Here's what SEBI is doing to restrict F&O trading

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Today on The Daily Brief:

• SEBI changes F&O rules
• RBI is concerned about gold loans

SEBI changes F&O rules

SEBI has finally rolled out new rules to cut down on F&O (Futures and Options) trading, and in this episode, we’re going to break down what these changes mean.

SEBI has been worried about the F&O trading craze in India. Their recent study found that 93% of individual F&O traders between FY22 and FY24 actually lost money.

So, it’s no surprise that SEBI is stepping in. Back in July, they shared a consultation paper proposing ways to reduce speculative activity in F&O trading, and now they've locked in six key changes. Let’s go over what SEBI has done.

1. Limiting weekly options to just the big indexes

Right now, traders can trade weekly options on several indices like Bank Nifty on Wednesdays, Nifty on Thursdays, and Sensex on Fridays. SEBI wants to change that by limiting weekly options to just one big index per exchange. For example:

• NSE might only offer Bank Nifty or Nifty weekly options.
• BSE might only offer Sensex or Bankex weekly options.

Other indices will only have monthly expiries, which means fewer short-term options for traders to speculate on. SEBI’s goal here is to slow down the intense trading in weekly options, which often leads to high-risk, short-term bets.

2. Cutting margin benefits on expiry day for calendar spreads

Currently, if you hold a calendar spread (when you buy and sell options on the same underlying asset but with different expiry dates), you get a margin benefit since the risk is spread out. This margin benefit is available even on expiry day.

But starting in February 2025, SEBI will remove this margin benefit on the expiry day. For example, let’s say you have a short option expiring on January 31st, with a margin of ₹1 lakh, and a long option expiring on February 28th. Because the short position is hedged by the long one, you only need ₹50,000 instead of the full ₹1 lakh. But on January 31st (expiry day), you’ll need to maintain the full ₹1 lakh margin.

SEBI’s reasoning? Options close to expiry can get volatile, and SEBI wants to make sure traders have enough funds to cover any sudden price swings.

3. Additional margins for options on expiry day

Selling options can be risky because if the market moves sharply against you, losses can pile up quickly. To manage this risk, SEBI is adding an extra 2% Extreme Loss Margin (ELM) on short options positions on expiry day, starting November 2024. This will apply to all short positions, whether created earlier or on the day itself.

So, if you’ve got a short position in a Nifty 27,000 call option expiring on October 30th with a margin of ₹1 lakh, you’ll need to keep an additional 2% margin on the expiry day.

The idea behind this extra margin is to act as a buffer, so traders aren’t caught off guard by sudden market moves.

In the consultation paper released, SEBI noted that 20-40% of trading activity typically occurs in the last 60 minutes, leading to heightened market volatility, often driven by speculative moves rather than any fundamental or news-based events.

4. Raising the minimum contract size for index derivatives

The minimum contract size for index derivatives like Nifty and Sensex futures is currently between ₹5 lakh and ₹10 lakh. This was set in 2015, but the market has grown a lot since then. SEBI is planning to raise the minimum contract size to ₹15 lakh - ₹20 lakh starting in November 2024.

This change aims to ensure that only experienced and well-capitalized traders are participating in the derivatives market, reducing the chances of smaller retail investors taking on too much risk.

5. Intraday monitoring of position limits

Right now, the maximum exposure you can take (position limits) in a contract is only checked at the end of the day. For individual traders, this is 5% of the total open interest, and for brokers, it’s 15%. Traders can exceed these limits during the day as long as they fix their positions before the market closes.

Starting in April 2025, SEBI will introduce intraday monitoring of position limits. Exchanges will take at least four snapshots during the trading day to make sure traders aren’t exceeding their limits at any point.

This will help ensure no one is taking on more risk than they should, even temporarily.

6. Paying the full option premium upfront

In 2020, SEBI introduced upfront margin requirements across the board. For equities, traders must pay at least 20%, and for futures and options selling, traders need to bring in the SPAN and exposure margins upfront. However, the upfront payment of option premiums was still collected at the end of the day.

Now, SEBI wants traders to pay the full premium upfront when buying options. This means no more using borrowed money or relying on brokers to cover it, ensuring there’s no extra leverage for an already leveraged product.

RBI is concerned about gold loans

You know how regulators like the RBI are basically the watchdogs of the financial world, right? They keep an eye on things to make sure everything runs smoothly. Every now and then, when they spot something off, they step in before things get out of hand—or at least they try to. This time, they’ve got their eyes on the gold loan market.

In this story, we’re diving into why the Reserve Bank of India isn’t too happy with how gold loans are being handled. They’ve just sent out a circular listing a bunch of problems they’ve found—and trust us, there’s quite a few.

But before we dive into what’s wrong, let’s take a quick step back and talk about how gold loans actually work. That way, everything will make more sense as we break it down.

A gold loan is a bit different from your usual bank or NBFC loan. In this setup, you give your gold as collateral, and the lender gives you a loan based on its value. It’s a secured loan, which means it’s safer for the lender, and it also allows borrowers to get lower interest rates. So, it’s kind of a win-win. That’s why this segment is (i) growing fast, (ii) becoming super profitable, and (iii) still safer than most other types of loans.

To give you some numbers, the gold loan market has almost doubled in the last four years, now crossing ₹7 lakh crores. For lenders, it’s especially attractive because it offers the highest return on assets—around 4.5%—compared to other types of loans like auto, housing, MSME, or microfinance, which only bring in returns between 1.8% to 2.5%. In short, lenders make more profit when lending against gold than with other loan types.

Source: PWC

Source: Business Today

The process itself is pretty straightforward: You express interest, the lender verifies your identity with a KYC check, and then your gold is evaluated for its purity and weight. Based on that evaluation, the loan is issued almost instantly, and the gold is kept safe until the loan is repaid.

Sounds simple, right? But here’s where things start to get complicated, and the RBI has a lot to say about it. In their latest circular, they’ve flagged several issues. Instead of diving into everything at once, let’s break it down step by step.

1. Problem with third-party partnerships

Many banks and NBFCs are outsourcing key steps, like gold evaluation, to third-party FinTechs or business correspondents. That’s fine—as long as they’re doing it right. But the RBI found that these third parties often evaluate the gold without the customer even being present. This is not okay and can lead to mistakes.

For instance, let’s say a 20-carat gold ornament gets graded as 22-carat. It might seem like a win because the borrower gets a bigger loan than they should, and the lender keeps a happy customer. But here’s the problem: If the borrower can’t repay the loan and the gold is auctioned off, the amount recovered is much lower than expected because the gold was overvalued from the start. The lender then has to take the hit.

That’s not all. Some third parties also keep the gold themselves or delay sending it to the bank branch—another big no-no. They even handle KYC checks in some cases, which the RBI does not approve of.

2. No monitoring of loan use

Lenders are supposed to check how the loan will be used—whether it’s for personal expenses or business purposes. But the RBI found that in many cases, this isn’t happening. Lenders are giving out loans without checking if the funds are being used for the intended purpose. This becomes a problem when people take new top-up loans just to pay off existing loans. It hides the fact that the borrower is in financial trouble.

3. Failing to track the loan-to-value (LTV) ratio

We’ve talked about how gold loans are given based on the value of the gold, called the Loan-to-Value (LTV) ratio. Currently, the LTV is capped at 75%. This means that if you pledge ₹100 worth of gold, you can only get a loan of ₹75.

But gold prices fluctuate, so the value of the loan can change over time. Lenders are supposed to monitor this closely, and if the LTV goes above 75% due to a drop in gold prices, they’re required to ask the borrower to pledge more gold to cover the difference.

The RBI found that many lenders weren’t doing this. By allowing the LTV to exceed the limit, they’re taking on more risk than they should, which could lead to bigger problems down the road.

4. Cash disbursal limits

Here’s a simple rule: Gold loans over ₹20,000 can’t be given out in cash. But some lenders are ignoring this and handing out loans in cash well over the limit. This is a clear violation of RBI rules, and it also makes it harder to track how the money is being used.

Now, these issues aren’t exactly new. If you’ve been keeping up with this space, you might remember that back in March, IIFL Finance was banned by the RBI from issuing new gold loans. Why? The RBI found similar problems with how they were handling things. That ban was only lifted recently, in September.

So, why is the RBI cracking down on gold loans now?

It’s because banks are jumping into the gold loan market. Traditionally, banks stayed away from gold loans due to the high operational costs involved. But now, they’ve changed their minds. Banks like HDFC and Axis, who weren’t big players in this space before, are now aggressively expanding their gold loan portfolios.

With the RBI becoming cautious about the growing risks in unsecured lending, many banks are turning to safer options. Gold loans, backed by physical assets, have quickly become an attractive product for banks in the retail sector.

We’re already seeing this shift. Banks held a 36% market share in the gold loan segment in FY22, and that went up to 39% by September 2023. It’s likely grown even more since then.

Source: PWC

In the end, the RBI isn’t saying gold loans are bad. They’re just saying, “Let’s clean this up and do business the right way.” They want to make sure that banks and NBFCs follow the rules and don’t take shortcuts. This circular is their way of giving everyone a heads-up before things get worse.

Tidbits:

1. Dabur India is expecting a mid-single-digit drop in revenue for Q2 FY2025, primarily due to weak demand and heavy rains, which have impacted "out of home" consumption. This is the company’s steepest revenue decline in four years, leading to a 7.7% drop in its stock price.
2. A strike involving 45,000 US dockworkers at 36 East Coast ports is causing major disruptions in trade and supply chains during the holiday season. This could have a significant impact on the US economy and India’s exports, with potential losses exceeding $1 billion a day.
3. The credit quality of Indian companies has improved after the moratorium period, with more rating upgrades than downgrades. Leading agencies like Crisil, ICRA, and Ind-Ra are reporting higher credit ratios, reflecting stronger corporate health and boosting investor confidence.
4. Top Indian engineering companies experienced strong order inflows in the first half of FY24, driven by demand for infrastructure and capital goods. L&T led the pack with orders worth ₹47,500 crore, while other firms like BHEL and HAL also secured significant new contracts.

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This post was first published on Substack.