Part 7: Legal & Regulatory Framework, Accounting, Taxation & Investor Protection

NISM Series VIII – Part 7: Legal & Regulatory Framework, Accounting, Taxation & Investor Protection

This is the final part — Part 7 — of our complete NISM Series VIII Equity Derivatives short notes series. In this post, we cover the legal and regulatory framework governing Indian derivatives markets, key committee recommendations, accounting treatment, taxation rules, and investor protection guidelines. These are directly tested in the NISM Series 8 equity derivatives certification exam.

Quick Answer (Featured Snippet): The Indian equity derivatives market is regulated under the Securities Contracts (Regulation) Act 1956, the SEBI Act 1992, and guidelines issued by SEBI. Key regulatory bodies are SEBI (policy maker) and the stock exchanges (operational regulators). The Dr. L.C. Gupta Committee and Prof. J.R. Verma Committee provided the foundational framework for India's derivatives regulations.

Legal Framework – Key Laws Securities Contracts (Regulation) Act, 1956 (SCRA)

An Act of the Indian Parliament aimed at preventing undesirable transactions in securities and controlling the functioning of stock exchanges
The term "securities" is defined under Section 2(h) of SCRA
The Act came into force on 20 February 1957
In 1999, SCRA was amended to include "derivatives" within the definition of securities, creating a formal legal basis for exchange-traded derivatives in India

Securities and Exchange Board of India Act, 1992 (SEBI Act)

SEBI was established under the SEBI Act, 1992 with statutory powers to:

Protect the interests of investors in securities
Promote the development of the securities market
Regulate the securities market

SEBI's regulatory jurisdiction extends to:

Corporates in the issuance of capital and transfer of securities
All intermediaries (brokers, clearing members, depository participants, etc.) associated with the securities market

Dr. L.C. Gupta Committee – Key Recommendations

SEBI formed this committee in 1996 to design the regulatory framework for derivatives trading in India. The major recommendations are directly tested in the NISM Series VIII exam.

Risk & Margin Framework

Margins must be based on Value at Risk (VaR) methodology at 99% confidence
Volatility and exposure must be monitored online in real time
Mark to Market margins must be collected daily (on the next trading day)
Mark to Market margins must be settled only in cash
Initial Margin levels should be dynamic and continuously recalculated based on volatility
Members' exposure must be linked to the amount of liquid assets maintained with the clearing corporation
Cross margining (netting cash and derivative positions for margin purposes) is not permitted

Market Participant Rules

Each dealer must pass a SEBI-approved certification exam (certificate validity: 3 years)
All clients must pay margins — brokers cannot fund client margins
Brokers must keep client margins in a separate bank account
Brokers cannot use client margin money for any purpose other than depositing it with the clearing corporation
Providing Client ID for every transaction is mandatory
If a client is a Trust or Company, the broker must obtain authorisation from the Board of Trustees or Board of Directors before trading derivatives on their behalf

Market Structure

The derivatives segment must be separate from the cash segment
A separate Investor Protection Fund must be created for the derivatives segment
The derivatives segment must attract at least 50 members
Clearing Members must have a minimum net worth of Rs 3 crore
Clearing Members must maintain a minimum deposit of Rs 50 lakh in liquid assets with the exchange or clearing corporation
The clearing function should be a separate entity — preferably a Clearing Corporation
In case of Clearing Member default, only the margins paid by that CM on its own account will be used to settle its dues

Regulatory Structure

Exchanges regulate at the operational day-to-day level; SEBI oversees and formulates policy
No common members between the Cash segment Governing Board and the Derivatives segment Governing Council
The Clearing Corporation has powers to levy additional margins, define maximum exposure limits, and suspend brokers from trading
SEBI must create a Special Derivatives Cell within itself
The exchange must set up Arbitration and Investor Grievance Cells in at least 4 regions across the country
All derivatives trading must be through online systems
A Disaster Recovery Site is mandatory
Market information must be disseminated via at least two information vending networks (e.g., Reuters, Bloomberg)
All brokers in the derivatives segment must obtain SEBI Registration
Derivatives should begin with Index Futures, with other products introduced in a phased manner
Both speculators/traders and hedgers are necessary for a healthy derivatives market
Mutual Funds should be allowed to hedge in the derivatives segment
Clients must be given a Risk Disclosure Document by their broker
Brokerage must be charged separately in the Contract Note
Transactions in the trading system must be entered exclusive of brokerage

Prof. J.R. Verma Committee – Key Recommendations

SEBI set up the Prof. J.R. Verma Committee in 1998 to recommend risk containment measures for India's derivatives markets.

Margin Methodology

Volatility must be calculated using the standard deviation of logarithmic daily returns
The Exponential Weighted Average Method (EWMA) must be used for volatility calculation
Initial margin levels must be dynamic — continuously recalculated based on current volatility
If an exchange wants to change the initial margin methodology, it must obtain SEBI approval
Any change in initial margin will apply to all outstanding contracts, not just new ones

Calendar Spread Margins

Calendar spreads attract lower margins (minimum 1%, maximum 3%; margin itself is 0.5% per month of spread on the far month value)
Calendar spreads carry only basis risk, not market risk — hence lower margins are justified
Calendar spreads must be treated as open positions as the near month contract expires
Differential margins for converting calendar spreads to open positions must be collected three days before the near month expires

Liquid Assets Framework

Liquid Assets = Deposits maintained by Clearing Members with the Clearing Corporation
Eligible forms: Cash, Cash Equivalents (Government Securities, Fixed Deposits, T-Bills, Bank Guarantees, Investment Grade Debt), and Equity Securities
Equity Securities: maximum 50% of Liquid Assets
Cash and Cash Equivalents: minimum 50% of Liquid Assets
Liquid Net Worth = Liquid Assets – Initial Margin
Liquid Net Worth of all Clearing Members must be maintained at a minimum of Rs 50 lakh at all times (including intraday)
Securities placed with the Clearing Corporation are marked to market on a weekly basis
Haircut on equity securities = 15%; on debt securities = 10%

Accounting for Derivatives Accounting for Forward Contracts (AS-11) When the Forward Contract is for Hedging:

Premium or discount on the forward contract is amortised over the life of the contract
Exchange differences are recognised in the Profit & Loss statement of the year
Profit or loss on cancellation or renewal of the forward contract is recognised in the P&L of that year

When the Forward Contract is for Trading / Speculation:

No premium or discount is recognised
The difference between forward rates for the remaining maturity is recognised as gain or loss in the P&L of that period
Profit or loss on cancellation or renewal is recognised in the P&L of that year

Accounting for Equity Index and Stock Futures (ICAI Guidance Note)

The Institute of Chartered Accountants of India (ICAI) has issued guidance notes on accounting for equity index and equity stock futures contracts from the perspective of traders (buyers and sellers). The focus is on how MTM gains and losses, margins, and final settlement are recorded in the books of the client.

Taxation of Derivative Transactions

Featured Snippet: Since the Finance Act 2005 (applicable from FY 2005-06), income or loss from derivative transactions carried out on a recognised stock exchange is NOT treated as speculative income. Derivative losses can be set off against any non-speculative business income and carried forward for up to 8 assessment years.

Key Tax Rules

Before FY 2005-06: Derivative transactions were treated as speculative transactions for tax purposes
Finance Act 2005 amended Section 43(5) to exclude derivatives on recognised stock exchanges from the definition of speculative transactions
Derivative income or loss from recognised exchanges is now treated as non-speculative business income/loss
Derivative losses can be set off against any other income in the same year except salary income
If not fully set off, losses can be carried forward for up to 8 assessment years and set off against non-speculative business income
Securities Transaction Tax (STT) paid on derivative transactions is eligible as a deduction under the Income Tax Act, 1961

Sales Practices and Investor Protection Core Principle

Financial institutions must adopt a customer-oriented approach. Sales must be guided by the client's interests, not the adviser's commissions.

"Customers have the right to receive good advice; finance employees have the duty to give good advice."

Common Investor Risks – What to Watch Out For High Return / Risk-Free Investment Promises

No investment is truly risk-free. Returns are always linked to the risk taken. Any adviser promising guaranteed high returns should be treated with extreme caution.

Unsuitable Investment Recommendations

Some advisers recommend products that do not match the client's investment objectives. For example, selling options or futures to a senior citizen with a low risk tolerance is an unsuitable recommendation. Investors should always review the risk profile of every recommendation.

Churning

Churning refers to a practice where a broker executes excessive and unnecessary trades in a client's account purely to generate commissions. This is a prohibited practice.

Investor Seminars

Advisers sometimes use seminars to pitch products using high-pressure sales tactics. Investors should avoid making rushed investment decisions at such events and should seek independent third-party advice before committing funds.

Risk-Based Approach – Client Due Diligence

Registered intermediaries must classify clients by risk level and apply due diligence proportional to that risk. Higher-risk clients require enhanced due diligence.

Clients of Special Category (high-risk): Non-Resident Indians (NRIs), High Net Worth Individuals (HNIs), Trusts, Charities, Politically Exposed Persons (PEPs), non-face-to-face clients, government executives.

Anti-Money Laundering (AML) Procedures

Every registered intermediary must implement written Anti-Money Laundering (AML) procedures under the Prevention of Money Laundering Act (PMLA), 2002. These procedures must cover:

Policy for acceptance of clients
Procedure for identifying clients (KYC – Know Your Client)
Transaction monitoring and Suspicious Transaction Reporting (STR)

Know Your Client (KYC) Policy

The KYC policy defines how a client's identity must be verified at various stages:

When establishing the broker-client relationship
While executing transactions on behalf of the client
When there are doubts about the accuracy or adequacy of previously obtained client information

Investor Grievance Mechanism

Every exchange has a formal grievance redressal process
All exchanges maintain a dedicated department to handle investor complaints against Trading Members and Issuers
Investors can file complaints against intermediaries through the exchange's grievance cell or through SEBI's SCORES (SEBI Complaints Redress System) portal

Quick Revision – Must-Know Points

SCRA came into force on 20 February 1957
Securities defined under Section 2(h) of SCRA
Minimum net worth for Clearing Members: Rs 3 crore
Minimum liquid asset deposit: Rs 50 lakh
Haircut: Equity = 15%, Debt = 10%
Liquid Net Worth minimum: Rs 50 lakh at all times
Equity Securities: max 50% of Liquid Assets
Cash + Cash Equivalents: min 50% of Liquid Assets
Volatility calculated via EWMA method (J.R. Verma Committee)
Derivative losses can be carried forward for 8 years
Derivatives on recognised exchanges are not speculative — Finance Act 2005
SEBI certification validity: 3 years
Grievance Cells in at least 4 regions of the country

Internal Links

This completes the 7-part NISM Series VIII Equity Derivatives Short Notes series on PassNISM.in. Use the mock tests and practice questions on our platform to test your preparation before the actual exam. Best of luck!