The Group recommends a phased introduction of the rupee option products with further product enhancements in stages. Since options are being introduced for the first time in India, the Group recommends that the same be introduced in the local market in a phased manner so as to avoid any unwarranted shocks. It is suggested that relatively less complex interest rate options may be permitted in the first phase. These products could include:

• Vanilla caps, floors and collars

• European Swaptions

• Call and put options on fixed income instruments or benchmark rates

While unleveraged structured swaps based on overnight indexed swaps (OIS) and FRAs where the risk profile of such structure is similar to that of the building blocks could simultaneously be introduced, the Group recommends that more sophisticated products may be introduced in the next phase which may include American and Bermudan swaptions, Digital options, Barrier options, Index Amortising caps, floors and other complex structures.

The Group recommends that scheduled commercial banks (excluding RRBs), financial institutions and primary dealers should be allowed to both buy and sell options for hedging balance sheet related exposures and market making, albeit with appropriate safeguards. These entities may also offer these products to corporates to help them hedge their balance sheet exposures. Corporates may, however, sell options to hedge their balance sheet exposures initially without being net receivers of premium. Such transactions should be monitored by banks. Mutual funds and insurance companies may also buy and sell options as and when their respective regulators allow them.

The Group recommends that in view of the need to adopt certain best practices banks could internally institute a procedure to enter into derivative transactions, particularly option-based structures, only with those counterparties that clearly understand the benefits and potential risks. In order to determine the same, some very basic criteria like an external risk rating or a minimum net worth could be employed by the bank as the first level check.

The Group recommends that banks should clearly delineate risks and benefits of the suggested derivatives strategies in their term-sheet/offer letter to clients. Wherever possible this should be corroborated with a sensitivity analysis of the changes in the payoff of such strategies with respect to changes in the underlying to clearly demonstrate the risks and rewards of the strategy.

While it is relatively simpler for banks in the foreign currency products to examine the underlying, the task becomes extremely difficult when the underlying is a rupee exposure. Hence, the Group recommends that a corporate buying a rupee derivative structure should certify in writing that the same is being used to hedge balance sheet exposures.

The Group recommends that there must be a formal credit clearance sought internally, either for the specific transaction or for a derivative facility, for every client that deals in derivatives.

With the current ban on short selling, “received” risks in the books of the dealers can only be hedged on a portfolio basis, which is inefficient and risky. Permitting short sale would reduce such risks. Therefore, the definition of short sale, as currently used, may be reviewed and modified so that it conforms to both practical and prudential requirements. The Group recommends that regulatory guidelines for short selling may be put in place as per international best practices.

The Group felt that there is a need for exchange-traded interest rate derivatives (IRDs) instruments as debt market volumes grow rapidly because exchange-traded products would reduce risk substantially. The Group recommends trading in IRDs through the anonymous order-driven screen-based trading system of the stock exchanges which will facilitate participation by all classes of investors and increase market access across the country.

The Group recommends that interest rate futures, interest rate options, interest rate swaps – both plain vanilla swaps as well as swaps with embedded options like caps/floors/collars, as well as standardised repos - may be allowed to be traded on the stock exchanges in a phased manner starting with Futures contract and followed by Option contracts.

After assessing the present state of underlying debt market, the Group recommends that four contracts, viz., a) Short-term MIBOR Futures Contracts, b) MIFOR Futures Contract, c) Bond Futures Contract and d) Long-term Bond Index Futures Contract could be considered for trading on exchanges at this stage. Of them, Bond Futures Contract could be launched where settlement should be done on the basis of delivery of securities for ensuring better integration between spot market and futures market. On other contracts, settlement could be done on cash basis.

The Group recommends that the market regulator should lay down only broad eligibility criteria and the Exchanges should be free to decide on the underlying stocks and indices on which futures and options could be permitted depending upon the preferences of market participants. The broad eligibility criteria should focus on the issues of risk containment and manipulability.

The Group recommends that netting should be allowed on intra-day basis at client level positions. However, the case of cross-margining with underlying market would be considered at a later stage.

The Group recommends that ICAI could be requested to develop guidelines for accounting of exchange-based transactions in IRDs. The tax issues incidental to derivative transactions in the equity market could also be applicable to IRDs transactions

The OTC derivatives market is highly concentrated among selected foreign banks, private sector banks and a PD. To broad-base the market in terms of different classes of participants in it, the Group recommends that measures be undertaken by all regulators seeking greater participation from target segments such as public sector banks, mutual funds (MFs), insurance companies (ICs) and primary dealers (PDs)

With a view to enhancing the level of transparency in derivatives market in order to encourage active participation, the Group recommends that RBI may consider mandatory anonymous disclosure of deals done, in a standardised manner, on the negotiated dealing system (NDS) platform. Publication of such figures on a consolidated basis would give the current as well as prospective participants a better picture of market liquidity and provide the much-needed historical data for analysis

In order to enhance familiarisation and expertise among participants, the Group recommends that FIMMDA may arrange to impart training in derivative products covering various aspects such as pricing, valuation, risk, documentation and back office functions. The approach could be two-pronged: one directed towards the senior management and the other at the level of dealers. The training programs for the dealers should be more intensive.

With a view to bringing about the required depth and liquidity in derivatives market, the Group recommends the introduction of brokers with due caution and allowing only the brokers accredited by FIMMDA, as per the framework in "Handbook of Market Practices", to act as authorised intermediaries in derivatives market. Brokers should function only as intermediaries with no proprietary involvement, to limit the probability of fraud. The Group recommends stringent regulation of the FIMMDA-accredited derivative market brokers with proper institution of systems of accountability and responsibility for these intermediaries as per international best practices.

With regard to participation of mutual funds (MFs), in the interest of abundant clarity, the Group recommends that SEBI may consider issuing guidelines in regard to products that MFs can trade in, the purpose for which MFs can enter into these transactions and any other related regulatory aspects

In respect of insurance companies, the Group recommends that IRDA should come out with guidelines for participation of insurance companies in derivatives marke

With a view to making the OTC derivatives contracts legally enforceable, the Group recommends that the following amendment to Section 18A may be now followed up vigorously with the Ministry of Finance by RBI:

“Notwithstanding anything contained in any other law for the time being in force or the provisions of section 28 of this Act, the following contracts shall be legal and valid:

(i) if such contracts in derivatives are:

1. traded on a recognised stock exchange;

2. settled on the clearing house of the recognised stock exchange in accordance with the rules and bye-laws of such stock exchange.

(ii) if such contracts are of the class and nature as notified by the Reserve Bank of India or the Securities and Exchange Board of India or the Central Government from time to time and entered into by persons or entities as may be authorised as ‘eligible persons/entities’ by the Reserve Bank of India or the Securities and Exchange Board of India or the Central Government from time to time.”

Additionally, since derivative trading is implicitly allowed by banks under Banking Regulation Act, 1949, the Group recommends that, in the meantime, to clarify the status of derivatives contracts in India undertaken by banks/FIs/PDs, the Banking Regulation Act, 1949 may be amended stating that notwithstanding anything contained under Section 30 of Contracts Act, 1872, if any such derivative contracts are of the class and nature as notified by the Reserve Bank of India from time to time and entered into by persons or entities as may be authorised as ‘eligible persons/entities’ by the Reserve Bank of India, they will be legally valid.

The Group recommends that a centralised clearing system for OTC derivatives may be introduced through CCIL.

A draft legislation on payment and settlement has been forwarded to the Government by RBI. With a view to ameliorating the problem arising from the lack of limits that counter-parties would have for one another as volumes expand in the derivatives market, the Group recommends that a suitable clause which will permit netting of derivative contracts may be incorporated in the above-mentioned draft legislation.

With a view to reducing liquidity risk and counterparty credit risk, the Group recommends that till such time as the legislation on netting is passed, bilateral netting by novation, on similar lines as done by FEDAI for foreign exchange contracts, may be operationalised by FIMMDA for the derivatives market.