India's capital markets are facing a significant regulatory shift following the Reserve Bank of India's decision to tighten collateral requirements for bank guarantees issued to proprietary trading firms. While the central bank's objective is to strengthen risk management and safeguard the banking system, market participants have highlighted potential implications for liquidity provision in certain market segments and have sought further discussion on risk-based calibration.
The revised framework requires bank guarantees issued for proprietary trading activities to be fully collateralised. At least half of the collateral must be in cash, while the remaining portion can consist only of cash equivalents and government securities. Industry representatives argue that the move marks a sharp departure from the previous regime, where only half the guarantee amount needed collateral backing and a wider range of assets could be used.
Market participants believe the change could significantly increase funding costs for proprietary trading firms that play a crucial role in providing liquidity and maintaining orderly markets.
The Role Of Proprietary Traders In Modern Markets
Proprietary trading firms have become an important component of India's financial ecosystem. These firms actively participate in equity, futures, and options markets by continuously buying and selling securities, helping ensure that investors can enter and exit positions efficiently.
According to industry estimates, proprietary traders account for nearly one third of futures market activity and approximately half of options premium turnover. Their participation is particularly important during periods of market stress when other investors may reduce exposure.
Industry participants note that many proprietary trading firms operate arbitrage, hedging and liquidity-provision strategies that differ materially from directional trading activity that help improve price discovery and narrow bid ask spreads. By maintaining balanced portfolios and managing risk dynamically, these firms contribute to market stability rather than volatility.
Industry data also suggests that proprietary participation has historically increased during periods when foreign institutional participation moderated, helping sustain market liquidity and trading activity during challenging market conditions and helping markets function smoothly.
A Regulatory Gap In Derivatives Markets
One of the key concerns raised by market participants relates to the treatment of liquidity providers in derivatives markets.
The RBI framework continues to provide certain benefits for formally recognised market makers. However, industry representatives argue that this provision has limited practical value because formal market maker designations currently exist mainly in segments such as SME stocks and selected debt instruments.
In India's highly liquid derivatives markets, there is no regulatory framework that formally recognises market makers, despite the fact that several firms perform functions that are economically similar to market-making activities on a daily basis.
As a result, firms that continuously provide liquidity in futures and options markets do not receive the same treatment as officially designated market makers elsewhere. Industry bodies believe this creates a mismatch between regulatory intent and market reality.
The concern is not about the absence of market-making activity but rather the absence of formal recognition for participants already performing that role.
To address this issue, Industry bodies have proposed the creation of a dedicated Liquidity Provider framework for exchange-traded derivatives.
Such frameworks already exist in major international financial centres. Leading global exchanges, including those in the United States, Europe, and Singapore formally recognise liquidity providers and establish specific obligations relating to continuous quoting, market depth, and risk management.
Under a proposed Indian framework, eligible firms would register as liquidity providers and operate through dedicated trading accounts. Their activities would be monitored separately from other proprietary trading operations, allowing regulators and banks to distinguish between risk managed liquidity provision and speculative trading.
Supporters argue that this approach would provide greater transparency while preserving the market benefits generated by liquidity providers.
The SPAN Based Solution
A major element of the industry's proposal involves using the existing SPAN margining framework as an objective method to measure risk.
SPAN is already used by clearing corporations to assess the risk of trading portfolios. Because it recognises hedging benefits and offsets between positions, it provides a more accurate picture of actual portfolio risk than notional exposure alone.
Industry representatives contend that portfolios maintained by liquidity providers often exhibit low directional risk because positions are heavily hedged. As a result, requiring the same collateral treatment as highly speculative positions may not accurately reflect the underlying risk profile.
Industry participants have suggested that existing risk-management metrics, including SPAN-based margining systems already used by clearing corporations, could potentially provide an objective basis for differentiating between various categories of trading activity.
Advocates believe such a system would align collateral requirements more closely with actual market risk while maintaining robust oversight.
The debate ultimately reflects a broader challenge faced by regulators around the world. Policymakers must balance the need for financial stability with the need to maintain deep, liquid, and efficient markets.
The RBI's objective of strengthening banking safeguards is widely acknowledged. However, market participants argue that the current framework may inadvertently increase costs for entities that provide a valuable public function by supporting liquidity and price discovery.
Industry estimates indicate that proprietary trading-related bank guarantees exposure represents a relatively smaller share of overall banking system credit exposure, while these participants contribute meaningfully to market liquidity.
As regulators continue to evaluate the issue, attention is likely to focus on whether a more risk-sensitive framework can be developed. The emergence of a formal liquidity provider regime could offer a path that supports both prudential objectives and market efficiency.
For now, the discussion highlights the growing importance of liquidity providers in India's rapidly evolving financial markets and the need for regulatory structures that accurately reflect their role in the modern trading ecosystem.
Disclaimer: The views expressed in this article are those of the author and do not necessarily reflect the views of the publication. |
