Dalal Street Advocates for Suitability Tests Over Stricter SEBI Regulations in F&O Trading

India's financial hub, Dalal Street, is imploring the Securities and Exchange Board of India (SEBI) regarding investor suitability tests for Futures and Options (F&O) trading instead of more stringent regulation that may restrain innovation and competition in the market.

This plea came after SEBI recently issued a consultation paper that intends to formulate stricter rules governing the equity derivatives market to reduce the risks of retail investors participating in high-risk trading activities.​

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Industry's Call for Investor Education

Market participants have suggested an alternative approach of mandatory suitability tests for retail investors. Such tests would put a battery of parameters on an investor, such as financial literacy, risk tolerance level, and understanding of derivatives, before access to F&O. This brings the whole process in line with other international financial centers like Singapore, Hong Kong, and the European Union, all of which attach great importance to investor education when it comes to participating in more sophisticated financial instruments.​

Concerns Over Proposed SEBI Measures

Among the proposed measures by SEBI are the suggested limitation on futures and options contract expiries to a particular day of the week, a fresh methodology for open interest calculation, and a market-wide position limit. All these steps are aimed at curbing speculative trading and enhancing the stability of the markets. However, experts in the industry are quick to warn of the potential for some unintended consequences. 

The limitation on contract expiries may concentrate trading on specific days and create a situation of volatility with many increased and simultaneous investments in risk management infrastructure. This concentration might pose issues for smaller exchanges and new entrants that could not afford the consequential infrastructure investment, harming competition and innovation in the derivatives chain. ​

Impact on Retail Participation

Notably, the mandate of the minimum size of the contract and the reduction in the extent of weekly option contracts are some of the earlier interventions by SEBI, which have severely limited retail participation. Results of a study show that retail traders lost almost ₹1.8 lakh crore on speculation in derivatives in the last 3 years. Further regulatory changes cut the 20% drop in retail premium turnover and reduced many options contracts traded. 

However, there is some pessimism regarding the strict regulations requiring excessive supervision, especially for retail investors. Generally, such laws turn traders to “dabba trading.” Because such forms of trading facilities are illegal, investors are not protected against them, and no oversight exists. ​

SEBI's Response and the Way Forward

SEBI has taken feedback from industry stakeholders and is considering implementing suitability tests as a balanced approach to safeguarding retail investors while maintaining market integrity. The regulator also underlines the importance of aligning derivatives trading with the underlying cash market to avoid excessive speculation that can lead to market manipulations.

While SEBI continues deliberating the final set of regulations, the financial community is playing a waiting game to achieve the ideal balance between individual safety and the requirements of having a dynamic and inclusive derivatives market.