Analysis Of Regulatory Frame Work Of Derivative Markets

Published Date: 02 Nov 2017

ABSTRACT

The term "Derivative" indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, live stock or anything else. In other words, Derivative means a forward, future, option or any other hybrid contract of pre determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities.With Securities Laws (Second Amendment) Act,1999, Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act, as:-A Derivative includes: -a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; a contract which derives its value from the prices, or index of prices, of underlying securities. With the amendment in the definition of ''securities'' under SC(R)A (to include derivative contracts in the definition of securities), derivatives trading takes place under the provisions of the Securities Contracts (Regulation) Act, 1956 and the Securities and Exchange Board of India Act, 1992.

Dr. L.C Gupta Committee constituted by SEBI had laid down the regulatory framework for derivative trading in India. SEBI has also framed suggestive bye-law for Derivative Exchanges/Segments and their Clearing Corporation/House which lays down the provisions for trading and settlement of derivative contracts. The Rules, Bye-laws & Regulations of the Derivative Segment of the Exchanges and their Clearing Corporation/House have to be framed in line with the suggestive Bye-laws. SEBI has also laid the eligibility conditions for Derivative Exchange/Segment and its Clearing Corporation/House. The eligibility conditions have been framed to ensure that Derivative Exchange/Segment & Clearing Corporation/House provide a transparent trading environment, safety & integrity and provide facilities for redressal of investor grievances. This research analysis aims to analyse the effectiveness of regulatory frameworks of derivative markets and recommend suggestions based on the analysis.

Objective of the study:

1.To study the regulatory framework for the financial derivative market.

2. To understand the areas where derivative market can be used.

3 RESEARCH METHODOLOGY

Primary Data-Descriptive research with survey method through questionnaire.: sample size : 100 individuals across the NCR region. Secondary Data:Management Journals (Journal of Finance, Journal of Marketing, Journal of Statistics) Official Website of NSE and SEBI and Print Articles.

INTRODUCTION

Dr. L.C Gupta Committee constituted by SEBI had laid down the regulatory framework for derivative trading in India. SEBI has also framed suggestive bye-law for Derivative Exchanges/Segments and their Clearing Corporation/House which lay's down the provisions for trading and settlement of derivative contracts. The Rules, Bye-laws & Regulations of the Derivative Segment of the Exchanges and their Clearing Corporation/House have to be framed in line with the suggestive Bye-laws. SEBI has also laid the eligibility conditions for Derivative Exchange/Segment and its Clearing Corporation/House. The eligibility conditions have been framed to ensure that Derivative Exchange/Segment & Clearing Corporation/House provide a transparent trading environment, safety & integrity and provide facilities for redressal of investor grievances. Some of the important eligibility conditions are-

* Derivative trading to take place through an on-line screen based Trading System.

*The Derivatives Exchange/Segment shall have on-line surveillance capability to monitor positions, prices, and volumes on a real time basis so as to deter market manipulation.

*The Derivatives Exchange/ Segment should have arrangements for dissemination of information about trades, quantities and quotes on a real time basis through atleast two information vending networks, which are easily accessible to investors across the country.

*The Derivatives Exchange/Segment should have arbitration and investor grievances redressal mechanism operative from all the four areas / regions of the country.

*The Derivatives Exchange/Segment should have satisfactory system of monitoring investor complaints and preventing irregularities in trading.

*The Derivative Segment of the Exchange would have a separate Investor Protection Fund.

*The Clearing Corporation/House shall perform full novation, i.e., the Clearing Corporation/House shall interpose itself between both legs of every trade, becoming the legal counterparty to both or alternatively should provide an unconditional guarantee for settlement of all trades.

*The Clearing Corporation/House shall have the capacity to monitor the overall position of Members across both derivatives market and the underlying securities market for those Members who are participating in both.

*The level of initial margin on Index Futures Contracts shall be related to the risk of loss on the position. The concept of value-at-risk shall be used in calculating required level of initial margins. The initial margins should be large enough to cover the one-day loss that can be encountered on the position on 99% of the days

*The Clearing Corporation/House shall establish facilities for electronic funds transfer (EFT) for swift movement of margin payments.

*In the event of a Member defaulting in meeting its liabilities, the Clearing Corporation/House shall transfer client positions and assets to another solvent Member or close-out all open positions.

*The Clearing Corporation/House should have capabilities to segregate initial margins deposited by Clearing Members for trades on their own account and on account of his client. The Clearing Corporation/House shall hold the clients’ margin money in trust for the client purposes only and should not allow its diversion for any other purpose.

*The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the trades executed on Derivative Exchange / Segment.

*Presently, SEBI has permitted Derivative Trading on the Derivative Segment of BSE and the F&O Segment of NSE.

Comparative View of Market Capitalization & Turnover Ratios

Ratio USA UK CHINA JAPAN India

Market

Capitalisation 358.8 130.7 73.6 66.4 54.5

Turnover 200.8 66.6 158.3 69.9 374.7

(Source: S&P Emerging Markets Fact Book, 2001)

The above figure in fact looks quite impressive. Further, India ha s been placed 23rd in world ranking in terms of market capitalization and 14th in terms of value of trades on stock exchanges by standard.

understand the size of each segment, the turnover in various derivative contracts over the past three years across the segments is given below. As may be seen, the OTC turnover as a percentage of exchange traded securities derivatives turnover has decreased over the years.

Exchange traded securities derivatives turnover (in Rs. crore)

(based on notional value of the products)

Commodities derivatives  Turnover (in Rs. crore)

Estimated turnover in the OTC Markets# (in Rs Crore)

Year

Equity Derivatives

Currency Derivatives

Interest Rate Futures

2009-10

17,663,665

45,397

2,973

77,64,754.05

30,22,101

2010-11

29,248,221

8,406,355

62

11,948,942.35

4,886,816

2011-12

31,349,732

9,897,286

3,959*

18,126,103.78

5,123,763

% increase in 3 years

77.48%

21701.63%

33.17%

133.44%

69.54%

(Sources: arthapedia.in/index.php)

Current Regulatory Framework(RBI GUIDELINES)

In the light of increasing use of structured products and to ensure that customers understand the nature of the risk in these complex instruments, RBI after extensive consultations with market participants issued comprehensive guidelines on derivatives in April 2007, which cover the following aspects:

 Participants have been generically classified into two functional categories, namely, market-makers and users, which would be specific to the position taken by the participant in a transaction. This categorisation was felt important from the perspective of ensuring Suitability & Appropriateness compliance by market makers on users.

ï‚· The guidelines also define the purpose for undertaking derivative transactions by various participants. While Market-makers can undertake derivative transactions to act as counterparties in derivative transactions with users and also amongst themselves, Users can undertake derivative transactions to hedge - specifically reduce or extinguish an existing identified risk on an ongoing basis during the life of the derivative transaction - or for transformation of risk exposure, as specifically permitted by RBI.

ï‚· The guidelines clearly enunciate the broad principles for undertaking derivative transactions :

Any derivative structure is permitted as long as it is a combination of two or more of the generic instruments permitted by RBI and

Market-makers should be in a position to mark to market or demonstrate valuation of these products based on observable market prices.

Further, it is to be ensured that structured products do not contain derivative(s), which is/ are not allowed on a stand alone basis. This will also apply in case the structure contains ‘cash’ instrument(s).

All permitted derivative transactions shall be contracted only at prevailing market rates.

 The guidelines set out the basic principles of a prudent system to control the risks in derivatives activities. It is required that all risks arising from derivatives exposures should be analysed and documented and the management of derivative activities should be integrated into the bank’s overall risk management system using a conceptual framework common to the bank’s other activities.

 The critical importance of ‘suitability’ and ‘appropriateness’ policies within banks for derivative products being offered to customers (users) have been underlined. It is imperative that market-makers offer derivative products in general, and structured products, in particular only to those users who understand the nature of the risks inherent in these transactions and further that products being offered are consistent with users’ internal policies as well as risk appetite.

ANALYSIS AND INTERPRETATION

Objective : Regulatory framework of the derivative market.

Components of the derivative market

Any derivative market is composed of the following factors.

The regulatory framework in India is based upon the working of the L C Gupta committee and JR Verma Committee. The SEBI has given the following guidelines for the regulatory framework of the derivative market:

Derivatives Markets

There are two distinct groups of derivative contracts: as latest RBI guidelines

ï‚· Over-the-counter (OTC) derivatives: Contracts that are traded directly between two eligible parties, with or without the use of an intermediary and without going through an exchange.

 Exchange-traded derivatives: Derivative products that are traded on an exchange. (RBI website)

. REGULATORY FRAMEWORK FOR DERIVATIVES:

. THE GUIDING PRINCIPLES

.Regulatory objectives 

The Committee believes that regulation should be designed to achieve specific, well-defined goals. It is inclined towards positive regulation designed to encourage healthy activity and behaviour. It has been guided by the following objectives :

Investor Protection: Attention needs to be given to the following four aspects:

Fairness and Transparency: The trading rules should ensure that trading is conducted in a fair and transparent manner. Experience in other countries shows that in many cases, derivatives brokers/dealers failed to disclose potential risk to the clients. In this context, sales practices adopted by dealers for derivatives would require specific regulation. In some of the most widely reported mishaps in the derivatives market elsewhere, the underlying reason was inadequate internal control system at the user-firm itself so that overall exposure was not controlled and the use of derivatives was for speculation rather than for risk hedging. These experiences provide useful lessons for us for designing regulations. 

Safeguard for clients' moneys: Moneys and securities deposited by clients with the trading members should not only be kept in a separate clients' account but should also not be attachable for meeting the broker's own debts. It should be ensured that trading by dealers on own account is totally segregated from that for clients.  

Competent and honest service: The eligibility criteria for trading members should be designed to encourage competent and qualified personnel so that investors/clients are served well. This makes it necessary to prescribe qualification for derivatives brokers/dealers and the sales persons appointed by them in terms of a knowledge base. 

Market integrity: The trading system should ensure that the market's integrity is safeguarded by minimising the possibility of defaults. This requires framing appropriate rules about capital adequacy, margins, clearing corporation, etc. 

Quality of markets: The concept of "Quality of Markets" goes well beyond market integrity and aims at enhancing important market qualities, such as cost-efficiency, price-continuity, and price-discovery. This is a much broader objective than market integrity. 

Innovation: While curbing any undesirable tendencies, the regulatory framework should not stifle innovation which is the source of all economic progress, more so because financial derivatives represent a new rapidly developing area, aided by advancements in information technology. 

Of course, the ultimate objective of regulation of financial markets has to be to promote more efficient functioning of markets on the "real" side of the economy, i.e. economic efficiency.  

Leaving aside those who use derivatives for hedging of risk to which they are exposed, the other participants in derivatives trading are attracted by the speculative opportunities which such trading offers due to inherently high leverage. For this reason, the risk involved for derivative traders and speculators is high. This is indicated by some of the widely publicised mishaps in other countries. Hence, the regulatory frame for derivative trading, in all its aspects, has to be much stricter than what exists for cash trading. The scope of regulation should cover derivative exchanges, derivative traders, brokers and sales-persons, derivative contracts or products, derivative trading rules and derivative clearing mechanism. 

In the Committee's view, the regulatory responsibility for derivatives trading will have to be shared between the exchange conducting derivatives trading on the one hand and SEBI on the other. The committee envisages that this sharing of regulatory responsibility is so designed as to maximise regulatory effectiveness and to minimise regulatory costs. 

. Major issues concerning regulatory framework

The Committee's attention had been drawn to several important issues in connection with derivatives trading. The Committee has considered such issues, some of which have a direct bearing on the design of the regulatory framework. They are listed below : 

Should a derivatives exchange be organised as independent and separate from an existing stock exchange? 

What exactly should be the division of regulatory responsibility, including both framing and enforcing the regulations, between SEBI and the derivatives exchange? 

How should we ensure that the derivatives exchange will effectively fulfill its regulatory responsibility.  

What criteria should SEBI adopt for granting permission for derivatives trading to an exchange?  

What conditions should the clearing mechanism for derivatives trading satisfy in view of high leverage involved? 

What new regulations or changes in existing regulations will have to be introduced by SEBI for derivatives trading?

.Should derivatives trading be conducted in a separate exchange? 

A major issue raised before the Committee for its decision was whether regulations should mandate the creation of a separate exchange for derivatives trading, or allow an existing stock exchange to conduct such trading. The Committee has examined various aspects of the problem. It has also reviewed the position prevailing in other countries. Exchange-traded financial derivatives originated in USA and were subsequently introduced in many other countries. Organisational and regulatory arrangements are not the same in all countries. Interestingly, in U.S.A., for reasons of history and regulatory structure, futures trading in financial instruments, including currency, bonds and equities, was started in early 1970s, under the auspices of commodity futures markets rather than under securities exchanges where the underlying bonds and equities were being traded. This may have happened partly because currency futures, which had nothing to do with securities markets, were the first to emerge among financial derivatives in U.S.A. and partly because derivatives were not "securities" under U.S. laws. Cash trading in securities and options on securities were under the Securities and Exchange Commission (SEC) while futures trading was under the Commodities Futures Trading Commission (CFTC). In other countries, the arrangements have varied. 

The Committee examined the relative merits of allowing derivatives trading to be conducted by an existing stock exchange vis-a-vis a separate exchange for derivatives. The arguments for each are summarised below. 

.Arguments for allowing existing stock exchanges to start futures trading: 

The most weighty argument in this regard is the advantage of synergies arising from the pooling of costs of expensive information technology networks and the sharing of expertise required for running a modern exchange. Setting-up a separate derivatives exchange will involve high costs and require more time. 

The recent trend in other countries seems to be towards bringing futures and cash trading under coordinated supervision. The lack of coordination was recognised as an important problem in U.S.A. in the aftermath of the October 1987 market crash. Exchange-level supervisory coordination between futures and cash markets is greatly facilitated if both are parts of the same exchange.  

Arguments for setting-up separate futures exchange: 

The trading rules and entry requirements for futures trading would have to be different from those for cash trading.  

The possibility of collusion among traders for market manipulation seems to be greater if cash and futures trading are conducted in the same exchange. 

A separate exchange will start with a clean slate and would not have to restrict the entry to the existing members only but the entry will be thrown open to all potential eligible players.

"We believe that the OTC derivative markets in India are well regulated. Some of the key regulatory safeguards available in the OTC derivative transactions are:

One of the counter parties to the OTC derivative transactions has to be a RBI regulated entity

Users are permitted to transact in derivatives essentially to hedge an underlying exposure

There are clear prescriptions about the roles and responsibilities of market makers; mostly banks and primary dealers (for interest rate derivatives) are permitted to act as market makers.

The market maker has the responsibility for assessing customer suitability and appropriateness and they are required to fulfill the prescribed set of requirements while selling any product to a user.

The overall framework within which derivative transactions are to be undertaken has to be guided by the Board approved policy. The risk management framework should lay down the procedures to deal with any violation of risk limits.

All derivative products are required to be marked to market if a liquid market in the product exists or otherwise marked to model, provided all the model inputs are observable market variables and full particulars of the model, including the quantitative algorithm are documented."

(Keynote address by Dr. Subir Gokarn, Deputy Governor, Reserve Bank of India at the International Options Market Association, World Federation of Exchanges Annual Conference organised by the National Stock Exchange at Mumbai on May 4, 2011)

Further to the above statement of RBI Dy. Governor it has been added as the roadmap for OTC derivatives in India

A number of initiatives for the further development of OTC derivatives in India have been initiated. Some of the major ones are:

New Products:The product on anvil is the Credit Default Swap (CDS). The draft guidelines on CDS were placed on RBI’s website in February 2011 for public comments.CDS on corporate bonds issued by single legal residential entities have been proposed, with the underlying bonds to be listed ones, but with two exceptions: unlisted but rated bonds of infrastructure companies and unlisted/unrated bonds issued by the SPVs set up by infrastructure companies. The final guidelines are expected soon.

Trade Repository:  CCIL has been acting as the trade repository for IRS transactions since August 2007. There is no such trade repository structure for the FX derivatives at present. There are proposals to introduce repository structure for USD-INR forwards (including swaps) and options.

Central counterparty clearing: CCIL has put in place guaranteed settlement for FX forward transaction effective from the date of contract since December 2009. In case of IRS, CCIL has been providing non-guaranteed settlement since November 2008. It is expected to transit to guaranteed settlement for IRS transactions shortly.

Portfolio Compression   An important innovation in OTC derivative markets introduced during the last few years relates to portfolio compression services. Since the only way to exit a position in an OTC derivative is to enter into another with opposite pay off, the gross notional outstanding multiplies manifold as a result. Huge build-up in gross notional outstanding demands higher capital charges and reduces the available counter-party limits for undertaking other business transactions. Moreover, it does not capture the economic essence of the portfolios. CCIL is the process of developing trade compression services.

Recommendation  

From the purely regulatory angle, a separate exchange for futures trading seems to be a neater arrangement. However, considering the constraints in infrastructure facilities, the existing stock exchanges having cash trading may also be permitted to trade derivatives provided they meet the minimum eligibility conditions as indicated below :

The trading should take place through an online screen-based trading system, which also has a disaster recovery site. The per-half-hour capacity of the computers and the network should be at least 4 to 5 times of the anticipated peak load in any half hour, or of the actual peak load seen in any half-hour during the preceding six months. This shall be reviewed from time to time on the basis of experience. 

The clearing of the derivatives market should be done by an independent clearing corporation, which satisfies the conditions listed in a later chapter of this report. 

The exchange must have an online surveillance capability which monitors positions, prices and volumes in real time so as to deter market manipulation. Price and position limits should be used for improving market quality. 

Information about trades, quantities, and quotes should be disseminated by the exchange in real time over at least two information vending networks which are accessible to investors in the country. 

The Exchange should have at least 50 members to start derivatives trading. 

If derivatives trading is to take place at an existing cash market, it should be done in a separate segment with a separate membership; i.e., all members of the existing cash market would not automatically become members of the derivatives market. 

The derivatives market should have a separate governing council which shall not have representation of trading/clearing members of the derivatives Exchange beyond whatever percentage SEBI may prescribe after reviewing the working of the present governance system of exchanges. 

The Chairman of the Governing Council of the Derivative Division/Exchange shall be a member of the Governing Council. If the Chairman is a Broker/Dealer, then, he shall not carry on any Broking or Dealing Business on any Exchange during his tenure as Chairman. 

The exchange should have arbitration and investor grievances redressal mechanism operative from all the four areas/regions of the country. 

The exchange should have an adequate inspection capability. 

No trading/clearing member should be allowed simultaneously to be on the governing council of both the derivatives market and the cash market.

If already existing, the Exchange should have a satisfactory record of monitoring its members, handling investor complaints and preventing irregularities in trading.

Stringent regulation for quality accounting & auditing information in several instances in the recent past in the US, like, Enron, Worldcom, Global Crossing, Merck etc, put out blatantly false numbers and auditors went along with this charade. Many companies in India also give poor quality audit information. Some authors suggest SEBI should act proactively with the government to have special audits done for the top 100 or 200 companies that account for more than 90%of market capitalization and trading.

The structure and pattern of securities markets in India and around the world is undergoing many changes. The current trading environment is charaterised by frequent regulatory interventions and competitive pressures. Further, the proliferation of the Indian capital market, the market players , the trading pattern and the emerging market for corporate control, brings to the forefront abovementioned issues which need immediate attention. As these issues have implications for the trading strategies employed by investors, the behaviour of specialists, liquidity in the market, the informational efficiency of prices, and ultimately the valuation of listed companies and welfare of their shareholders.