Proposed regulatory changes, which would prohibit banks from lending for proprietary trading and require 100% hedging for any other financing extended to brokers, could halve profit margins and lead to a potential 20% decline in derivatives trading volumes, these sources indicate. The Indian derivatives market has seen explosive growth, attracting significant retail investment, though official data suggests nearly 90% of these investors experience losses.
Reuters spoke with leaders from six national and international trading firms, all of whom requested anonymity as they were not authorized to speak publicly.
The Reserve Bank of India (RBI) initiative – slated to take effect on April 1 – is part of a broader effort by the government and market regulator to curb the rapid expansion of the Indian equity derivatives market. Analysts believe policymakers are concerned about potential contagion risks to household finances and the broader economy. The National Stock Exchange of India (NSE) currently holds the top global position for equity derivatives, accounting for 70% of worldwide options trading, according to data from the World Federation of Exchanges.
LEVERAGE UNDER PRESSURE
Currently, trading firms utilize bank financing to amplify leverage and generate substantial profits, often outperforming retail investors due to their expertise. Shifting to alternative funding sources, which generally carry higher costs, would significantly erode margins, according to leaders and analysts. Proprietary trading accounts for nearly half of the NSE’s derivatives activity by value, with high-frequency trading (HFT) firms representing approximately 50% of that proprietary trading, according to Jefferies.
“Domestic proprietary trading firms fear their business model has develop into obsolete,” said one executive at a mid-sized trading firm. “Larger firms still have some of their own capital, but that will limit their growth prospects,” added a leader at a major domestic high-frequency trading (HFT) firm. The move highlights the RBI’s increasing scrutiny of risk within the rapidly expanding Indian financial market.
SMALLER TRADING FIRMS FACE CHALLENGES
“Smaller proprietary trading firms, which traditionally rely on broker financing, will be the most impacted as they lack strong balance sheets and access to alternative credit,” Mumbai-based brokerage IIFL noted in a report this week. The response from trading firms echoes that of the brokerage lobby, which on Thursday called for a six-month delay in the implementation of the new rules to allow for consultation and impact assessment.
The Reserve Bank of India and the Securities and Exchange Board of India did not respond to email requests for comment. Policymakers are facing a significant challenge: the Indian derivatives market has grown to more than double the size of its underlying cash market, a stark contrast to the 2-3% ratio seen in major global markets.
Previous measures have included increasing trading fees on derivatives, reducing the number of contracts offered by exchanges, and raising taxes on profits from these transactions. While these steps have reduced the number of contracts traded, the total value of transactions remains high, indicating continued significant capital deployment.
According to trading firm leaders, the RBI’s latest initiative could disproportionately affect domestic players. Foreign trading firms may suspend plans to establish operations in India and shift activities to offshore centers where financing is cheaper, giving them a competitive advantage, three of the leaders said. This potential shift underscores the global interconnectedness of financial markets and the importance of competitive regulatory environments.
