Derivative trading in India takes can place either on a separate and independent Derivative Exchange or on a separate segment of an existing Stock Exchange. Derivative Exchange/Segment function as a Self-Regulatory Organisation (SRO) and SEBI acts as the oversight regulator. The clearing & settlement of all trades on the Derivative Exchange/Segment would have to be through a Clearing Corporation/House, which is independent in governance and membership from the Derivative Exchange/Segment.
Regulatory Objectives
The LCGC outlined the goals of regulation admirably well in Paragraph 3.1 of its report. We therefore reproduce this paragraph of the LCGC Report:
"The Committee believes that regulation should be designed to achieve specific, well-defined goals. It is inclined towards positive regulation designed to encourage healthy activity and behaviour. It has been guided by the following objectives:
A. Investor Protection: Attention needs to be given to the following four aspects:
Fairness and Transparency:
The trading rules should ensure that trading is conducted in a fair and transparent manner. Experience in other countries shows that in many cases, derivatives-brokers / dealers failed to disclose potential risk to the clients. In this context, sales practices adopted by dealers for derivatives would require specific regulation. In some of the most widely reported mishaps in the derivatives market elsewhere, the underlying reason was inadequate internal control system at the user-firm itself so that overall exposure was not controlled and the use of derivatives was for speculation rather than for risk hedging. These experiences provide useful lessons for us for designing regulations.
Safeguard for clients' moneys:
Moneys and securities deposited by clients with the trading members should not only be kept in a separate clients' account but should also not be attachable for meeting the broker's own debts. It should be ensured that trading by dealers on own account is totally segregated from that for clients.
Competent and honest service:
The eligibility criteria for trading members should be designed to encourage competent and qualified personnel so that investors/clients are served well. This makes it necessary to prescribe qualification for derivatives brokers/dealers and the sales persons appointed by them in terms of a knowledge base.
Market integrity:
The trading system should ensure that the market's integrity is safeguarded by minimising the possibility of defaults. This requires framing appropriate rules about capital adequacy, margins, clearing corporation,etc.
B. Quality of markets:
The concept of "Quality of Markets" goes well beyond market integrity and aims at enhancing important market qualities, such as cost-efficiency, price-continuity, and price-discovery. This is a much broader objective than market integrity.
C. Innovation:
While curbing any undesirable tendencies, the regulatory framework should not stifle innovation which is the source of all economic progress, more so because financial derivatives represent a new rapidly developing area, aided by advancements in information technology."
Derivatives Trading - Regulatory Framework
With the amendment in the definition of 'securities' under SC(R)A (to include derivative contracts in the definition of securities), derivatives trading takes place under the provisions of the Securities Contracts (Regulation) Act, 1956 and the Securities and Exchange Board of India Act, 1992. Dr. L.C Gupta Committee constituted by SEBI had laid down the regulatory framework for derivative trading in India. SEBI has also framed suggestive bye-law for Derivative Exchanges/Segments and their Clearing Corporation/House which lay's down the provisions for trading and settlement of derivative contracts. The Rules, Bye-laws & Regulations of the Derivative Segment of the Exchanges and their Clearing Corporation/House have to be framed in line with the suggestive Bye-laws. SEBI has also laid the eligibility conditions for Derivative Exchange/Segment and its Clearing Corporation/House. The eligibility conditions have been framed to ensure that Derivative Exchange/Segment & Clearing Corporation/House provide a transparent trading environment, safety & integrity and provide facilities for redressal of investor grievances
Market Regulation & Investor Protection
We have seen that pursuant to the recommendations of JR Verma Committee SEBI formulated and approved guidelines to the stock exchanges (NSE/BSE) and permitted trading in Derivatives. We will now discuss the regulatory measures as envisaged by SEBI.
Futures/ Options contracts in both index as well as stocks can be bought and sold through the trading members of National Stock Exchange, or the BSE Mumbai Stock Exchange. Some of the trading members also provide the internet facility to trade in the futures and options market.
The investor is required to open an account with one of the trading members and complete the related formalities which include signing of member-constituent agreement, constituent registration form and risk disclosure document.
The trading member will allot the investor an unique client identification number.
To begin trading, the investor must deposit cash and/or other collaterals with his trading member as may be stipulated by him. SEBI has issued detailed guidelines for the benefit of the investor trading in the derivatives exchanges. These may be viewed and studied.
Margins are computed and collected on-line, real time on a portfolio basis at the client level. Members are required to collect the margin upfront from the client & report the same to the Exchange.
All the Futures and Options contracts are settled in cash at the expiry or exercise of the respective contracts as the case may, be. Members are not required to hold any stock of the underlying for dealing in the Futures / Options market.
Important Eligibility/Regulatory Conditions Specified by SEBI
Derivative trading to take place through an on-line screen based Trading System.
The Derivatives Exchange/Segment shall have on-line surveillance capability to monitor positions, prices, and volumes on a real time basis so as to deter market manipulation.
The Derivatives Exchange/ Segment should have arrangements for dissemination of information about trades, quantities and quotes on a real time basis through atleast two information vending networks, which are easily accessible to investors across the country.
The Derivatives Exchange/Segment should have arbitration and investor grievances redressal mechanism operative from all the four areas / regions of the country.
The Derivatives Exchange/Segment should have satisfactory system of monitoring investor complaints and preventing irregularities in trading.
The Derivative Segment of the Exchange would have a separate Investor Protection Fund.
The Clearing Corporation/House shall perform full novation, i.e., the Clearing Corporation/House shall interpose itself between both legs of every trade, becoming the legal counterparty to both or alternatively should provide an unconditional guarantee for settlement of all trades.
The Clearing Corporation/House shall have the capacity to monitor the overall position of Members across both derivatives market and the underlying securities market for those Members who are participating in both.
The level of initial margin on Index Futures Contracts shall be related to the risk of loss on the position. The concept of value-at-risk shall be used in calculating required level of initial margins. The initial margins should be large enough to cover the one-day loss that can be encountered on the position on 99% of the days.
The Clearing Corporation/House shall establish facilities for electronic funds transfer (EFT) for swift movement of margin payments.
In the event of a Member defaulting in meeting its liabilities, the Clearing Corporation/House shall transfer client positions and assets to another solvent Member or close-out all open positions.
The Clearing Corporation/House should have capabilities to segregate initial margins deposited by Clearing Members for trades on their own account and on account of his client. The Clearing Corporation/House shall hold the clients' margin money in trust for the client purposes only and should not allow its diversion for any other purpose.
The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the trades executed on Derivative Exchange / Segment.
Measures Specified by SEBI to Enhance Protection of the Rights of Investors
in the Derivative Market
SEBI has also specified measures to ensure protection of the rights of investors. These measures are as follows:
Investor's money has to be kept separate at all levels and is permitted to be used only against the liability of the Investor and is not available to the trading member or clearing member or even any other investor.
The Trading Member is required to provide every investor with a risk disclosure document which will disclose the risks associated with the derivatives trading so that investors can take a conscious decision to trade in derivatives.
Investor would get the contract note duly time stamped for receipt of the order and execution of the order. The order will be executed with the identity of the client and without client ID order will not be accepted by the system. The investor could also demand the trade confirmation slip with his ID in support of the contract note. This will protect him from the risk of price favour, if any, extended by the Member.
In the derivative markets all money paid by the Investor towards margins on all open positions is kept in trust with the Clearing House /Clearing Corporation and in the event of default of the Trading or Clearing Member the amounts paid by the client towards margins are segregated and not utilised towards the default of the member. However, in the event of a default of a member, losses suffered by the Investor, if any, on settled / closed out position are compensated from the Investor Protection Fund, as per the rules, bye-laws and regulations of the derivative segment of the exchanges.
Presently, SEBI has permitted Derivative Trading on the Derivative Segment of BSE and the F&O Segment of NSE. Derivative products have been introduced in a phased manner starting with Index Futures Contracts in June 2000, Index Options and Stock Options introduced in June 2001 and July 2001 followed by Stock Futures in November 2001.
Types of Derivative Contracts Permitted by SEBI
Derivative products have been introduced in a phased manner starting with Index Futures Contracts in June 2000. Index Options and Stock Options were introduced in June 2001 and July 2001 followed by Stock Futures in November 2001.
Minimum Contract Size
The Standing Committee on Finance, a Parliamentary Committee, at the time of recommending amendment to Securities Contract (Regulation) Act, 1956 had recommended that the minimum contract size of derivative contracts traded in the Indian Markets should be pegged not below Rs. 2 Lakhs. Based on this recommendation SEBI has specified that the value of a derivative contract should not be less than Rs. 2 Lakh at the time of introducing the contract in the market.
The Lot Size of a Contract
Lot size refers to number of underlying securities in one contract. Additionally, for stock specific derivative contracts SEBI has specified that the lot size of the underlying individual security should be in multiples of 100 and fractions, if any, should be rounded of to the next higher multiple of 100. This requirement of SEBI coupled with the requirement of minimum contract size forms the basis of arriving at the lot size of a contract
For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the minimum contract size is Rs.2 lacs, then the lot size for that particular scrips stands to be 200000/1000 = 200 shares i.e. one contract in XYZ Ltd. covers 200 shares.
SEBI Amendment to Stipulations on Lot Size
While the Legislative body stipulated the minimum contract size in terms of value (Rs.2 Lacs), the system of standardising securities trade in Lots, had a multiplying effect, on the minimum value of a contract, when the prices of the premium Scrips started appreciating over time. BSE Sensix Index which was less than 3000 at that time swelled to nearly 6000 presently. As the value of individual scrips increased, smaller number of such scrips would be sufficient to cover the minimum contract value of Rs.2.00 Lacs prescribed by the Standing Committee of the Parliament. But stipulating a fixed number of shares as the lot in many cases swelled the value of the contract to Rs.5 Lacs and even more in many cases. This brought derivatives trading beyond he scope of the small investor.
Considering the fact SEBI revised its stipulations regarding Lot size, but retaining the minimum contract value at Rs.2 Lacs and issued a press release on 07.01.2004 stating:
It has been noticed that in several derivative contracts the value has exceeded Rs. 2 lakh. In such cases it has been decided to reduce the value of the contract to close to but not less than Rs. 2 lakh by using an appropriate lot size / multiplier which could be half or 50%. The exchanges could determine any other lot size / multipliers to keep the contract size of derivatives close to Rs. 2 lakh, but in any case not less than Rs. 2 lakh. The exchanges would be able to reduce the contract size of a derivative contract by submitting a detailed proposal to SEBI and after giving at least two weeks prior notice to the market.
