Sebi Proposes Steps To Limit Spill-Over Of Volatility From Derivatives To Cash Market

The Securities and Exchange Board of India (Sebi) has proposed new rules aimed at preventing potential market manipulation and reducing the impact of volatility from equity derivatives on the broader cash market.

The capital markets regulator has proposed how changing the way open interest in single-stock derivatives is calculated to provide a more accurate view of exposure.

It also proposed adjusting the position limit to 15 per cent of a stock's free-float market capitalisation or 60 times its average daily delivery value, whichever is lower. Currently, the limit is set to the lower of 20 per cent of the free-float market capitalisation or 30 times the daily average.

This metric will be recalculated every three months based on the rolling average daily delivery value for the preceding three-month period.

Sebi said, "Tying the market-wide position limits to cash market delivery volumes will reduce potential  manipulation  and  better  align derivatives  risk  with  the underlying cash market liquidity."

The proposed limit would reduce "artificial pushes" into the ban period and make such manipulation more difficult, the market regulator added.

The regulator also proposed that index derivatives should only be allowed if the index meets certain conditions, in order to prevent what it described as a "nexus" between the cash and derivatives markets.

Index derivatives are cash-settled, but the nexus between cash and derivative markets nevertheless exists, Sebi noted.

"Given the nexus between cash and derivative markets, high Option Interest relative to  the  average daily delivery in the cash market can cause settlement risks in the case of single stocks, or in general increase risks of price manipulation or excessive volatility. Currently, the market-wide position limit formulation does not explicitly consider such cash market activity," Sebi said.

"If a high proportion of index weightage is attributable to a small number of stocks, participants could effectively replicate a large (and  unmonitored) position in those constituents, giving rise to fears or risks of market manipulation and/ or excessive market volatility," it said.

To address this issue, the regulator proposed new criteria for introducing derivatives on non-benchmark indices. These include having at least 14 constituents in the index, ensuring that the weight of the top constituent does not exceed 20 per cent and that the combined weight of the top three constituents is no more than 45 per cent. Additionally, all other constituents must have individual weights lower than those of the higher-weighted constituents, creating a descending weight structure.

These changes will not materially affect small investors beyond reducing the frequency of stocks entering the ban period, thereby simplifying their trading experience, Sebi said.

Sebi has also proposed introducing pre-open and post-closing sessions for the derivatives market, similar to those in the cash market, for both single stocks and indices. Initially, these sessions will apply only to current-month futures contracts on single stocks and indices, as well as next-month futures contracts during the last five trading days of the current month's contract expiry.

Sebi has sought public comments on all the proposals by March 17.