SEBI's F&O Reforms: Are Indian Brokerages Overestimating Regulatory Losses?

In recent months, we've observed SEBI's growing concern regarding the surge in retail F&O trading volumes in India. The statistics are alarming: 9 out of 10 retail traders incur losses, with 1.1 crore unique individual traders collectively losing a staggering ?1.8 lakh crore during FY22-FY24. This wealth transfer benefits proprietary traders and foreign portfolio investors (FPIs), who recorded profits of ?61,000 crores from the F&O segment in FY24 alone, while retail investors lost ?75,000 crores in the same period.

SEBI has proposed multiple regulatory changes to address this issue, causing concern among retail discount brokerages about potential impacts on their revenues and profitability. Zerodha's recent annual report highlights these concerns, with the company preparing for significant revenue losses of the tune of 30-50% - although it is not clear how exactly these losses would materialize. We'll look deeper into some of these aspects in the remainder of this post.

This is expected to shift retail activity* away from direct futures trading, which comes with uncapped loss potential.

Transaction Charge Pass-Through and STT hike

One approved regulatory change, set for implementation on October 1st 2024, is the pass-through of transaction charges in derivative trading. Currently, brokerages charge ?49.5 per lakh of trade from low-volume retail traders while paying only ?29.5 to the exchange, keeping the arbitrage for themselves and thereby benefiting from volume discounts. This regulatory move effectively eliminates this arbitrage scheme, and could reduce brokerages' profits by ~10%. However, it may paradoxically increase retail trading volumes as the new pass-through transaction charges would almost certainly be lower than current rates. This change appears to be more of a business model correction rather than a measure to reduce trade volumes.

Another significant change is the increase in Securities Transaction Tax (STT) rates on F&O trades, also effective October 1st. This is expected to shift retail activity* away from direct futures trading, which comes with uncapped loss potential. Instead, it may push traders towards options trading with bounded losses. Notably, this shift wouldn't hurt brokerage revenues since they charge on a per-transaction basis (typically Flat Rs. 20 per executed order) for both futures and options trades.

Some listed brokerages (such as AngelOne) derive up to 20% of their total revenues from margin funding and financing against securities.

Other Proposed Changes: Volume & Margin

Other proposed regulatory changes may limit trading volumes, though the extent remains unclear. For instance, increasing the minimum value of derivatives contracts to up to ?30 lakhs could deter smaller retail traders. However, it might encourage larger traders to place higher bets on fewer contracts, especially given the proposed restriction of limiting the number of weekly options contracts.

Interestingly, proposed increases in margin requirements could actually benefit brokerages. Some listed brokerages (such as AngelOne) derive up to 20% of their total revenues from margin funding and financing against securities. A 20% increase in margin requirements could potentially boost their revenues by 4-5%, partially offsetting other regulations-induced losses.

While safeguarding retail investors is crucial, we must balance this with encouraging the ongoing shift of household assets into equities. Currently, retail investors account for 14% of India's total market capitalization, compared to 35% in developed economies like the US. This indicates significant room for growth and financial inclusion.

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*Also see https://x.com/swaminathankp/status/1742134563441168534… (Jan 2024)