The LCGC discussed the issue of separation of the cash and derivative markets at length: and recommended as under:

"From the purely regulatory angle, a separate exchange for futures trading seems to be a neater arrangement. However, considering the constraints in infrastructure facilities, the existing stock exchanges having cash trading may also be permitted to trade derivatives provided they meet the minimum eligibility conditions as indicated below..." (Paragraph 3.8)

After deliberation the committee recommended that SEBI should only be concerned with separation of legal architecture of the derivative segment by ensuring separate Bye-laws, Rules, Regulations, Governing Council & membership. The functional, operational and administrative modalities should be left to the discretion of the exchanges. The cash and derivative segments could have common personnel, trading terminal and infrastructure.

The committee specified the areas in the derivative segment which should be separate from the cash segment for the present.

These are as under:-

• The legal framework governing trading, clearing & settlement of the Derivative segment should be separate form the cash market segment. In other words, the Regulations & Bye-laws of derivative segment, as the case may be for specific exchanges, should be separate.

• TGF/SGF of the derivative segment should be separate form the cash market segment and merging / pooling of TGF/SGF may be considered at a later date.

• Membership of the derivative segment should be separate from the cash market segme

• The Governing Council / Clearing Council / Executive Committees of the derivative segment should be separate from the cash market segment.

The committee specified the areas in the derivative segment which should be separate from the cash segment for the present. These are as under:

• The legal framework governing trading, clearing & settlement of the Derivative segment should be separate form the cash market segment. In other words, the Regulations & Bye-laws of derivative segment, as the case may be for specific exchanges, should be separate

• TGF/SGF of the derivative segment should be separate form the cash market segment and merging / pooling of TGF/SGF may be considered at a later date.

• Membership of the derivative segment should be separate from the cash market segment.

• The Governing Council / Clearing Council / Executive Committees of the derivative segment should be separate from the cash market segment.

The LCGC Report made no mention of sub brokers though it recommended a two tier market structure consisting of trading members and trading members. The ACD has discussed the issue of sub brokers on several occasions. Its view has consistently been that there can be no compromise on (a) client level gross margins (b) regulation of sales practices at client level. Sub brokers as they operate in cash market are inconsistent with this. However, the ACD has consistently taken the view that other forms of multi-tier broking relationships are possible consistent with the above two requirements.

• The Trading member - Clearing Member structure itself is two-tier structure and the regulatory regime imposes no minimum capital requirement on trading members as the clearing member is responsible for all settlement obligations. It is therefore possible for a sub broker to be registered as a trading member with fairly low capital requirements. The ACD has also been of the view that exchanges should be allowed to use any terminology that they like for such sub-broker turned trading member so long as they are registered with SEBI as trading members.

• It is also possible to adopt a remisier model in which client of the sub broker receive contract notes issued in the name of and on behalf of the main broker.

The ACD is of the view that SEBI should be open to any proposal from the exchanges for assimilating sub brokers into the market structure so long as these are consistent with the twin requirements of client level gross margins and regulation of sales practices at client level.

The LCGC recommended 100% inspection of all derivative brokers every year:

The advisory committee after deliberating on the issue was of the view that inspection should be linked to the level of activity of the member and other criteria as the circumstances demand. The committee was of the view that condition of 100% inspection may be done away with and the quantum of members to be inspected could be linked to the cost and benefit of inspections and the criteria decided in this regard. The Exchange should work out an appropriate inspection strategy in consultation with SEBI. This inspection strategy should lay down:

1. the criteria for identifying the top members to be taken up for 100% inspection;

2. the percentage of remaining members to be inspected on a sampling basis ;

3. mechanisms to ensure that active members do not go uninspected for several years in succession .

The committee also deliberated on the issues which would be covered in the Surveillance Systems / Mechanism in the derivative markets. While many aspects of surveillance would be the same for derivatives and for other securities, the committee felt that some the exchanges should consider developing a specific stock watch system for derivative markets. The cash market surveillance mechanism may not meet all the requirements of the derivatives market. Some of the important issues that arise are as follows:

1. There should be monitoring of open interest, cost of carry, impact cost, and volatility. The open positions in the derivative market should be seen in conjunction with the open positions in the cash market i.e. the position deltas should be monitored.

2. The timing of information disclosure by corporates should be monitored as this could influence the prices of the contract at the time of contract introduction and expiry.

3. Strike prices with large open positions should be monitored as such strike prices could be a target price to be achieved in the cash market to derive maximum benefit from the derivative position.

4. It is also necessary to monitor contract expirations very carefully. The ACD has sometimes reviewed this on an ad hoc basis. For example, in one of its meetings, it reviewed the contract expirations coinciding with large volumes and high volatility on February 28, 2002 (budget announcement) and March end (close of the financial year). Both BSE & NSE submitted details of the analysis that they had carried out in this regard and stated unequivocally that there were no risk management or market integrity concerns associated with these expirations. Expiration monitoring should be done systematically from a surveillance point of view

5. Unified surveillance of the cash and derivatives markets is essential both at the exchange level and at the level of SEBI.

6. SEBI and the Exchanges should study surveillance practices in various global equity derivative markets. Surveillance practices in global commodities and bullion derivative markets could also be studied where appropriate as some of the well publicized cases of market manipulation in derivatives have been in these markets. Case studies on some market manipulations in various derivatives markets could be looked at to see what lessons could be drawn.

The LCGC Report took it for granted that physical settlement would be used for derivative contracts on individual stocks:

"In the case of individual stocks, the positions which remain outstanding on the expiration date will have to be settled by physical delivery. This is an accepted principle everywhere." (Paragraph 2.8(5))

However, when single stock derivatives were introduced in India, it was decided to use cash settlement to begin with because the exchanges did not then have the software, legal framework and administrative infrastructure for physical settlement. It was proposed that cash settlement would be replaced by physical settlement within a period of six months as the exchanges developed the capabilities to achieve physical settlement efficiently.

In the light of the above broad policy framework, committee recommends the following operational parameters for physical settlement:

1. Clearing Corporation of the cash market would act as an agent10 of the clearing corporation of the derivative segment, for clearing the exercised / expired stock option and stock futures contracts. The delivery obligation at the Trading Member level in the derivative markets would be settled through the cash market clearing corporation as per the delivery mechanism prevalent in the cash market clearing corporation.

2. The trading member of the derivative market would enter into an agreement/arrangement with a clearing member of the cash market and such clearing member of the cash market would act as an agent of the trading member/ clearing member of the derivative market for the purpose of settling the delivery obligation of such member.

3. The Clearing Corporations of the Cash segment and the Derivative segment may enter into an agreement/arrangement which could address the issues of risk management, cross margining system, and the other concerned areas. In the event of default the proportion in which the burden of default would be shared between the Settlement Guarantee Funds of cash and derivative segment, could also be specified in the agreement/arrangement.

4. Similarly, a tripartite agreement between the client, the trading member of derivative segment and the clearing member of the cash segment could be entered which could specify issues pertaining to delivery offsets, margin requirement and any other concerned issue.

5. The delivery obligation of the derivative segment would be netted at Trading Member level and passed on to the clearing member of the cash market for settlement as an agent.

6. To allow option writers to deliver stock in time, one day's notice shall be given for the exercise of options. On exercise, the delivery would be settled in the time frame specified in the cash market.

7. The margin set off at the client level would be made available by adopting the cross margining between the clearing corporation of derivatives segment and the cash segment.

8. The 'effective date' from which stock futures and stock option contracts change to physical settlement mode should coincide with the date of inception of a new contract month. From the 'effective date' the outstanding stock futures and stock option contracts, would also change to physical settlement, though at inception, these contracts were stated to be for cash settlement.

9. The 'effective date' for physical settlement should be announced 45 days in advance.