Derivatives Trading in India

Commodity Derivative Markets have been functioning in India since very long in agricultural products like cotton, wheat, pepper etc. and in precious metals like gold, silver etc. The Forward Contracts (Regulation) Act, 1952. provided the basis for forward trading in commodities. India prohibited futures trading in gold in 1962 after the war with China and in most other commodities in the 1970s, when domestic production of farm products was not enough to meet local demand. In the 1980s, it began re-introducing futures in select farm products. In the first instance futures trading in around 40 commodities, including oils and oilseeds, sugar and turmeric were permitted. Futures in several commodities, such as grains and bullion, are however banned. Recently during February 2003, the Government lifted the ban on futures trading in 54 more commodities including rice, wheat, bullion and other metals, to enable traders manage risk, as the prices of these commodities fluctuate wildly.

India also has a strong dollar-rupee forward market with contracts being traded for one, two … six-month, one-year expiration. Indian users of hedging services are also allowed to buy derivatives involving other currencies on foreign markets. But other equity and currency derivatives were unknown in India till the year Nineties. In fact derivatives trading in securities and currencies were unenforceable due to the provision in Indian Contract Act, 1872, as Section 30 of the Act, renders all wagering contracts as unenforceable and void. Further a notification was also issued under Securities Contracts Regulation Act,1956, banning all forward trading including forward trading in commodities. The said notification since stands revoked in the year 2000. Further the definition of Securities in Securities Contract Regulation Act, 1956 under Sec.2 did not include derivative products in the definition of securities and Sec.20 of the act specifically prohibited all trading in options from the commencement of the act. Consequent on the recommendations of LC Gupta Committee at the initiatives taken by SEBI the amendments were introduced as per Securities Laws ( Second Amendment ) Act,1999 introduced on 16 December 1999. The prohibition in trading in options in securities was lifted earlier in the year 1995 the Securities Laws (Amendment)Act, 1995. Section 18-A was introduced through the amendment of the year 1999 making exchange traded derivatives legal. While the introduction of Section 18A of Securities Contract (Regulation) Act, 1956 has resolved the legality problem as far as exchange-traded derivatives are concerned, the issue is still open for OTC derivatives.

The definition of derivative as contained in Section 2 (aa) of SCRA, 1956 is not wide enough to cover OTC derivatives like Interest Rate Swaps and Forward Rate Agreements, and it would render all OTC contracts void ab initio under Section 18A, which states:

18A. Contracts in derivatives

Notwithstanding anything contained in any other law for the time being in force, contracts in derivatives shall be legal and valid if such contracts are -

• (a) traded on a recognised exchange;

• (b) Settled on the clearing house of the recognised stock exchange in accordance with the rules and bye-laws of such stock exchange

Similarly in respect of commodity trading Options in goods are presently prohibited under Section 19 of the Forward Contracts (Regulation) Act, 1952. Hence Contracts in commodities futures through commodity exchanges are presently permitted in India.

As a result the following types of Derivatives Products are legally permitted to be traded in Indian Markets

1. Equity Derivatives (Index/stock futures/options) - Legally permitted to be traded through stock exchanges approved by SEBI

2. Commodity Trading - Commodity futures are permitted. Commodity futures permitted only for trading in commodities approved by the Government in Commodity Exchanges recognised by Forward Markets Commission. Option contracts in commodities trading are not permitted.

3. Foreign Exchange Derivatives - Forward Contracts as approved by RBI permitted to be transacted by Banks and other approved foreign-exchange dealers.

4. OTC rupee derivatives in the form of Forward Rate Agreements (FRAs)/Interest Rate Swaps (IRS) - These were introduced by RBI in India in July 1999 in terms powers vested with it Foreign Exchange Management Act, 2000. These derivatives enable banks, primary dealers (PDs) and all-India financial institutions (FIs) to hedge interest rate risk for their own balance sheet management and for market-making purposes. Banks/PDs/FIs can undertake different types of plain vanilla FRAs/IRS. Swaps having explicit/implicit option features such as caps/floors/collars are not permitted now.

5. Exchange Traded Interest Rate Derivatives were introduced by RBI/SEBI during June, 2003. These can be traded through stock exchanges by primary dealers subject to conditions stipulated by RBI. OTC Rupee derivatives are presently not permitted.

The different derivatives products traded in the Indian Markets are as under:

1. Commodities Futures for Coffee, Oil Seeds, Oil (Castor, Palmolein), Pepper, Cotton, Jute and Jute Goods are traded in the Commodities Futures. Forward Markets Commission regulates the trading of commodities futures.

2. Index futures based on Sensex and Nifty Index are also traded under the supervision of SEBI.

3. RBI has permitted Banks, FIs and PDs to enter into forward rate agreement (FRAs)/interest rate swaps in order to facilitate hedging of interest rate risks and ensuring orderly development of the derivatives market;

4. NSE became the first exchange to launch trading in options on individual securities. Trading in options on individual securities commenced from July 2, 2001. Option contracts are American style and cash settled and are available on 41 securities stipulated by the Securities & Exchange Board of India (SEBI)

5. NSE commenced trading in futures on individual securities on November 9, 2001. The futures contracts are available on 41 securities stipulated by the Securities & Exchange Board of India (SEBI).BSE also has started trading in individual stock options & futures (both Index & Stocks) around the same time as NSE

• The NSE certification programme is called NCFM (NSE's Certification in Financial Markets). NSE has outsourced training for this to various institutes around the country.

• The BSE certification programme is called BCDE (BSE's Certification for the Derivatives Exchange). BSE conducts it's own training run by it's training institute.

• Both these programmes are approved by SEBI.