SEBI Proposes Overhaul Of Derivative Exposure Limits For Enhanced Risk Management
With rising participation and maturity in the derivatives market, having sound risk management practices in place has become crucial. In a recent development to strengthen investor protection and market stability, SEBI has sought to make far-reaching changes to the calculation of exposure limits for Mutual Funds (MFs) and Alternative Investment Funds (AIFs) in derivatives and position limits for index futures and options.[1] The proposals show a clear intention to strengthen the precision of risk calculation and prevent any potential systemic risks.
Table of Contents
Current Practices and Concerns
Exposure Limits for MFs and AIFs
The current approach to computing derivative exposure for MFs and AIFs has some limitations. Exposure for futures and short options is computed based on the notional value of the contract. In contrast, exposure for long options is calculated only by the premium paid. This asymmetrical treatment does not reflect the built-in leverage of long options and may underestimate the actual risk exposure. In addition, the current framework fails to provide any offsetting advantages for hedged derivative positions, resulting in an overall gross exposure calculation that may not necessarily capture the net risk taken by the fund. This method provokes questions as to whether the current measures effectively capture the net risk and leverage in the derivatives portfolio of an AIF or Mutual Fund.
Position Limits For Index Futures And Options
Likewise, the position limits on index futures and options, introduced in March 2020, are under criticism due to some anomalies. Although short positions in index derivatives are capped by the holding of underlying stocks, and long positions are capped by cash and cash-like instruments, the netting mechanism for index options has shown a possible loophole. The existing practice of adding long and short notional positions to reach a net number permits entities to carry significant offsetting positions that seem to have little notional exposure. These putative zero-net positions can contain high net Delta risk. For example, a long at-the-money call option and a short out-of-the-money call option would have a zero net notional value but would constitute a huge net long Delta exposure. This problem occurs relatively infrequently in index futures, where the notional value equals the FutEq (Delta-equivalent notional) in the case of long futures.
SEBI’s Proposed Changes
Computation Of Exposure Limits MFs and AIFs
Intending to answer these issues and promote a better risk-sensitive regime, SEBI has submitted detailed proposals. To calculate exposure limits for MFs and AIFs, the regulator suggests that the focus shall be on having a more standardised approach depending on the principle of FutEq (Delta). Whereas the computation for single stock and index futures will continue to be the same, long and short options will now be quantified in terms of their Delta, which captures the current sensitivity of the price of the option to the change in the price of the underlying asset. Additionally, SEBI suggests netting derivative exposures at the individual scrip or index level. The net exposure of every underlying will be calculated by the amount that is left after subtracting the total short Delta from the total long Delta for all the derivative instruments. The aggregate exposure of a fund will then be the gross summation of these net FutEq exposures for all underlying. To achieve a seamless shift, the existing exposure limits of MFs and AIFs will be redesigned to conform to these new FutEq-based estimations. SEBI has also recognized the sophistication of some derivative strategies and can examine additional intricacies in consultation with stakeholders later on.
Position Limits For Index Futures And Index Options
In the area of position limits for index derivatives, SEBI’s main agenda is to improve the limits for index options. Considering the limitation of notional-based netting, the regulator suggests revised end-of-day limits on FutEq. These are a Net FutEq Limit of INR 500 crore or the absolute amount by which long and short Delta positions differ from each other, and a Gross FutEq Limit of INR 1,500 crore, computed as the sum of absolute values of long and short Delta positions. The introduction of a gross limit is intended to pick up risks that are latent beyond Delta, like Vega and Gamma risks, without subjecting them to unnecessarily complicated individual limits for each of the risk parameters. To cover market-making operations and ensure essential liquidity, SEBI has also suggested increased intraday position limits.
Impact And Implications
Enforcement of the suggested changes will have a broad impact on how market participants offset their derivative exposures. By transitioning to a Delta-based option measurement and netting at the scrip/index level, MFs and AIFs will have a more precise and maybe even more effective means of handling their risk. The new index options limits are set to tackle the problem of latent Delta risk, making sure that big directional wagers find themselves squarely on the books, even when they are designed with offsetting notional positions. These steps are most likely to spur wiser risk-taking behaviour and enhance the general stability and openness of the Indian derivatives market.
Conclusion
Finally, SEBI’s intended redesign of the derivative exposure caps is a proactive move towards an improved risk management framework in the Indian financial marketplace. By implementing FutEq-based measures for options and adjusting the position limits for index derivatives, the regulator hopes to offer a better reflection of risk, plug loopholes that currently exist, and ultimately strengthen a more resilient derivatives ecosystem. The effective adoption of these proposals should go a long way in helping to protect investors and enhance the general integrity of the Indian securities market.
[1] https://www.sebi.gov.in/reports-and-statistics/reports/feb-2025/consultation-paper-on-enhancing-trading-convenience-and-strengthening-risk-monitoring-in-equity-derivatives_92133.html.
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