Starting July 1, 2026, proprietary trading firms in India woke up to a new reality. The Reserve Bank of India's (RBI) capital market exposure rules, originally set for April but postponed after industry pushback, are now in full effect. The core change is deceptively simple: banks issuing guarantees to prop trading firms must now back them with 100% collateral, with at least 50% in cash or cash equivalents like fixed deposits. Previously, firms needed just 50% collateral with only 25% in cash. This seemingly technical shift has effectively slashed leverage from roughly 1.7 times capital to about 0.85 times—cutting trading capacity in half overnight.
Under the old system, a prop firm could deposit ₹50 crore as an FD, get a ₹100 crore bank guarantee, and place it with the clearing corporation to trade with 2x leverage. Banks earned fees of 50-100 basis points, but if multiple prop firms defaulted simultaneously on margin calls, banks would have to honour those guarantees. They could recover some money by selling collateral, but the rest would come from banks' own funds—money meant for lending and other banking operations. Widespread failures could threaten the banking system and, indirectly, depositors.
The central bank isn't waiting for worst-case scenarios anymore.
Excessive leverage in such a massive market can amplify risks and trigger market shocks. While banks' exposure to capital markets accounted for less than 3% of total advances in FY25 and defaults were extremely low, the RBI is focused on tail risk rather than average outcomes.
SEBI's analysis of equity derivatives trading between FY22 and FY24 reveals a troubling pattern that likely influenced the RBI's thinking.
But here's the catch: 96% of those profits came from algorithmic trading, and only about half of the 626 prop trading entities analyzed actually used algorithms. This means a relatively small number of large, sophisticated firms generated most profits, while many smaller firms were likely breaking even or losing money.
For a bank guaranteeing a mid-sized or smaller prop trading firm, there's no comfort in knowing some large algo desk elsewhere made money. Each guarantee stands on its own merit. The RBI's concern is that while the segment has low default rates historically, the concentration of profits among a few large players creates asymmetric risk profiles. Smaller firms without algorithmic advantages may have fragile business models with higher vulnerability to market stress.
The impact on market liquidity could be significant. Prop traders account for more than half of NSE's options turnover, 30.9% of NSE cash market turnover, and 36.9% of BSE cash market turnover. With their trading capacity halved, industry estimates suggest derivatives volumes could fall by up to 20%. This reduction in market-making activity could lead to wider bid-ask spreads, reduced market depth, and higher trading costs for all participants—including retail investors.
The feedback loops are concerning. Reduced liquidity from domestic prop traders leads to wider spreads and higher costs, which may further discourage participation, creating a self-reinforcing cycle of liquidity decline. Lower liquidity also increases volatility, which forces firms to reduce positions, further decreasing liquidity. The initial impact could be just the beginning of a longer-term market structure transformation.
Perhaps the most contentious aspect is the competitive imbalance created. The RBI's jurisdiction over Indian banks means domestic prop trading firms must navigate the new collateral requirements. Foreign prop firms, operating outside the RBI's purview, can access guarantees from global banks with potentially less stringent requirements. They may also use Standby Letters of Credit (SBLCs) from international banks, which typically cost 10-100 basis points compared to 50-100 basis points for Indian bank guarantees, and may require lower collateral commitments.
This creates a 2-3x differential in capital efficiency.
The result? Trading activity and market share could migrate from domestic to foreign prop firms, potentially reducing NSE turnover and fundamentally altering market structure.
For banks, the new rules present a complex trade-off. On one hand, fee income from guarantee services will decline significantly as volumes contract and guarantee sizes shrink. Industry estimates suggest derivatives trading volumes could fall 20%, which would proportionally reduce guarantee business. Banks that previously derived meaningful fee income from this segment face substantial revenue compression.
On the other hand, the risk profile improves dramatically. With 100% collateral coverage and 50% cash requirements, net exposure after collateral is minimal. The shift toward cash and government securities reduces Risk-Weighted Assets, potentially improving capital adequacy ratios. Banks may choose to exit relationships with smaller, higher-risk clients and focus on larger, well-capitalized prop trading firms with stronger risk profiles.
The 50% cash collateral requirement also affects banks' liquidity management and asset allocation decisions. While increased cash deposits boost the deposit base and improve Liquidity Coverage Ratios, they create allocation challenges as cash typically offers lower yields. Banks must balance liquidity needs with yield requirements, potentially accepting lower returns on enhanced safety.
The RBI's action through banking regulation rather than direct coordination with SEBI on margin requirements reflects a deliberate strategic choice. The RBI has direct authority over banks under the Banking Regulation Act, 1949, making intervention through the banking channel more efficient and immediate. This upstream approach controls the flow of funds from banks to capital markets, addressing systemic risk at its source.
However, coordination challenges exist between the RBI's prudential regulation of banks and SEBI's market regulation of prop trading firms and exchanges. The two regulators have different primary objectives—stability versus market development—different regulatory philosophies, and different risk tolerances. While high-level meetings and technical committees exist, more formal coordination frameworks may be needed for effective joint risk assessment and crisis management.
The prop trading industry is undergoing a structural transformation. Marginal firms, especially smaller non-algorithmic players, may exit the market due to unviable economics. Well-capitalized algorithmic trading desks will likely strengthen their market position. The industry may become more concentrated among fewer large players, though potentially at the cost of reduced liquidity and increased trading costs.
Markets typically adapt to regulatory changes over time. New participants may emerge to fill liquidity voids, trading strategies will evolve to work within new constraints, and the market will eventually reach a new equilibrium. But this transition period could be extended and painful. The net impact will depend on how quickly the market adapts and whether alternative risk transfer mechanisms develop to fill the void left by reduced bank participation.
For now, the RBI has made its choice: financial stability and depositor protection take precedence over market efficiency and liquidity. Whether this proves to be prudent risk management or overreach that harms India's position as the world's largest derivatives market remains to be seen. The next few months will be critical in assessing whether the benefits of reduced systemic risk outweigh the costs of potentially diminished market liquidity and competitive distortions.
