Evolution of a Legal Framework for Derivatives 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]

An important step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which lifted the prohibition on "options in securities" (NSEIL, 2001). However, since there was no regulatory framework to govern trading of securities, the market could not develop. SEBI set up a committee in November 1996 under the chairmanship of Dr. L.C. Gupta to develop appropriate regulatory framework for derivatives trading. The committee suggested that if derivatives could be declared as "securities" under SCRA, the appropriate regulatory framework of "securities" could also govern trading of derivatives. SEBI also set up a group under the chairmanship of Prof. J.R. Varma in 1998 to recommend risk containment measures for derivatives trading. The Government decided that a legislative amendment in the securities laws was necessary to provide a legal framework for derivatives trading in India.

Consequently, the Securities Contracts (Regulation) Amendment Bill 1998 was introduced in the Lok Sabha on 4 th July 1998 and was referred to the Parliamentary Standing Committee on Finance for examination and report thereon. The Bill suggested that derivatives may be included in the definition of "securities" in the SCRA whereby trading in derivatives may be possible within the framework of that Act. The said Committee submitted the report on 17th March 1999.

The Committee was of the opinion that the introduction of derivatives, if implemented, with proper safeguards and risk containment measures, will certainly give a fillip to the sagging market, result in enhanced investment activity and instill greater confidence among investors/participants. The Committee was of the view that since cash settled contracts could be classified as "wagering agreements" which can be null and void under Section 30 of the Indian Contracts Act, 1872, and since index futures are always cash settled, such futures contracts can be entangled in legal controversy. The Committee, therefore, suggested an overriding provision as a matter of abandoned caution- "Notwithstanding anything contained in any other Act, contracts in derivatives as per the SCRA shall be legal and valid". Further, since Committee was convinced that stock exchanges would be better equipped to undertake trading in derivatives in sophisticated environment it would be prudent to allow trading in derivatives by such stock exchanges only. The Committee, therefore, suggested a clause- "The derivative shall be traded and settled on stock exchanges and clearing houses of the stock exchanges, respectively in accordance with the rules and bye-laws of the stock exchange". The Proposed Bill, which incorporated the recommendations of the said Parliamentary Committee, was finally enacted in December 1999.

Further the Committee recommended various operational/legal measures to safeguard the integrity of the capital market and protect investors. These measures, inter alia, include the following:

1. The Committee observed that Dr. L.C. Gupta Committee appointed by SEBI had drawn out detailed guidelines pertaining to the regulatory framework on derivatives prescribing necessary preconditions which should be adopted before the introduction of derivatives. The Committee, therefore, recommended that these should be adhered to fully.

2. The Committee felt that there was an urgent need to educate the Indian investors by creating investment awareness among them by conducting intensive educational programmes, so that they are able to understand their risk profiles in a better way.

3. Measures should be taken to strengthen the cash market so that they become strong and efficien

4. The Committee felt that it is imperative that the regulatory authorities ensure a strong surveillance/vigilance and enforcement machinery.

5. The Committee was of the view that since derivatives trading requires a critical mass of sophisticated investors supported by credit and stock analysts, SEBI should, in consultation with the stock exchanges, endeavour to conduct certification programme on derivatives trading with a view to educating the investors and market intermediaries.

6. Keeping in view the swift movement of funds and the technical complexities involved in derivatives transactions, the committee felt that there was a need to protect particularly the small investors by preventing them from venturing in to options and futures market, who may be lured by the sheer speculative gains. The Committee, therefore, recommended that the threshold limit of the transactions should be pegged not below Rs. 2 lakhs.

7. The Committee was of the view that there is an urgent need to prescribe pronounced accounting standards in the case of investors/dealers and also back office standards for intermediaries with a view to reducing the possibility of concealing loss and perpetrating the frauds by companies/intermediaries. The Committee also noted that the need of accounting disclosure had also been recognized by Dr. L.C. Gupta Committee. The committee, therefore, recommended that the Institute of Chartered Accountants of India, in consultation with the stock exchanges, should formulate suitable accounting standards and SEBI should prescribe the same before trading in derivatives is commenced.

8. (viii) The Committee also asked the Government to consider exempting derivatives transactions from the imposition of stamp duty. It is important to note that the suggestions and recommendations of the said Committee were implemented by the statutory regulators.

Thus the enactment of Securities Laws (Amendment) Act 1999 and repeal of 1969 notification provided a legal framework for securities based derivatives trading on stock exchanges in India, which is co-terminus with framework of trading of other "securities" allowed under the SCRA. The trading of stock index futures started in June 2000 and later on, other products, such as, stock index options and stock options and single stock futures were also allowed. The derivatives are formally defined under the said Act of 1999 (No. 31 of 1999) to include: (a) a security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security, and (b) a contract which derives its value from the prices or index of prices or underlying securities. The Act also clarified that, notwithstanding anything contained in any other law for the time being in force, contracts in derivatives shall be legal and valid only if such contacts are traded on a recognized stock exchange and settled on a clearing entity of the recognised stock exchange in accordance with the rules and bye-laws of such stock exchange, thus precluding OTC derivatives (this has implications for legal validity of such derivatives, as discussed later). The detailed legal framework for derivatives trading on stock exchanges was suggested by the L.C. Gupta Committee on derivatives, which had submitted its report in March 1998. It not only provided a conceptual basis for various regulatory features, but also suggested bye-laws for derivatives exchanges and clearing corporations. These bye-laws were required to be adopted by the stock exchange and clearing entities before derivatives activity can start within their jurisdiction.