A Brief History of Forward Trading in India
[Source: from an article titled "Legal Aspects of Derivatives Trading in India"
by Mr.Susan Thomas, Asst.Professoor, Indira Gandhi Institute of Development
Research, - http://www.igidr.ac.in/~susant/DERBOOK/PAPERS/ss_draft2.pdf]

The precursor to exchange based derivatives in India was a kind of "forward trading" in securities in the form of call options (teji), put options (mandi) and straddles (fatak) etc. The Securities Contracts Regulation Act, 1956 (SCRA) was enacted, inter-alia, to prevent undesirable speculation in securities.

The contracts for "clearing" commonly known as "forward trading", were banned by the Central Government through a notification issued on 27th June 1969 in exercise of the powers conferred under Section 16 of the SCRA. As the prohibition of forward trading in securities led to a decline of traded volumes on stock markets, the Stock Exchange, Mumbai (BSE), evolved in 1972 an informal system of "forward trading", which allowed carry forward between two settlement periods, which resulted in substantial increase in the turnover of the exchange. However, this also created several problems and there were payment crises from time to time and frequent closure of the market. During December 1982 - January 1983 the Government reviewed the position and in exercise of its powers under Section 10 of the SCRA amended the bye-laws of stock exchanges to facilitate performance of contracts in "specified securities". In pursuance of this policy the stock exchanges at Bombay, Calcutta and Ahmedabad introduced a system of trading in "specified shares" with carry forward facility after amending their bye-laws and regulations.

The Joint Parliamentary Committee on Irregularities in Securities and Banking Transactions, 1992 (JPC of 1992) discussed the issue of "carry forward of deals" and observed that this system was not functioning appropriately as there werelot of irregularities in the stock exchanges in the form of non enforcement of margins, non-reporting of transactions and illegal trading outside the stock exchange.

SEBI was of the view that carry forward transactions should be disallowed and transactions conducted strictly on delivery basis and trading in futures and options should be permitted in separate markets. Consequently, SEBI issued a directive in December 1993 prohibiting the carry forward of transactions.

However, this was reviewed by SEBI, and pursuant to the recommendations of the G.S. Patel Committee to review the system, carry forward transactions in securities were permitted in 1995 subject to certain safeguards. This was further reviewed by the J.R. Varma Committee report in 1997 and the system was further modified subject to a number of safeguards such as segregation of carry forward transactions at the time of execution of trade, daily margin of 10%, 50% of which would be collected upfront, overall carry forward limit of Rs.20 crore per broker per settlement and other prudential safeguards.

On the other hand, repo transactions in Government securities and public sector bonds developed during 1980s. Following the discussion of JPC of 1992, which indicated that some banks were found to have entered into transactions in violation of RBI circulars, RBI banned all repos except treasury bills since June 1992. The Special Court, however, declared such transactions null and void in December 1993 as being violative of the provisions of SCRA and Banking Regulation Act, 1949. The Supreme Court, however, decided in March 1997 that the ready forward contracts (Repo) were severable into two parts, viz. ready lag and the forward lag.

The ready lag of transactions having been completed, the forward lag, which alone was illegal, had to be ignored. As repo transactions violated the Government notification of 27 th June 1969 under SCRA, certain institutions such as banks, co-operative banks and other RBI registered dealers were permitted to undertake ready forward transactions in Government securities through amendment notifications from time to time during second half of 1990s. The objective was to enhance liquidity market for Government securities and to further develop it.

There were problems with such kind of facility such as, no standard documentation, "master agreement", non-use of clearing houses to undertake counter party risk and opacity of the regulatory validity in view of the pronouncements of the Special Court and the Supreme Court. As a result the repo market was neither deep nor liquid.

This was an anomalous situation where there was a notification, which prohibited forward trading, while some form of forward trading (carry forward/ready forward) was prevalent. In view of the changed circumstances particularly the need to develop derivatives market the repeal of 1969 notification was considered desirable not only to remove the existing anomaly, but also as a measure of market reforms. The issue was that the notification was to be repealed only after amendment of the SCRA so that the powers could be appropriately delegated to RBI in addition to SEBI. There were complex regulatory issues relating to repeal of the said notification and delegation of powers to RBI and SEBI. The issue was what powers in respect of which transactions in which securities should be delegated to RBI, since SEBI was already exercising delegated powers under SCRA, irrespective of type of transactions/securities. The Securities Laws (Amendment) Bill, 1999 was passed (before the legislation sufficient ground work was done as would be discussed later) by the Parliament permitting a legal framework for derivatives trading in India in December 1999. Consequently, the Central Government lifted a three decade old prohibition on forward trading in securities on 1 st March 2000.

Simultaneously, in order to promote an orderly development of the market, the Government issued another notification on 1st March 2000 delineating the area of responsibility between RBI and SEBI. In terms of this notification, the contracts for sale and purchase of Government securities, gold related securities, money market securities and securities derived from these securities and ready forward contracts in debt securities were to be regulated by RBI.

Such contracts if executed on stock exchanges, would be regulated by SEBI in a manner that this consistent with the guidelines issued by RBI. On the same date, both RBI and SEBI issued notifications specifying the regulatory framework in their respective areas. The RBI's notification while retaining the general prohibition on forward trading, permitted ready forward contracts by the specified entities subject to certain conditions, such as, maintenance of subsidiary ledger account and a current account and such other conditions, as may be prescribed. SEBI also retained the general prohibition on forward trading but permitted derivatives contracts, as permissible under the securities law. Since both the regulators have been made responsible for regulation of debt markets, of course, with some demarcation, issues of coordination become