Chapter 9: Regulatory Framework for Financial Derivatives in India (Part 1)

Overview of Derivative Regulations in India

The legal and regulatory framework for financial derivatives trading in India is designed to ensure investor protection, market integrity, liquidity, and systemic stability. Derivatives trading on Indian stock exchanges is primarily governed by two statutes: the Securities Contracts (Regulation) Act, 1956 (SCRA) and the Securities and Exchange Board of India Act, 1992 (SEBI Act), along with rules, regulations, and exchange bye-laws framed under them.

9.1 Securities Contracts (Regulation) Act, 1956 (SCRA)

The Securities Contracts (Regulation) Act, 1956 provides the direct legal foundation for regulating transactions in securities and derivatives markets in India. The Act was originally enacted in 1956 and subsequently amended in 1996, 1999, 2004, 2007, and 2010 to incorporate modern financial instruments and regulatory structures.

Definition of "Securities" under Section 2(h)

Under Section 2(h) of the amended SCRA, the term "securities" explicitly includes the following:

• Shares, scrips, stocks, bonds, debentures, debenture stock, or other marketable securities of a like nature in or of any incorporated company or other body corporate.
• Derivatives.
• Units or any other instrument issued by any collective investment scheme to investors.
• Security receipt as defined under Section 2(zg) of the SARFAESI Act, 2002.
• Units or any other such instrument issued to investors under any mutual fund scheme (excluding unit-linked insurance policies/ULIPs combining life insurance risk and investment).
• Any certificate or instrument issued to an investor by an issuer (special purpose distinct entity) possessing debt or receivables, acknowledging beneficial interest in such debt/receivables.
• Government securities.
• Such other instruments declared by the Central Government to be securities.
• Rights or interests in securities.

Legal Definition of "Derivative"

Under SCRA, a "derivative" is defined to include:

1. A security derived from a debt instrument, share, loan (whether secured or unsecured), risk instrument, contract for differences, or any other form of security.
2. A contract which derives its value from the prices, or index of prices, of underlying securities.

Legality of Derivative Contracts (Section 18A)

Section 18A of the SCRA explicitly affirms that notwithstanding anything contained in any other law, contracts in derivatives shall be legal and valid if such contracts are:

• Traded on a recognized stock exchange.
• Settled on the clearing house/corporation of the recognized stock exchange, in accordance with its rules and bye-laws.

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

The SEBI Act, 1992 established the Securities and Exchange Board of India (SEBI) with statutory powers to perform three primary statutory duties:

1. Protecting the interests of investors in securities.
2. Promoting the development of the securities market.
3. Regulating the securities market.

Regulatory Jurisdiction and Powers of SEBI

SEBI’s regulatory jurisdiction covers corporate issuers, market intermediaries, and all persons associated with the securities market. Its statutory powers include:

• Regulating business operations in stock exchanges and other securities markets.
• Registering and regulating stock brokers, sub-brokers, clearing members, and other intermediaries.
• Promoting and regulating Self-Regulatory Organizations (SROs).
• Prohibiting fraudulent and unfair trade practices relating to securities markets.
• Calling for information, inspecting, conducting inquiries, and performing audits of stock exchanges, mutual funds, intermediaries, and SROs.
• Exercising powers delegated to it by the Central Government under the SCRA, 1956.

9.3 Regulation for Derivatives Trading

The Dr. L. C. Gupta Committee Framework

To establish a regulatory framework for financial derivatives in India, SEBI constituted a 24-member committee chaired by Dr. L. C. Gupta. On May 11, 1998, SEBI accepted the committee’s recommendations and approved the phased introduction of derivatives trading, starting with stock index futures.

Key Governance & Operational Requirements

• Exchange Eligibility: Any exchange fulfilling eligibility criteria can apply to SEBI under Section 4 of SCRA, 1956 for recognition to start derivatives trading. The derivative exchange/segment must have a separate governing council where trading/clearing members cannot exceed 40% of total council members. The exchange must regulate member sales practices and obtain prior SEBI approval before launching any derivative contract.
• Minimum Member Strength: The derivative exchange/segment must have a minimum of 50 members. Existing cash market members do not automatically become derivative segment members; they must separately fulfill eligibility criteria.
• Clearing Corporation Approval: Clearing and settlement must be conducted through a SEBI-approved clearing corporation/house complying with specified standards.
• SEBI Registration: Derivative brokers/dealers and clearing members must obtain explicit registration from SEBI, over and above their existing broker registrations.
• Minimum Net Worth for Clearing Members: Clearing members (CMs) of the derivatives clearing corporation must maintain a minimum net worth of Rs. 300 Lakh.
• Minimum Contract Value: The minimum contract value for derivative instruments shall not be less than Rs. 2 Lakh at the time of introduction.
• Customer Protection & KYC: Strict enforcement of the "Know Your Customer" (KYC) rule is mandatory. Every client must be registered with the broker and must sign the Risk Disclosure Document (RDD) acknowledging derivative risks before trading.
• Certification Requirement: Trading members must employ qualified approved users and sales personnel who have passed a SEBI-approved certification examination (such as NCFM).

Net Worth Calculation Formula for Clearing Members

For regulatory compliance, net worth is computed using the following simple single-line formula:

Net Worth = Capital + Free Reserves - Non-Allowable Assets

Where Non-Allowable Assets consist of:

1. Fixed assets
2. Pledged securities
3. Member's exchange card
4. Non-allowable securities (unlisted securities)
5. Bad deliveries
6. Doubtful debts and advances
7. Prepaid expenses
8. Intangible assets
9. 30% of marketable securities

9.3.1 Forms of Collateral Acceptable at NSCCL

Members and authorized clearing entities must provide collateral deposits to NSCCL, which are segregated into two distinct components:

9.3.2 Membership Requirements for F&O Segment

Entities desirous of operating in the Futures & Options (F&O) segment must obtain membership as specified by NSE and NSCCL.

Eligibility Criteria for Corporate Membership (Table 9.1 Summary)

All monetary values are in Rs. Lakh:

Note on Clearing for Others: A member clearing for other trading members must bring an additional IFSD of Rs. 2 Lakh and CSD of Rs. 8 Lakh per trading member cleared in the F&O segment.

Professional Clearing Membership (PCM) Requirements (Table 9.2 Summary)

Professional Clearing Members (PCMs) do not trade on their own account but clear and settle trades for other trading members, custodians, or institutions:

• Eligible Entities: Trading Members of NSE, SEBI-registered Custodians, or Recognized Banks.
• Net Worth: Minimum Rs. 300 Lakh.
• IFSD with NSCCL: Rs. 25 Lakh base deposit (plus Rs. 2 Lakh per TM cleared in F&O; Rs. 6 Lakh / Rs. 9 Lakh for corporate TMs in CM segment).
• CSD with NSCCL: Rs. 25 Lakh base deposit (plus Rs. 8 Lakh per TM cleared in F&O; Rs. 17.5 Lakh / Rs. 25 Lakh for corporate TMs in CM segment).
• Annual Subscription: Nil for F&O Segment (Rs. 2.5 Lakh for CM Segment).

9.3.3 Requirements for Authorized Persons and Approved Users

Trading members and participants can appoint authorized persons and approved users to operate workstation terminals on the trading system, subject to exchange approval.

• Authorized Persons: Can be individuals, registered partnership firms, or corporate bodies under the Companies Act, 1956. They cannot collect any commission or money directly from clients introduced; they can only receive commission directly from their appointing trading member.
• Approved Users: Must pass a SEBI-approved certification program (e.g., NCFM Derivatives Module). Each approved user is issued a unique identification number and password to access the NEAT trading system.

Key Terms & Concepts

• Section 18A of SCRA: The statutory provision that makes exchange-traded, clearing-house-settled derivatives legal and valid in India.
• Dr. L. C. Gupta Committee: The 24-member committee whose recommendations formed the foundation of India's derivatives regulatory architecture.
• Risk Disclosure Document (RDD): A mandatory document issued to clients explaining the inherent risks of derivatives before trading commences.
• Professional Clearing Member (PCM): A specialized clearing member (such as a custodian or bank) that clears trades for other trading members without engaging in proprietary trading.
• Non-Allowable Assets: Specific asset deductions subtracted from capital and free reserves to determine net worth for capital adequacy compliance.

Key Takeaways

1. Derivatives in India are recognized as "securities" under Section 2(h) of SCRA, 1956, and derive their legality from Section 18A.
2. Derivatives must be traded on a recognized stock exchange and settled through a SEBI-approved clearing corporation to be legally valid.
3. SEBI regulates derivative markets under the SEBI Act, 1992, based on the governance framework recommended by the Dr. L. C. Gupta Committee.
4. Clearing members must maintain a minimum net worth of Rs. 300 Lakh, and the minimum initial contract value for derivatives is Rs. 2 Lakh.
5. Client protection is enforced through mandatory KYC execution, Risk Disclosure Document signing, and mandatory certification for terminal operators.