RBI lands a gut punch on prop traders
In today’s Finshots, we explain why prop traders are worried about the RBI’s latest capital market exposure rules for banks.
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Now onto today’s story.
The Story
Of late, the RBI (Reserve Bank of India) has become something of a villain for the stock market.
That’s because starting this month, the central bank has effectively pulled back how much leverage proprietary (prop) trading firms can use while trading in the capital markets.
Now we know what you’re thinking.
The RBI regulates banks and it’s the SEBI (Securities and Exchange Board of India) that regulates capital markets. So how is the RBI suddenly influencing what happens on Dalal Street?
We’ll get to that. But first, some context.
A prop trading firm or desk is simply a firm that trades using its own money. So unlike stockbrokers, who execute trades for clients, or mutual funds, which invest other people’s savings, prop desks put their own capital as well as borrowed money at risk to earn profits. They trade everything from stocks to futures and options (F&O), either manually or through high-frequency and algorithmic trading (where computer programs, not humans, execute trades).
But to trade, exchanges typically ask participants to maintain sufficient margin money. Think of it as a security deposit. If a trade goes wrong and you make losses, the exchange can recover those losses from this margin.
As an example let’s imagine you’re a prop trader with ₹1 lakh. The exchange tells you to keep aside 20% as margin (we’re ignoring leveraged trades here for simplicity). That means ₹20,000 gets locked up with the exchange, leaving you with only ₹80,000 to actually trade.
That’s not a great situation, especially if your business depends on deploying as much capital as possible.
But thankfully, margins don’t always have to be cash. Exchanges also accept government securities and even bank guarantees (BG).
And that’s where banks come in. Instead of parking ₹20,000 with the exchange, a prop trader could approach a bank and ask for a BG. In simple terms, the bank tells the exchange, “If this trader fails to pay, we’ll pay instead.”
Of course, the bank doesn’t do this for free. It charges a fee, which is usually much smaller than the amount of capital the trader would’ve had to lock up.
The bank also protects itself by typically checking whether the trader has a strong enough financial profile to avoid defaulting in the first place apart from asking them to provide collateral such as securities, deposits or cash worth around half the guarantee amount. So if the trader defaults, the bank can sell that collateral to recover part of its money.
This essentially means that instead of locking away ₹20,000, the trader pays a relatively small fee, pledges some collateral, and gets to use almost the entire ₹1 lakh for trading.
In the real world, that translated into prop traders being able to operate with roughly 1.7 times the capital they actually had.
And this system worked fairly well for years. To put that in perspective, according to a CareEdge Ratings report, banks’ exposure to the capital markets accounted for less than 3% of their total advances in FY25. As a share of their net worth, it was only around 7–13%.
Even defaults in this segment were extremely low.
Another interesting thing is if you look at SEBI’s analysis of equity derivatives trading between FY22 and FY24, prop traders actually earned the highest profits of around ₹33,000 crore on the NSE. That’s even more than Foreign Portfolio Investors (FPIs), unlike individual traders, 91% of whom lost money in F&O.
But think about what were to happen if a bunch of prop trading firms suffered massive losses and failed to meet their margin calls. Banks would then have to honour the guarantees they issued and pay the exchanges on behalf of those traders.
Sure, they could recover part of that money by selling the collateral. But the rest would come from the banks’ own funds — money that would otherwise be used for lending or other banking operations. If such failures became widespread, it could eventually threaten the banking system and, indirectly, depositors like you and me.
Now, that’s certainly an extreme scenario. But regulators don’t seem to be waiting for worst-case scenarios anymore.
And that may be exactly what prompted the RBI to tighten the screws. A few months ago, it directed that banks issuing guarantees to prop trading firms must now do so against 100% collateral, with at least half of it being cash or cash equivalents such as fixed deposits.
The rule was originally supposed to kick in from April 2026. But after brokers, banks and other affected market participants argued they needed more time to transition to the new framework, the RBI pushed back the implementation. And on Thursday, the new rules finally came into effect.
There may also be another reason the RBI isn’t entirely comfortable.
Remember the ₹33,000 crore profit prop traders made?
If you dig deeper into SEBI’s report, you’ll find that 96% of those profits came from algorithmic trading. But only a little over half of the 626 prop trading entities that the regulator analysed actually used algorithms.
In other words, a relatively small number of large, sophisticated firms generated most of the profits, while many smaller firms could very well be breaking even or even losing money.
This means that a bank guaranteeing a mid-sized or smaller prop trading firm gets no comfort from the fact that some large algo desk elsewhere in the country made money. And that’s a risk.
There’s another factor too. India is now the world’s largest derivatives market, with average daily notional turnover touching nearly $5.2 trillion by the end of 2025. And that’s not exactly something regulators are proud of because excessive leverage in such a massive market can amplify risks and trigger market shocks. It’s also one of the reasons the government hiked the securities transaction tax (STT) on equity derivatives in the latest Budget.
And while the RBI can’t do much about all the hype in the stock market, it can at least make sure banks aren’t taking on excessive risk, which is what it did.
As you can imagine though, prop traders aren’t thrilled.
For one, they say the move slashes the leverage they once enjoyed. Earlier, they could effectively trade with about 1.7 times their capital. But now, because they have to lock up much more money with banks to obtain a guarantee, that falls to roughly 0.85 times. Less deployable capital could also mean lower liquidity in the markets, especially considering prop traders accounted for more than half of the NSE’s options turnover last year.
Their second complaint is that the new rules only affect Indian prop trading firms because foreign firms fall outside the RBI’s jurisdiction. And that can create an uneven playing field.
That said, some folks in the broking industry believe the sector will eventually adapt. After all, the markets have weathered plenty of regulatory changes over the years. Besides, this wasn’t really a surprise. The industry has known for a while that this blow was coming. And now, the only way forward is to adapt and move on.
How quickly that happens or how painful the transition turns out to be, is something we’ll have to wait and see.
Until then…
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