SEBI's Potential F&O Trading Restrictions Could Severely Impact Discount Brokers' Revenue

 

Digital and modern discount brokerage firms will suffer greatly if the market regulator SEBI puts any restrictions on futures and options (F&O) trading, also known as derivatives trading.

Last week, SEBI Chairperson Madhabi Puri Buch mentioned that the market regulator is open to removing derivative products if the expert committee reviewing the segment recommends it.

Digital and new-age discount broking firms will be badly affected if SEBI, the markets regulator, places any restrictions on futures and options (F&O) trading, also called derivatives trading.

While only 10-20% of active clients trade in F&O, this trading generates 60-70% of revenue for most large brokers. Among the top four discount brokers, companies like Zerodha, Groww, and Upstox are private, so their exact numbers are unknown. However, it's estimated that Zerodha relies heavily on F&O trading, which contributes to about 70-75% of their revenue.

Discount brokers charge a flat fee of Rs 20 or less per trade and focus on high volume, hence the term "discount brokers." Traditional brokers offer research and investment services to their clients.

Angel One, the third largest digital discount broker and a public company, reported in their Q4 FY24 investor presentation that 68% of their revenue came from broking. Of this, 85% came from F&O trading, making up about 60% of their overall revenue. According to a consultant, Angel One might have a lower mix of F&O revenue due to older clients still trading in cash equities. Despite SEBI's announcement, Angel One shares only dropped slightly by 0.7% on July 1, while the overall market rose by 0.43%.

Volumes, a cause for concern

According to SEBI, about 90% of F&O traders lose money. F&O trading volume makes up more than 99% of all trades on major exchanges like NSE and BSE. For comparison, in the US, derivatives trading accounts for only 70% of the overall market trading volume. Last month, RBI governor Shaktikanta Das also mentioned that the F&O trading craze is being monitored by the central bank.

Zerodha founder and CEO Nithin Kamath acknowledged that his company has benefited from the rise in options trading. He noted that options trading volumes increased from 4.6 lakh crore in 2018 to 138 lakh crore in 2024, with retail participation growing from 2% to 41%. Kamath admitted that while Zerodha benefited from this volume surge, regulations could significantly reduce these volumes and hurt revenues, which is why they never made forward projections.

Kamath said that the broking industry will face tough times ahead because most business models rely heavily on earnings from options trading.

Could alter business models

Another broking firm, FYERS, anticipates a reduction in trading volumes and a potential shift in their product offerings. They remain committed to adapting and providing valuable services within the regulatory framework. FYERS also noted that SEBI's move could impact market dynamics and liquidity, potentially leading to wider spreads and higher trading costs. Investors might shift to other financial instruments or asset classes, changing current trading dynamics.

Approximately 15-20% of brokerage income comes from interest earned on customers' funds. If these customers move to cash markets, this income might gradually increase. However, this can't fully compensate for the loss of derivatives trading, which contributes around 70% to revenue and profits.

Putting up a brave face

Broking firms have stated that SEBI's move could increase market stability and customer confidence in trading. Kamath of Zerodha emphasized that the biggest risk for any regulated entity is regulatory changes. Discount brokers have been educating customers about the risks of derivatives trading for a long time. Zerodha’s Kite app shows a pop-up message that 90% of F&O traders lose money.

Groww founder Lalit Keshre mentioned that their "Safe Exit" feature helps customers mitigate the risk of losing money. This feature allows customers to set a maximum loss threshold, and positions are squared off once this limit is reached. This feature has seen 25% adoption among derivative traders. Keshre also noted that Groww warns customers when they place high-risk orders and encourages voluntary pauses in F&O trading.

Despite these measures, more retail customers are turning to F&O trading, prompting SEBI to consider restrictions. Devam Sardana, business head at trading platform Lemonn, views SEBI's move as a positive step to enhance market strength by protecting investors from low liquidity and underperforming stocks. Sardana added that without significant restrictions, trading volumes are unlikely to decrease by more than 20-30%, as the majority of derivatives volumes come from institutions, proprietary traders, and high-net-worth individuals.

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Also Read:

The New Rules of F&O Trading

The stock market regulator's approval of physical delivery for equity derivatives could lead to big changes in the F&O (futures & options) segment. This move might reduce the speculative activity that has been harmful to small investors.

The stock market regulator's approval of physical delivery for equity derivatives could bring major changes to the F&O (futures & options) segment. This move might reduce speculative activity, which has been harmful to small investors. The physical delivery rule will make it harder to enter the F&O segment, possibly keeping small investors out for their own good. SEBI (Securities and Exchange Board of India) is discussing this issue with stock exchanges and will announce detailed guidelines on derivative trading after these talks.

The Current Situation:

Right now, equity derivatives are settled in cash. For example, if an investor bought a futures contract of Reliance Industries at Rs 1,050 and sold it at Rs 1,100, they would earn the difference. With a lot size of 300 shares, that would mean a profit of Rs 15,000.

What Will Change:

If physical delivery is introduced, buyers and sellers will have to actually buy or sell the shares in the contract. This increases the barrier to entry in the F&O segment. Currently, investors need to submit about 20% of the contract value as margin money with the broker. With physical delivery, buyers will need to have cash ready, and sellers will need to have the shares.

Push for Index Derivatives:

With equity derivatives becoming harder to access due to the large cash requirements, small investors and speculators might shift to index-based derivatives. These are less volatile because the risk is spread over multiple stocks.

What's Unclear:

SEBI hasn't said whether physical settlement will be optional or mandatory. It's also unclear if physical settlement for equity options will only apply at contract expiry (like with index options) or if it will apply whenever the buyer chooses to exercise it.

SEBI might reconsider physical settlement for options if it reduces interest in this important hedging tool.

Related Link:

https://tradebrains.in/features/biz-sebi-fo-experts/