In a move to address the burgeoning derivatives market and its potential stability risks, India’s leading financial regulator is set to establish a committee dedicated to assessing derivative risk and recommending policy changes, if deemed necessary. This significant development comes as options trading in India has witnessed exponential growth, particularly fueled by small investors, over the past five years.

The Surge in Derivatives Trading

• According to data from the National Stock Exchange (NSE), the notional value of index options has soared from $447.69 trillion to $907.09 trillion within a year, marking a doubling in value from 2022 to 2023-24.
• This surge underscores the need for closer scrutiny and proactive measures to ensure market stability and investor protection.

Formation of the Committee

• The committee tasked with assessing derivative risk will be established under the auspices of the Financial Stability Development Council.
• Comprising key stakeholders such as the finance minister, central bank governors, and market regulators, the committee’s primary mandate will be to evaluate the risks associated with the exponential growth in derivatives trading.
• While decisions regarding committee members and reporting timelines are forthcoming, the plan to form such a committee was not previously disclosed.

Focus Areas of Assessment

• The committee will delve into the potential risks emanating from the surge in derivatives trading, emphasizing the imperative for robust investor protection measures and enhanced regulatory oversight.
• Additionally, the correlation between the proliferation of small unsecured loans and the surge in options trading will be scrutinized. Specifically, the committee will examine the utilization of credit extended by non-banking financial companies (NBFCs) linked to broking units and ascertain whether these funds have been channeled into the capital market.
• Given the rapid increase in personal loans beyond the purview of traditional banking supervision, the committee aims to address concerns surrounding the potential systemic implications of this trend.

The Global ContextA report by Axis Mutual Fund in October 2023 highlighted that the notional value of derivatives trading in India is a staggering 422 times that of traditional cash trading, the highest ratio globally.

Furthermore, the contribution of derivatives trading to the overall market has risen significantly in various markets worldwide, with ratios ranging from 5 to 15 times that of cash market trading.

As India’s derivatives market continues to expand rapidly, proactive measures are imperative to safeguard market stability and investor interests. The formation of the committee represents a proactive step towards assessing derivative risk comprehensively and formulating policy interventions to mitigate potential vulnerabilities. In an increasingly interconnected global financial landscape, the prudent management of derivative risk is paramount to fostering a resilient and sustainable financial ecosystem.