Consider turfing out short-term equity derivatives

In focus was something called a Bank Nifty weekly options index (now closed), but there remain other weekly indices, run by the National Stock Exchange and Bombay Stock Exchange. Having never engaged with the stock market, either financially or academically, I had never peered at those instruments. But the compelling reason for not neglecting them now is that index options have entered the pages of the half-yearly Financial Stability Report (FSR) issued by the Reserve Bank of India (RBI), including the latest June 2025 issue.

Financial Stability Reports are an outcome of the global financial crisis of 2008. The G-20, as a wider group of countries than the G-7, also emerged as an outcome of that crisis. The International Monetary Fund (IMF) exhorted member countries to issue periodic reports on their internal financial stability. In India, this responsibility fell to RBI. The FSRs of RBI are very well-written, and should be compulsory reading for all students of economics at any level. My sense, though, is that they are not very widely read (I hope I am wrong on this).

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The FSR has to be optimistic overall, since any alarm bells could by themselves be triggers for financial instability. Wisely, RBI collects opinions by circulating a questionnaire among an anonymous panel of (unpaid) respondents as part of a Systemic Risk Survey, tabulated in an Annex of every FSR. This makes the FSR more broad-based than a document driven solely by analysis done within RBI. 

The FSR must necessarily do a wide-angle surveillance of financial markets and regulatory agencies, including Sebi. But RBI, as the  banking regulator itself, must tread a thin line between advising what other regulators like Sebi could do to improve financial stability, while at the same time refraining from overt criticism.

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The latest June 2025 report praises Sebi for its prompt action on a number of fronts. But some paragraphs are so important that they need to be quoted at length, like No. 1.38 of the report: 

“The growing participation of individual investors and associated risks in the equity derivatives segment were highlighted in (the) June 2024 FSR. Since then, the SEBI has taken several important measures to strengthen this market segment, including but not limited to, rationalization of weekly index derivatives products, increase in tail risk coverage on the day of options expiry, ensuring expiry of all index derivatives products on single day of the week, increase in contract sizes, upfront collection of option premium from buyers, removal of calendar spread treatment on the expiry day and intraday monitoring of position limits. 

Consequently, between December 2024 and March 2025, the average daily traded value by individuals and number of individuals trading per month declined by 14.4 per cent and 12.4 per cent, respectively, compared to an increase of 47.6 per cent and 101.8 per cent, respectively, between December 2023 and March 2024.”

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While Sebi certainly deserves to be commended for its corrective actions, why allow weekly index derivatives at all, and especially open to retail participation? These complex financial instruments might be comprehended by enough individuals in New York or London to give depth to those derivatives markets, but here in India, do we really have enough individuals who know what they  are plunging into? Most seem to be engaging in a market they don’t understand, a blind gamble.

It should not be surprising that mountains of losses have been suffered by individuals in the equity derivatives market. In currency markets, it makes sense to have derivatives, to iron out the  volatility inherent in freely tradable currencies, about which we first learned from the work of Rudiger Dornbusch. But in equity markets, do weekly index derivatives do anything to reduce volatility? Do they not actually enhance volatility? Surely, we can have long-term equity futures (a horizon of one year or more) without weekly  derivatives.

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If, as the Sebi report of 2024 reported, the majority of losses are suffered by young participants from small towns, it is no surprise that real growth in the Indian economy is being held back by sluggish consumer demand. Equity derivatives, with that kind of participation, are a self-inflicted wound to the real economy. They distort choices among young earners in small-town India. 

After the seminal work of Daniel Kahneman, these kinds of policy mistakes should not have been made. Purchasing power has been diverted from current consumption, which could then have kick-started real investment by the domestic manufacturing sector. 

The Bank Nifty index covered a very small number of stocks and was therefore particularly vulnerable to manipulation. But the case for banning all weekly index derivatives is strong. Particularly at a time of falling interest rates, those options will become even more attractive. Equity markets are meant to encourage informed risk taking, not misinformed plunges into short-term derivatives of the kind still on offer on Indian exchanges. 

The author is an economist.