NISM Series IV Interest Rate Derivatives: Chapter VII Regulations and Compliance Study Notes

Chapter VII: Regulations and Compliance

1. Regulatory Architecture and Joint Oversight

The statutory regulation of interest rate derivatives in India operates under a joint regulatory framework shared between two primary market authorities:

1. The Reserve Bank of India (RBI): Regulates everything related to the underlying Government Securities (G-Secs) and money markets, both in the primary and secondary market channels. It also regulates investment in debt securities by foreign institutional investors.
2. The Securities and Exchange Board of India (SEBI): Regulates exchange-traded contracts and specifies rules for market intermediaries, trading, and clearing structures.

Jointly Approved Parameters

To prevent regulatory overlap and ensure market safety, key parameters of exchange-traded interest rate futures (IRF) contracts are jointly defined by the RBI and SEBI:

• Product Features: Structure, maturity, and underlying rates.
• Deliverable Bonds: Eligible basket of securities allowed for physical delivery.
• Settlement Method: Guidelines on cash versus physical settlement.

Within these statutory boundaries, the individual Exchanges and Clearing Corporations define the specific micro-level operational rules, trading procedures, and risk management parameters under their own bye-laws.

2. Statutory Jurisdictions and Legislative Mapping

The legal authority and scope for interest rate derivatives transactions are derived from distinct parliamentary acts and statutory bodies in India:

3. Detailed Role of the Reserve Bank of India (RBI)

A. Primary & Secondary Debt Market Oversight

The RBI is the issue manager and regulator for the Central and State Government borrowing programmes. Because interest rate futures are derived from underlying treasury instruments (like 91-day T-bills or 10-year G-Secs), the RBI retains direct jurisdiction over these foundational cash assets.

B. CSGL Accounts and Gilt Custody

To trade and deliver physical government securities under the Government Securities Act, 2006, specific accounts are required:

• Constituent Subsidiary General Ledger (CSGL) Account: Opened with the Public Debt Office (PDO) of the RBI by specific eligible institutional entities (such as commercial banks, clearing houses, and primary dealers) on behalf of their constituents.
• Gilt Account: Maintained by clients/constituents with their CSGL account holder to hold government securities electronically.
• Delivery Settlement: SGL and CSGL accounts are the mandatory routing channels for executing physical delivery in government bond futures.

C. Entry Restrictions and Naked Shorting

The RBI enforces strict entry rules on the financial institutions under its supervision to maintain systemic balance sheet safety:

• Prior Approval: All RBI-supervised financial entities (banks, primary dealers, etc.) must obtain prior permission from the RBI before trading or executing interest rate futures.
• Naked Short-Selling: A naked short-sale (selling futures without holding the underlying cash asset or an offsetting hedge) is strictly prohibited for general market participants. It is allowed only for banks and primary dealers.

4. Detailed Role of the Securities and Exchange Board of India (SEBI)

SEBI translates the joint regulatory guidelines into actionable market rules for stock exchanges.

A. Segment Integration

To simplify membership and keep market access cost-effective, SEBI does not run a separate, isolated segment for interest rate derivatives.

• Automatic Integration: Membership in the Currency Derivatives Segment of Futures & Options automatically enables trading in exchange-traded interest rate futures.
• Operational Modes: Members can execute trades for their proprietary accounts ("pro") or on behalf of clients ("cli").

B. Minimum Net Worth Criteria

SEBI mandates strict minimum financial net worth parameters for segment members to ensure clearing safety. These net worth figures must be certified based on the latest audited balance sheet:

• Trading Member (TM):
  • Operational Scope: Executes trades on the exchange platform on behalf of clients or self, but cannot clear or settle trades independently.
  • Minimum Net Worth: Rs. 1 Crore.
  • Settlement Path: Must clear trades through a Professional Clearing Member (PCM) or Trading-cum-Clearing Member (TCM).
• Clearing Member (CM):
  • Operational Scope: Authorized to clear and settle transactions for self and other trading members. Includes TCMs, PCMs, and SCMs.
  • Minimum Net Worth: Rs. 10 Crores.

C. Market Surveillance and Risk Auditing

• Back-Testing: Stock exchanges and clearing houses must perform systematic, empirical back-testing to evaluate the defensive effectiveness of their margining models (such as SPAN and VaR parameters).
• Audit Frequency: Back-testing must be conducted at least twice a year.
• Regulatory Compliance: Results of these margin audits must be officially submitted and communicated to SEBI.

5. Investor-Specific Rules and Participation Restrictions

A. Resident Investors (Under FEMA, 1999)

• Status: Individual or corporate residents defined under the Foreign Exchange Management Act, 1999.
• Trading Rights: Allowed to freely buy or sell exchange-traded interest rate futures.
• Permitted Intent: Residents are authorized to utilize these contracts for both hedging and speculation.

B. Supervised Financial Corporations (Non-RBI)

• Entities: Mutual Funds, Insurance Companies, Housing Finance Companies, and Non-Banking Financial Companies (NBFCs) supervised by separate state regulators (e.g., SEBI, IRDAI).
• Permission Mandate: These entities must obtain prior permission from their respective concerned regulator before participating in interest rate futures.

C. Foreign Institutional Investors (FIIs)

FIIs registered with SEBI face tight regulatory limits designed to prevent speculative volatility in the sovereign debt markets:

1. Purchase / Long Positions: The total combined position of an FII in cash debt assets and interest rate futures must not exceed the investment limit specified for FII investment in government securities.
2. Sold / Short Positions:
   • Speculative shorting is strictly prohibited for FIIs.
   • FII short positions can only be maintained as hedges.
   • Gross Short Cap: The gross short position of an FII in interest rate futures must never exceed their total cumulative long position in government securities held in cash and interest rate futures.

D. Position Limits

• Definition: A position limit is a regulatory restriction designed to prevent any single market participant from cornering the market by restricting their share in the total open interest (OI).
• Structure: SEBI limits are monitored and set as a percentage of the gross open positions across all contracts traded.

6. Role of FIMMDA in Indian Derivatives Markets

The Fixed Income Money Market and Derivatives Association of India (FIMMDA) is a voluntary self-regulatory organization (SRO) composed of commercial banks, primary dealers, insurance firms, and financial institutions.

A. Strategic Objectives

• Maintains standard ethical codes, healthy business practices, and standard principles to be followed by members in debt and derivatives transactions.

B. Operational Role in Derivatives Risk Management

FIMMDA provides the underlying data inputs necessary for daily exchange valuation and margin calculations:

1. Bond Yield Curves: FIMMDA publishes the daily sovereign bond yield curve. Clearing Corporations use this yield curve to calculate and update SPAN margining risk parameters.
2. Daily Market Valuations: FIMMDA publishes market prices for various bonds. These are used in calculating theoretical futures prices to determine the Base Price and Daily Settlement Price (DSP) of futures contracts.
3. Reference Settler: In actual cash-settled bond futures, if fewer than five trades are executed in the cash NDS-OM market during the final settlement window, the Final Settlement Price (FSP) is officially determined based on valuation prices published by FIMMDA.

7. Regulatory Reporting, Disclosures, and Accounting

A. Monthly RBI Compliance Reporting

Commercial banks and All-India Financial Institutions must submit detailed futures reports to the RBI at monthly intervals. These reports must cover:

• Outstanding futures positions and their percentage share in the market's total open interest.
• Monthly activity volume, specifically:
  • Opening Notional Balance: Initial position size.
  • Notional Traded: Transaction volume executed.
  • Notional Reversed: Offsetting trades executed to square off positions.
  • Notional Outstanding: Ending net open positions.
• Hedge effectiveness analysis, specifically categorized into:
  • Granular analysis of "effective" hedges.
  • Granular analysis of "NOT effective" hedges (speculative or non-matching positions).

B. Balance Sheet Disclosures (Notes on Accounts)

All regulated corporations must disclose the following quantitative and qualitative details instrument-wise in the Notes on Accounts of their annual balance sheets:

• Notional amount of futures traded during the year.
• Notional amount of futures outstanding on the balance sheet date.
• Notional amount of futures outstanding and not effective for hedge.
• Mark-to-Market (MTM) value of futures outstanding and not effective for hedge.

C. Accounting and Valuation (ICAI AS 30)

• Accounting standard AS 30, framed by the Institute of Chartered Accountants of India (ICAI), specifies the accounting, recognition, presentation, and disclosure rules for all derivative contracts.
• This standard dictates that corporate entities must mark derivatives to fair value, separate hedging transactions from speculative positions, and record MTM value adjustments in the appropriate accounts.

8. Quick-Revision Summary Table