Derivatives trading in India is regulated by:
- Securities Contracts (Regulation) Act, 1956
- SEBI Act, 1992
- Relevant rules, regulations, and stock exchange bye-laws
Securities Contracts (Regulation) Act, 1956 :
- Objective: The Securities Contracts (Regulation) Act, 1956 aims to prevent undesirable securities transactions and regulate securities trading in India.
- Definition of Securities: Includes shares, bonds, debentures, derivatives, mutual fund units, security receipts, government securities, and other instruments declared by the Central Government.
- Exclusions: Unit-linked insurance policies and similar instruments combining life risk and investment are excluded from the definition.
- Definition of Derivatives: Encompasses securities derived from other financial instruments, contracts based on underlying securities’ prices, commodity derivatives, and others declared by the government.
- Legal Validity: Section 18A deems derivatives contracts valid if traded and settled through recognized stock exchanges as per their rules.
- Learning Objectives:
- Understand definitions of securities and derivatives under the Act.
- Learn about SEBI’s functions.
- Know the regulatory framework for derivatives market.
- Identify membership eligibility for derivatives segments.
Securities and Exchange Board of India Act, 1992 :
- The SEBI Act, 1992 established SEBI with statutory powers.
- Its core objectives are investor protection, securities market development, and regulation.
- SEBI regulates capital issuance, securities transfers, and market intermediaries.
- It can regulate stock/securities markets and register intermediaries.
- SEBI prohibits unfair trade practices and conducts inspections/audits.
- It may perform functions delegated under the Securities Contracts (Regulation) Act, 1956.
Regulations in Trading :
- SEBI adopted the L.C. Gupta Committee recommendations in 1998, initiating phased derivatives trading starting with index futures.
- Derivatives were included under the Securities Contracts Regulation Act (SCRA) after its amendment.
- Exchanges must meet eligibility norms and get SEBI recognition under SCRA Section 4 to trade derivatives.
- Derivatives segment must have a separate governing council with a max 40% representation from trading/clearing members.
- Clearing and settlement must be through SEBI-approved clearing corporations.
- Derivative brokers/dealers need SEBI registration; clearing members must have a minimum net worth of ₹3 crores.
- Minimum contract value is currently between ₹15–20 lakhs (effective Nov 2024).
- Know Your Customer (KYC) norms, risk disclosures, and SEBI-approved certification for salespersons are mandatory.
- Trading members must maintain records for 5 years and are subject to annual inspections.
- A default in derivatives is treated as default across all segments and exchanges for that member.
- Position limits are set by SEBI; once reached, only squaring-off of trades is allowed.
- Brokers can face penalties or suspension for violations, misconduct, or poor financial health under SEBI regulations.
Regulations in Clearing & Settlement and Risk Management :
- Membership in F&O requires also being a member of the Capital Market segment; CM members can apply for F&O membership.
- Trading members can become clearing members by meeting extra criteria; some members are only clearing members.
- Clearing members must pay initial and exposure margins upfront using cash, bank guarantees, FDRs, or approved securities.
- Clearing members may set collateral limits for each trading member or custodial participant daily.
- Margin non-fulfillment results in penalties and potential disciplinary actions by the Clearing Corporation.
- Clearing members must maintain liquid assets—at least 50% in cash—for margin and net-worth requirements.
- The Clearing Corporation handles margin collection, settlement, position monitoring, and acts as legal counterparty.
- It can transfer client positions if a broker defaults and must ensure client margins aren’t used for broker dues.
- Exchanges must report VAR breaches, broker defaults, and daily market activities to SEBI.
- The Trade Guarantee Fund ensures transaction settlement, builds confidence, and protects investors; all active members contribute to it.
Eligibility criteria for membership on derivatives segment :
- Net Worth Requirements:
- Clearing members must have a net worth of Rs. 3 crores, with a bi-annual auditor’s certificate.
- Self-clearing members require a net worth of Rs. 1 crore.
- No specified net worth requirement for trading members.
- Liquid Net Worth:
- Clearing members (both clearing and self-clearing) must maintain at least Rs. 50 lakhs as Liquid Net Worth with the exchange/clearing corporation.
- Certification Requirements:
- Members must pass SEBI-approved certification programs.
- Trading members must appoint at least two approved users who have passed the certification to operate the derivatives trading terminal.
Standard Operating Procedure in the case of default by TM or CM :
- SEBI has outlined actions for stock exchanges, clearing corporations, and depositories in case of a possible default by a Trading Member (TM) or Clearing Member (CM).
- On warning signals of default, these entities must follow the Standard Operating Procedure (SOP) to protect non-defaulting clients of the TM.
- The TM’s Clearing Member must also take the necessary actions as per the SOP.
- As an interim measure, stock exchanges and clearing corporations must settle the credit balances of small investors (less than Rs. 25 lakh) using unencumbered deposits.
- Investors with credit balances above Rs. 25 lakh will be paid on a pro-rata basis from remaining funds.
Standard Operating Procedure (SOP) for handling stock exchange outage:
- Stock Exchange Outage Procedure: SEBI has defined a Standard Operating Procedure (SOP) for stock exchange outages.
- Immediate Notification: The affected exchange must inform SEBI immediately via email when an outage occurs.
- Informing Market Participants: The exchange must inform market participants and other MIIs within 15 minutes of the outage through broadcast messages and on its website.
- Trading in Unaffected Segments: If certain segments are affected, trading can continue in other unaffected segments.
- Alternative Exchanges: Trading can also continue on other unaffected stock exchanges.
- Restoration Efforts: The exchange should work to restore normal operations quickly, including using a Disaster Recovery Site.
- Pre-Resumption Notification: The exchange must notify participants at least 15 minutes before resuming trading.
- Extension of Trading Hours:
- If trading does not resume 1 hour before the scheduled closure, exchanges should extend trading by 1.5 hours.
- If an outage occurs in the last hour of normal operations (within 15 minutes of closure), trading hours should be extended by 1.5 hours for the day.