Could SEBI’s new proposal unintentionally favour BSE over NSE?

In today’s Finshots, we tell you about a plausible new SEBI proposal that could give BSE an unfair advantage over NSE in the derivatives market.

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The Story

You probably already know this, but the rise of derivatives trading in India has market regulator SEBI (Securities and Exchange Board of India) quite worried.

For the uninitiated, a derivative is a financial instrument whose value is derived from an underlying asset, such as a stock, commodity or index. Traders use derivatives to speculate on price changes or hedge their risk from losses on other assets they own. And futures and options (F&O) are the most common types of derivatives trading.

Here’s an example.

You believe Stock X, currently at ₹50, will rise. You enter a futures contract to buy 100 shares at ₹50 each in three months using leverage, meaning you only pay a small upfront margin. If Stock X rises to ₹60, you profit ₹1,000 (100 shares x ₹10 gain). If it falls to ₹40, you lose ₹1,000, but your initial margin amplifies the impact of gains or losses.

And these derivatives have been skyrocketing of late. For context, the derivative turnover has jumped from ₹210 trillion in FY18 to ₹500 trillion in FY24. The participation has skyrocketed too, with F&O segment participation increasing to 9.6 million in FY24, which is over 40% more than the previous year.

You may be led to believe that this popularity is a byproduct of consumer success. That people who trade futures walk away with loads of money. However, 9 out of 10 individual traders in equity F&O incur losses, according to a SEBI study. In fact, the average loss for these traders was a whopping ₹1.1 lakh in FY22.

So, you can imagine why it has got SEBI looking hot and bothered. It’s been trying to rein in derivatives trading in India for a while now.

For instance, in the past, SEBI has asked brokers to prominently disclose the risks associated with trading derivatives on their websites. It has also cracked down on “finfluencers” who contribute to the buzz around derivatives, especially among younger investors. While some influencers spread financial education, others give unauthorised trading advice, making futures and options a buzzword in India.

But now, SEBI is contemplating getting even stricter. It’s concerned that the current market conditions may be encouraging small investors to take on more risk than they can handle. And that’s exactly why SEBI’s working group, formed to suggest measures to enhance investor protection and risk management in the derivatives segment, will meet on Monday to discuss new proposals.

And the chatter around this upcoming meeting suggests that the proposals include increasing the lot sizes for option contracts (for stocks) from ₹5 lakh to up to ₹30 lakh. For context, buying an option contract is a promise to buy or sell an asset like a stock at a predetermined price before an agreed date or the expiry. Without getting into the technicalities, let’s just say that increasing lot size could make it unaffordable for small traders to trade in the derivatives market.

Another proposal on the cards could be to restrict options contracts to one contract per stock exchange or one contract expiry per exchange per week. Once again, you don’t have to know a lot about expiry, but just know that this will offer fewer opportunities for people to trade these instruments.

In summary, this could be a huge volume dampener for Indian derivatives trading, potentially hurting the revenues and profit margins of stock brokers, whose profits have soared due to increased derivatives trading. It could also be a significant setback for stock exchanges.

But in all this, one party might stand to benefit from SEBI’s new proposals. And that folks, is BSE. Over the years, BSE has been trying to increase its market share in the Indian derivatives market but has always lagged behind NSE despite decades of efforts. To put things in perspective, it just commands a measly 20% of the derivatives market in terms of average daily trading volume, while the rest is NSE’s playfield.

But guess what? SEBI’s rumoured proposal could be BSE’s chance to shine.

How’s that, you ask?

Well, before we answer that, there’s another question that needs to be answered. And that is ― Despite being over a century older than NSE, how does BSE have such a low penetration in the derivatives market?

Well, let’s rewind a bit.

You see, the Bombay Stock Exchange (now BSE) was set up in 1875 as The Native Share and Stock Brokers Association. And until 1992, it was the undisputed centre for stock trading in India, with a powerful set of brokers controlling trading. This dominance meant that other regional exchanges played minor roles while BSE accounted for 70% of all trading in India.

But the Harshad Mehta scam changed everything. Mehta, a powerful BSE broker, colluded with other brokers and several Indian and foreign banks to defraud the stock market of crores of Rupees, fuelling a disguised stock market rally. This prompted the government to clean up the financial system, even if it meant taking on the powerful broker cartel.

And as American economist Milton Friedman once said, “The concentration of power in any one person or group is dangerous”, the government felt that India needed another stock exchange to break free from BSE’s hegemony.

So, it roped in a bunch of Indian financial institutions, including LIC, SBI, IFCI and IDFC, along with some global ones, to promote a new stock exchange ― the National Stock Exchange (NSE). In 1994, NSE was up and running, ready to trade.

And what set it apart was its fresh approach. It was India’s first computer-driven stock exchange, allowing NSE to set up trading terminals across the country and let traders place orders electronically. In contrast, BSE had to wait a few years before fully transitioning to electronic trading, which was a key factor in NSE gaining a competitive edge. By 1995, NSE became India’s largest stock exchange, surpassing BSE’s trading volumes and demonstrating the success of electronic-based trading.

But NSE didn’t stop there. It invested heavily in upgrading its trading systems and pioneered several strategic innovations.

For instance, NSE was the first to introduce automated and paperless trading in the Indian market. It set up the first depository — the National Securities Depository Ltd. (NSDL), which initiated the demat revolution by digitising physical share certificates and other securities. This lowered the cost of equity ownership and made investing and trading in stock markets highly transparent and efficient. NSE also established a clearing corporation (NSE Clearing Limited) to reduce trading and settlement risks.

So retail investors were naturally attracted to NSE. And when both stock exchanges entered the derivatives market in the year 2000, traders preferred NSE over BSE. For one, BSE’s derivatives never became popular among traders because of higher lot sizes, making it expensive. And two, NSE’s higher trading volume made it easier for traders to find buyers and sellers for their shares, providing more liquidity. And if traders preferred to trade in the equity segment on one stock exchange, it was a given that they’d trade on the same one for derivatives.

So, over the years, it was only natural for NSE to gain an upper hand over BSE, not just in the derivatives segment but in all aspects of stock trading.

Now, it’s not as if BSE has not tried to up its game.

In 2011, BSE tried to relaunch its derivatives segment by incentivising brokers to drum up trader interest. But nearly a decade later, it had to wind up this scheme as it failed to spur broader participation from retail and institutional traders.

But failure didn’t set it back. Last year, BSE relaunched its SENSEX and BANKEX derivatives contracts. It kept the lot size and transaction charges low and ensured that the expiry of its contracts didn’t fall on the same day as NSE’s. This helped bring in product differentiation.

BSE also reduced the tick size of its regular stock trading to 1 paisa for stocks costing below ₹100. A tick size is the minimum price difference between two consecutive buy and sell prices. And a smaller tick size allows for finer price adjustments and potentially more precise price discovery, boosting its stock trading volumes and indirectly its derivative volumes.

The irony though? All of this was under the leadership of its MD & CEO Sundararaman Ramamurthy, the man who was part of the founding team of NSE, BSE’s nemesis. Under his leadership, BSE’s share in the derivatives segment skyrocketed from nearly nothing to 20% in just a year!

And now, it has another chance to up its game ― SEBI’s new proposal.

Look, SEBI’s new proposal could mean asking exchanges to choose one derivative contract expiry per week. NSE’s NIFTY and Bank NIFTY are its two most actively traded contracts. Besides, the equity options segment is an important revenue source for NSE, accounting for four-fifths of its transaction revenue. But if NSE is asked to choose between its two most important contracts, it won’t be able to offer both contracts on weekly expiries. That will significantly shift trading volumes from NSE’s derivatives contracts to BSE’s nascent derivatives contracts, mainly the SENSEX derivatives contracts.

In fact, Rajesh Baheti, Managing Director at the Mumbai-based broking firm Crosseas Capital Services, told CNBC-TV18 that this could actually give “BSE a chance to become 50% of the [derivatives] market and not by a very fair means.”

So yeah, SEBI’s new proposal could be a blessing in disguise for BSE, which has been trying to catch up with NSE for decades. But these recommendations still need to pass through a handful of discussions and consultations before being approved by SEBI.

And we’ll just have to wait and see if this prediction comes true for BSE and if luck finally smiles upon it.

Until then…

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