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Derivatives Trading in India

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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:

Categories of Derivatives Traded in India

  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

Calendar of Introduction of Derivatives Products in Indian Financial Markets

OTC Exchange Traded

  • 1980s - Currency Forwards

  • 1997 - Long term FC - Rupee swaps

  • July 1999 - Interest rate swaps and FRAs

  • July 2003 - FC-Rupee options


  • June 2000 - Equity Index futures

  • June 2001 - Equity Index Options

  • July 2001 - Stock Options

  • June 2000 - Interest rate futures

November 2002 - RBI Working Group on Rupee Derivatives
March 2003 - RBI Working group on credit derivatives


Derivatives in India: A Chronology

Date Progress
14 December 1995 NSE asked SEBI for permission to trade index futures.
18 November 1996 SEBI setup L. C. Gupta Committee to draft a policy framework for index futures.
11 May 1998 L. C. Gupta Committee submitted report.
7 July 1999 RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps
24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian index.
25 May 2000 SEBI gave permission to NSE and BSE to do index futures trading.
9 June 2000 Trading of BSE Sensex futures commenced at BSE.
12 June 2000 Trading of Nifty futures commenced at NSE.
31 August 2000 Trading of futures and options on Nifty to commence at SIMEX.

Product Specifications BSE-30 Sensex Futures

  • Contract Size - Rs. 50 times the Index

  • Tick Size - 0.1 points or Rs. 5

  • Expiry day - last Thursday of the month

  • Settlement basis - cash settled

  • Contract cycle - 3 months

  • Active contracts - 3 nearest months

Product Specifications S&P CNX Nifty Futures

  • Contract Size - Rs. 200 times the Index

  • Tick Size - 0.05 points or Rs. 10

  • Expiry day - last Thursday of the month

  • Settlement basis - cash settled

  • Contract cycle - 3 months

  • Active contracts - 3 nearest months

Membership

  • Membership for the new segment in both the exchanges is not automatic and has to be separately applied for.

  • Membership is currently open on both the exchanges.

  • All members will also have to be separately registered with SEBI before they can be accepted.

Membership Criteria - National Stock Exchange (NSE)

Clearing Member (CM)

  • Networth - 300 lakh

  • Interest-Free Security Deposits - Rs. 25 lakh

  • Collateral Security Deposit - Rs. 25 lakh

In addition for every TM he wishes to clear for the CM has to deposit Rs. 10 lakh.

Trading Member (TM)

  • Networth - Rs. 100 lakh

  • Interest-Free Security Deposit - Rs. 8 lakh

  • Annual Subscription Fees - Rs. 1 lakh

Membership Criteria - Mumbai Stock Exchange (BSE)

Clearing Member (CM)

  • Networth - 300 lacs

  • Interest-Free Security Deposits - Rs. 25 lakh

  • Collateral Security Deposit - Rs. 25 lakh

  • Non-refundable Deposit - Rs. 5 lakh

  • Annual Subscription Fees - Rs. 50 thousand

In addition for every TM he wishes to clear for the CM has to deposit Rs. 10 lakh with the following break-up.

  1. Cash - Rs. 2.5 lakh

  2. Cash Equivalents - Rs. 25 lakh

  3. Collateral Security Deposit - Rs. 5 lakh

Trading Member (TM)

  • Networth - Rs. 50 lakh

  • Non-refundable Deposit - Rs. 3 lakh

  • Annual Subscription Fees - Rs. 25 thousand

The Non-refundable fees paid by the members is exclusive and will be a total of Rs.8 lakhs if the member has both Clearing and Trading rights.

Trading Systems

  • NSE's Trading system for it's futures and options segment is called NEAT F&O. It is based on the NEAT system for the cash segment.

  • BSE's trading system for its derivatives segment is called DTSS. It is built on a platform different from the BOLT system though most of the features are common.

Settlement and Risk Management systems

  • Systems for settlement and risk management are required to satisfy the conditions specified by the L.C. Gupta Committee and the J.R. Verma committee.

  • These include upfront margins, daily settlement, online surveillance and position monitoring and risk management using the Value-at-Risk concept.

All these are discussed in detail in subsequent pages.

Certification Programmes

  • 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.


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