Exchange Board of India (SEBI) conducted a study in January 2023 to examine profit and loss of individual traders dealing in equity forwards and options. It found that, based on data from the top ten brokers representing 67% of such activities on the NSE, the number of retail investors had increased fivefold since 2019, reaching 2.8 million in 2022.

Nine out of ten individual traders lost money in 2022, incurring a loss of 110,000 Indian rupees ($1,320) on average. The average gain for the winners was only $1,800.

Addressing the issue is challenging. Crackdowns on social media influencers promoting speculative trading have had little impact. Increasing the minimum contract sizes for equity derivatives in 2015 and implementing tighter margin rules in 2021 have prompted retail traders to try their luck with options instead of futures contracts that are binding.

For now, SEBI does not perceive a systemic threat to financial stability. But it has repeatedly cautioned investors to focus on long-term investing and emphasised the importance of investor education. These messages are echoed by the exchanges. The Reserve Bank of India's Financial Stability Report also calls for vigilance but points out that India’s margin requirements are higher than those of other countries.

The 8.5 million individual investors in equity derivatives represent less than a quarter of total retail investors in India. Almost 80% of their traded contracts are less than 1 million Indian rupees, contributing only 2.5% of total turnover.

Nevertheless, retail investors now account for 27% of the notional turnover in equity derivatives, while proprietary traders have 60% market share. Given the continuous increase in retail participation, the trend cannot be ignored.

Risks

The outsized derivatives market itself can pose additional macro and market risk over time, as seen in global cases involving credit derivative swaps. Black swan events and the resultant spike in volatility can trigger exaggerated movements in stock prices and create market dislocations.

At the individual level, loss of capital from options trading can be significant due to the embedded leverage. Risky bets and losses can lead to distress among retail traders, which may have social implications.

In April, SEBI introduced a new rule to rein in the $5 billion currency derivatives market, requiring participants to have actual foreign exchange exposure for their contracts. The rule aligns with the central bank’s broader foreign exchange management policy to control swings in the rupee ahead of the inclusion of India’s bond markets in JPMorgan Chase’s global indexes from June this year and the Bloomberg global index in January 2025. As a result, individual traders, speculators and arbitragers will be forced out, leading to a decline of at least 70% in trading volumes.

Indian stocks have reached unprecedent valuations despite favourable macroeconomic developments, prompting some funds to shift to cheaper alternatives. According to Bloomberg, nervous global investors withdrew a net $3.5 billion from India’s stock markets over the first three weeks in May.

It’s timely that Indian regulators are currently discussing the creation of a panel to assess the derivatives market’s stability and make necessary policy changes to prevent unforeseen risks. This, along with investor education, will be key to ensuring long-term health of the financial system.

*This article was published in Asia Asset Management’s June 2024 magazine titled “Explosive growth.”