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Introduction

Stock market plays a significant role in an economy's growth and

development. Stock markets, also called as secondary markets,refer to those markets where existing issued securities like

shares, debentures, mutual funds, and other government

securities are traded. The stock markets mostly deal in stock or

equity shares but now other securities like bonds, gilt-edged and

debts are also becoming popular. Thus, (lie stock markets enable

the investors to sell their stock holdings readily and thereby

ensuring liquidity. Further, they can also continuously rearrange

their stocks if they so desire. In this way, they can update theirstock holdings in the light of changes in the market. The functions

of the stock markets are facilitated at the stock exchanges. In

brief, stock exchanges provide a market where stock trading are

performed.

At present, in India, there are 23 stock exchanges which are

operating, however, their organizations vary, e.g. 15 are public

limited companies, 5 are limited by guarantees and 3 are

voluntary non-profit making organizations. Presently, 8 exchanges

have been granted permanent recognition whereas rest others

have to renew their recognition every year. The Securities and

Exchange Board of India Act, 1992 provides for the establishment

of Securities and Exchange Board of India (SEBI) whose main

functions are to protect the interest of the investors and to

promote, develop and regulate the securities market Though each

exchange has its own bye laws and regulations for regulation and

control stock trading activities, but the SEBI has also framedcertain guidelines in this respect.

The Indian capital markets have metamorphosis over the last few

years. A sea changes in the stock markets have seen

dematerialized stocks, faster settlements, increased

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transparency, reduced fraud and competitive costs. The

introduction of derivatives in the market required the existence of

a clean, efficient and paperless cash market, which was delivered

just in time. Introduction of exchange traded derivatives in June,

2000 was proceeded by parleys for over 5 years, involving a lot of serious deliberations for introducing the best practices from

around the world. Before discussing the forward trading in Indian

stock market, a brief view of functioning of stock exchanges in

India is discussed in this section.

Structure of the Market

The stock market in India has developed more over the last few years than it has

over its history of over hundred years. The introduction of screen based trading in

1995 by the then newly developed National Stock Exchange of India (NSE) was

responsible for a similar development by other stock exchanges in the country. The

capital market is essentially comprised the Bombay Stock Exchange (BSE, perhaps

the oldest stock exchange in Asia) and the National Stock Exchange. Together they

account for over 90 percent of the trades in the secondary markets. Development of

a screen based trading system brought far reaching access and speed, but the

market infrastructure still was poorly developed and a typical clearing and

settlement cycle took over 14 days. For registering a share after a transaction,

postal delays, the mercy of the share registrars, thefts while in postal service andmismatched transfer or signatures were some of the systemic risks a buyer of an

Indian stock had to face. Over the last few years more and more stocks have been

put on the compulsorily dematerialized list (over 99 percent of all shares traded

today are in a paperless form). If someone does have a particular fetish for a

physical stock certificate, he/she would still need to buy a dematerialized stock and

then have it sent for conversion into physical mode, since trading in physical stocks

is prohibited while holding is not.

Competition amongst the two largest exchanges has brought enormous benefits to

shareholders in terms of providing better and more cost effective services. As if that

were not enough, a competing depository (established by the BSE) has brought

down prices in that industry by over 80 percent. The market for exchange traded

derivatives started in June of 2000 when the two stock exchanges almost

simultaneously started trading in futures on indices. The exchanges created

separate segments where derivatives trading would take place. These segments

would have a separate set of regulations and a separate clearing and settlement

mechanism. The guarantee fund is also separate from the stock market (also called

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the cash segment). The last few months have seen a movement in the cash

segment to a T+ 5 settlement and beginning 1 April, 2002 the exchanges have

moved to a T+ 3 settlement, with daily) net settlement (i.e., a buy and a sell order

of the same person made on a day shall be set off). Reduction of fraud, easing of

costs, easing of complications and a virtual elimination of mistakes in clearing and

settlement of securities have made the Indian capital markets amongst the best interms of efficiency technology and costs. Unfortunately, with the recent downturn in

the economy, liquidity has dried up and exchanges are facing larger volatility in

stocks. The markets in derivatives, though they took off with I tepid start, have seen

double digit growth almost every month over the last year. The exchanges are

clamoring for a smaller contract size and, therefore, access to more investors. With

growing evidence that small investors benefit greatly from investing in stock futures

rather than from investing in mutual funds, the case of protecting smaller investors

by keeping them away from the derivatives market might not sound very noble in

the future.

Securities' Listing and Groupings

The stock exchanges provide an organized market place for the

investors to buy and sell securities freely. Only such securities are

traded on stock exchanges which are 'listed* or 'quoted' on them.

So, each stock exchange has its own listing requirements and

rules which are to be adhered by a company which intends HB for

trading on that exchange. For example, any company whichwants to be traded on Bombay Stock Exchange (BSE), then it has

to abide by all the rules of BSE for listing purposes.

The listed securities on an stock exchange are classified into

various groups. Till recently, they were 'cleared' or 'specified* or

'group A* securities, and other one as 'non-cleared* or

'unspecified' *cash securities*. The Governing Board of the

Exchange frames the guidelines for inclusion of a security into

group A' category. However, recently the BSE has changed the

above mentioned classification and adopted a new one which is

as under:

• Group 'A' or 'Specified' securities have weekly settlement

and carry forward is allowed in their case.

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• The non-specified group has been split into group B, and

group B? Securities.

• Group 'B,' has weekly settlement and is at par with group 'A'

in every respect, but carry forward is not allowed in its case.It includes actively traded securities.

• Group B2 securities are subject to settlement procedure

which earlier existed in case of 'group B' securities.

• Group 'C' relates to odd lots securities.

• Recently, from 1996, the BSE has also included another

group called 'group F' for trading all the debentures listed on

it.

• The BSE has also introduced 'Z' category of scrips for

companies not employing with listing requirements and not

entertaining the investors' complaints.

Trading Systems

Most of the exchanges carry out stock trading transactions on either 'cash basis' or

'carry over' basis, though their own clearing houses. Let us discuss herein brief the

system of trading in general which is anally followed on the stock exchanges.

The trading business in 'Group A' securities is settled through clearing houses in

addition to other methods of settlements. The year of a stock exchange is divided

periods called 'Accounts' which normally runs into a fortnight; but sometimes, it

may be of a longer durations of three to four weeks. Thus, all the transactions

performed during that period (one account period) are settled by payment and

delivery of securities by the traders on the 'notified days' of the clearing programme

of a given stock exchange.

Non-specified securities transactions are settled compulsorily by delivery and

payment, no further carry-over of the transaction. It is allowed only in Group 4 A'

securities. In this category* the investor has three options at the end of settlement

period which are as under:

1. He can terminate the contract by sale or purchase by a cross contract, i.e., by

squaring up transaction. For example, if he has an outstanding contract of sale then

he can make purchase of the same security and same quantity.

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2 He can fulfill the contract by delivery or payment as the case may be. For

purchase of securities, he will make the payment and for the sale he will hand over

the delivery of securities to the broker.

3. He can carry over the contract to the next settlement. In other words, if an

investor has purchased some shares but has no money to pay for delivery then hecan request to his broker to cany forward his business transaction to the next

settlement account. In such situation, the broker of the investor would then find out

someone who would pay on due date, (also called as pay-in day) on the behalf of

the investor and would take delivery of the shares. The financer who finances in

such carry forward transaction will charge interest on such funds, this is also known

as 'cantango' or badla, for the fortnight till the next pay-in-day. Similarly, on the

other side, the seller, sometimes, may also have to pay the 'charge' to the buyer

when the shares are over sold and the buyer demands the delivery of the shares,

this is known as 'backwardation charges' or 'andha badla'. The badla system or

charges play a significant role in forward trading. This system has to be operated

with the approval of the concerned stock exchange which may even fix badlacharges H under exceptional circumstances.

Badla System in Indian Stock Market

In India, badla system was allowed for speculation in shares

without paying up the full cost of the transaction. The term 'badla'

refers to that system whereby the buyer or seller of shares may

be allowed to postpone payment of money, or delivery of the

shares, as the case may be, in return for paying or receiving a

certain amount of money. It is oftenly also known as carry forward

trading. Badla can be classified into two types namely 'Badla' (orCantango) and 'Ulta' or Undha badla (or backwardation). The

following example will explain the system of badla trading:

Example of' Badla On March 3, X buys a State Bank of India (SBI)

share for Rs 300 and he is required to pay Rs 30,000 for 100

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shares on the settlement day, i.e., 16 March to take the delivery.

Assuming that the price of the share is still Rs 300 on that day,

instead of paying of Rs 30,000, he informs his broker that he

would like to carry forward the transaction to the next settlement

period ending on 30 March. Then the broker locates the otherparty (seller) who is also willing to carry forward the transaction,

i.e., who does not insist the payment of the shares amount on 16

March. In return for agreeing to postpone the receipt of money

from 16 March to 30 March, the seller imposes a charge on the

buyer, which is popularly known as 'Badla'. It means it is a charge

in form of interest for the postponement of the payment for the

period from one settlement to the next settlement. Assuming the

price of SBI share Rs 300 and a badla rate 4 percent per month,X, therefore, will pay to the seller Rs 6 (4x 300/2 x 100) per share,

being the badla charge for 15 days (half a month).

If the market price of the SBI share changes on 16 March for

example, if it is Rs 315 then the seller is to adjust and settle this

transaction as follows: X has to pay badla charges @4 percent per

month for a period of 1 5 days, i.e., 6.30 (4x315/2x 100) per share

being total Rs 630 (100X 6.30). Separately, the seller has to pay

to X the appreciation in the share price, i.e., Rs 15. The net

amount of Rs 8.70 (1-6.30) per share will be paid by the seller,

being total Rs 870 to the buyer. In this way, X is allowed to

postpone (i.e., carry forward) payment till the next settlement

date. Similarly, if the share price has decreased, then the buyer

has to pay badla charges, i.e., Rs 5.80 (290 x 4/2 x 100) and Rs

10 (Difference of Rs 300 - 290), being Rs 15.80 per share,

totalling Rs 1580 in order to carry forward.

Ulta or Undha Badla: Sometimes; there are certain cases

where the sellers of the shares may ask for postponing the

delivery of the shares which may occur due to various reasons,

e.g. number of carry forward sellers as a whole significantly

exceeds the number of buyers on carry forward basis. In such (he

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brokers would face a situation of lack of floating shares and will

persuade to some buyers to postpone the settlement to the next

one. Alternatively, they would find scrip lender who lend shares,

pi charges paid by the seller in such case to the buyer is known as

'ulta' or 'undha badla* or 'backwardation* charges.

Example: Continuing the earlier stated example, let us assume

that the party Y is the seller who is the price of the SBI share to

fall below Rs 300 per share by the settlement date. Assume that

the price remains unchanged on settlement date, i.e., March 16.

However, Y feels that it will fall later, and carry forward the

transaction to the next settlement date. In such situation,sometimes, the sellers has to pay charges to the buyer for such

postponement, which is known as undha badla or Backwardation

Charges .

Bala vs Forward trading

Similarities

• Both permit/initiate speculation without paying the full amount on the

market price of share.

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• Both enhance the liquidity of the stock market

Differences

• The price for future delivery is defined in advance in the forward

trading whereas in 'badla* it is known only at the time of finalsettlement Badla charges change from time to time.

• Forward trade is for a specified period, defined in advance in the

forward trading whereas in 'badla* the period of transaction is

undefined as the transaction can be carry forward indefinitely from

settlement to settlement

• In forward trading, there is invariably a deposit or margin payment

usually ranging from 5 to 15 percent of the transaction value whereas

in old badla system, no margin was required, and hence, which led tohigh speculation.

It may be concluded that badla has an indeterminate price. So there is no

relationship between spot price and future price and the future price is

uncertain. It means the badla trading cannot be used for hedging and price

stabling purposes.

In brief, the settlement system in vogue for trading in specified shares is

called the badla system. It has the facility for carry forward the transactions

from one settlement to another. The facility of carry forward extends liquidityand breadth of the stock market. Badla system has three components:

I. Transfer of market position

II. Stock Lending

III. Borrowing and lending in money market

In general, a customer has to sign a stock loan consent from which allows

the broker to lend the clients' securities to others for short sales. Short

sellers provide liquidity to genuine investors. Further, badla operators alsoprovide finance to the members who need to meet their commitment in the

current settlement and transfer their position to the later settlement.

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Ban on Badla System

The carry forward system (CPS) or badla system remained a

controversial matter, specifically on Bombay Stock Exchange

(BSE), and it had a chequered history, for example, it was banned

between June 1969io June 1972 Further it was officially banned

but continued to exist in practice from 1972-1982. It was

permitted to function during August 1982 to December 13,1993.

However, in October, 1987, there was some checks put on this

system like laying down the 'bands' within which the shares prices

could fluctuate and limits on sales and purchases of the stocks.

However, all the measures could not control the excessive

speculation in the market. Consequently, on December 13,1993,

the Securities and Exchange Board of India (SEBI) issued on order

abolishing 'badla system'—a Directive not to permit any further

carry-over in 'specified shares' and to reduce to zero the

outstanding carry-over position in two settlements issued to the

Bombay, Calcutta, Delhi and Ahemadabad Stock Exchanges.

However, this order later on extended by four more settlements. Thus, it came to a halt on March 12,1994.

SEBI Prudential Conditions and Precautions

on RCFS(1995)

Consequent to the Patel Committee report and recommendation on the carry

forward system, the SEBI introduced a revised carry forward system subject

to the following prudential conditions and precautions:

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• Stock exchange would be allowed to introduce carry forward system

only with the prior permission of SEBI. For this screen based trading

and systems capability for effective monitoring and surveillance would

be essential pie-requisite. There must be full transparency.

• The Executive Director would be responsible for transparency,monitoring, surveillance and reporting. The exchanges would also

ensure for prompt and regular submission of information about the

various parameters and their implementation.

• The transaction can be carried forward for a maximum period of 90

days, and would be allowed to square off up to the 5th settlement

(75th day). The transactions remained unsettled until that day, they

will have to be settled by deliver)' or payment, as the case may be.

• The stock exchange should record and report at the end of tradingperiod, transactions into those for delivery, jobbing, carry forward and

own account separately. This is known as four track trading. However,

the SEBI implemented as a thin trade system in which transaction for

delivery were separated from those for carry forward.

• A daily margin at the flat rate of 15 percent will be recorded from the

brokers for carry forward deals and on a marked-to-market basis every

week. Margin will depend upon the volatility of share prices.

• The stock exchanges would be introducing the capital adequacy normof 3 percent for individual brokers and 6 percent for corporate to begin

with. Brokers are allowed self certification, in place of audit, regarding

their deals carried forward.

• The financiers funding the carry forward transactions should not be

permitted under buy circum-stances to square up their positions till the

repayment of the loan.

• Every member would be required to keep books of record showing the

source of the finance with sub-accounts being maintained in theclearing house.

• There should be over all limits on carry forward transactions of a

broker with separate sub-limits for purchases and sales and a limit on

the transactions in any one share.

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• Vandhas (or objection memos) would be rectified immediately and the

Kapli system and Chaluupla transactions will not be permitted.

Since the market operators and speculators made a lot of resentment over

the implementation of the RCFS, ultimately the SEBI set up another

committee J.R. Committee in March, 1997 to review this revised system. TheCommittee submitted its report in July, 1997 and its main recommendations

(popularly known as the Modified Carry Forward System or MCFS), are as

follows:

Recommendations of J.R. Verma committee (1997)

• Abolition of the twin-track- track system of segregating carry forward

and delivery transaction.

• A uniform margin of 10 percent on gross basis (position), instead of 15

percent as earlier on forward trade and 7.5 percent on delivery trade,

with daily marking-to-market prices on both the transactions.

• Elimination of the limit of 90 days for carry forward transactions.

• Elimination of settlement only by delivery after 75 days.

• Removal of the limit of Rs 10 crores on the financing funding or on

badla financing.

• Scrapping the overall limit on carry forward of transaction of Rs 5

crores.

• The new system should be introduced only when an exchange has the

necessary software for calculating margins on a daily basis.

• Capital adequacy and other prudential safeguards should be strictly

enforced.

• The scrips chosen for carry forward trade should have sufficient

floating stock.

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• The financiers should be allowed to take custody of the shares with

safeguards in case of vyaj badla. The shares lent by badla financiers

will continue to be deposited with the clearing house.

• The exchanges should strengthen the regulatory and surveillance

system to enforce the rules on the carry forward trading.

Hopefully, the above recommendations should lead to a strong and vibrant

forward trading, generating liquidity, reducing volatility and providing

medium for hedging.

Undoubtedly the carry forward trading can be misused, particularly in the

context of computerized trading where huge positions build up quickly and

easily. So both the committees (Varma and Patel) t misted the exchanges

should be given adequate powers to regulate the market. In brief, these

powers relate to suspending carry forward facility, fixing different rates of making up prices, imposition of price corrective measures, prohibiting short

sales and long purchases, imposing limits on forward trading, suspending off

the floor trades, fixing minimum and maximum prices, etc. SEBI has

accepted most of the recommendations but has stipulated that screen based

on line trading has to be provided by the exchange for opting the modified

carry forward system.

Further to enhance liquidity and to shorten the carry forward cycle, the SEBI

has introduced compulsory rolling settlement on a T+ 5 basis for 119 scrips

from May 8,2000 and which are subject to compulsory dematerializedtrading. The SEBI has also instructed to the stock exchanges to complete

their settlement within seven days and to conduct the auction immediately

after the completion of relevant trading period in those cases where the

members have failed to give the delivery.

It is observed that the above said norms have created a positive impact on

carry forward trading as well as functioning of the stock exchanges in the

country. The stock exchanges have enforced the disclosures andtransparency norms on the listed companies. The surveillance systems have

improved and their boards are now broadbased. The trading cycle is made

uniformly for seven days, and there are almost 8000 electronic trading

terminals all over the country. Further, now the stock exchanges have set up

trade guarantee funds to ensure smooth trading and reduce counter-party

risk.

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Derivatives Regulations in Indian Stock Market

June, 2000 saw the introduction of financial derivatives in the country for the first

time—even though carry forward of positions and weekly settlement had meantthat a quasi-forward market existed for over a century. The first trade in derivatives

was a culmination of legislative and legal efforts which had begun as early as 1995.

In 1995, SEBI appointed a committee for exploring issues in introduction and

creating a regulatory framework for a derivative market.

After the committee report was tabled, the first action taken was to wet nurse the

derivatives market adopting the entire regulatory framework of securities. This was

done simply by defining securities to include derivatives and removing certain

prohibitions on forward and options trading. Thus, the entire framework of existing

securities regulations including anti-fraud and various disclosure obligations have

become part of the regulations of derivatives in India. This is in sharp contrast tothe introduction of futures on individual stocks in US. Their introduction took 20

years, endless bickering between the two regulators Securities Exchange

Commission (SEC) and Commodity Futures Trading Commission (CFTC), anew Act

which lays down several requirements for trading which should rightfully be in the

bye-laws of the exchange/board of trade. By that standard, India managed to

leapfrog as far as not just technology but also regulations. The introduction of new

products has seen more of changes in the micro regulations like margining and

default which are discussed subsequently.

The participants and their role in the structure of the

exchange

A graphic presentation of an overview of regulatory framework of financial

derivatives in India is shown in brief in Fig. below. The Indian trading system, as

presented in Fig. below, comprises the exchange at the top—which is governed by

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the three governing bodies: Governing Council, Governing Board and Clearing

Council. It is further assisted by Clearing House, Clearing Bank, Clearing Member,

Trading Member.

The clearing house of the Bombay Stock Exchange (BSE) is a part of the exchange

currently though it may, in the future, be spun off into an independent company.

The clearing banks are banks that have agreed to clear the trades through theirbranches and transfer payments efficiently and often automata ate* order

execution. The banks work under the terms of an agreement signed with the

clearing house of exchange for terms of automatic withdrawal and payment of

funds into the accounts of the members, who must have accounts with the

designated clearing banks.

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The clearing member is a member of the derivatives segment who is directly

responsible for all trades entered by trading members clearing with it. On the other

hand, trading members are responsible for being in touch with clients and placing

the trade orders through the terminals provided them. A trading member must be

clear through a clearing member. A clearing member may refuse or restrict the

trading rights of any or all its trading members clearing under it (even if legitimateunder existing rules) because a clearing member is responsible for any default of

trading members clearing under his/her tutelage. A clearing member can also be a

trading member, however, no separate membership category exists for such

persons because such persons must comply with the rights and obligations of both

independently.

Products available

The first derivative product introduced in India was Index Futures. Subsequently,

options on index, futures on single stock and option on single stocks were

introduced. 87 stocks have been permitted for individual futures/option tradingbased on fairly stringent measures of the particular exchange. Till now, all products

are cash settled, however, securities settled products are intended to be inducted

into the market soon to provide better arbitrage opportunities to market players. In

the future, the markets might even play the games at the Over-the-Counter (OTC)

derivatives markets—which usually handle currency, interest rates and other

products. Currently, the financial derivatives are regulated almost exclusively by

SEBI. If currency and interest rates are introduced, the regulatory bodies may have

some overlap as to regulations.

The regulatory framework and the existing infrastructure of the markets were

suitably modified and most issues around the cash segment were resolved by thetime the derivatives contracts were introduced. Further improvements, in the

settlement of the cash segment have seen a correlated increased confidence in the

markets, resulting into better volumes and reduced arbitrage opportunity. What has

worked most in favour of the derivatives market, however, is the checks and

balances, the systematic strength of the structure of the markets and the

regulations which have translated into volumes.

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Market regulations

The primary laws in relation to derivatives are not legislative. They are created by

the respected stock exchanges .In fact, the only legislative acts passed are those

that define derivatives and remove earlier bans on options and forward trading. The

Bombay Stock Exchange and the National Stock Exchange, both these two

exchanges authorized by the regulator to start trading have passed extensive

regulations for the organized trading of derivatives. Thus, the regulations at the

exchange level are discussed in substantial detail. Before that we will briefly

introduce the statutory background of the markets.

The relevant acts and statutory provisions are contained in the Securities Contract(Regulations) Act. 1957, Securities and Exchange Board of India, 1992 (SEBI Act)

and various rules and regulations pitted under them. SEBI has passed guidelines

from time to time regulating the role of market intermediaries and Self Regulating

Organizations (SROs). Guidelines under the SEBI Act do not pass through the muster

of Parliament. In fact, some people have challenged the validity of these guidelines

—unsuccessfully

These regulations in fact provide the regulatory framework for securities regulations

by the Indian regulator (SEBI). Though the guidelines of SEBI do not pass the muster

of Parliament, the rules and bye- taw* of a stock exchange are in fact tabled in the

Indian Parliament. In fact the rules and regulations of the USE have been held to

bypass certain statutory provisions like insolvency laws and the arbitration Mute in

limited parts because to do otherwise would be to affect the risk profile of the

market.

The extant regulations which regulate securities automatically apply to derivatives

because of the definitional change in the term securities. Thus, for instance,

Securities and Exchange Board of India (Stock Brokers and Sub-brokers)

Regulations, 1992 would automatically apply to all trading members of 0te

derivatives segment.

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Eligibility for entering in derivatives trading

A person (individual or corporate) must be admitted as a member of the cash

segment of the exchange and therefore satisfy all capital and other entry

requirements of the cash segment before he/she considered for membership to

trade in the derivatives segment. There appear no restriction as to residence of the

individual of the country of registration of a company so long as they abide by all

Indian peculations and furnish their annual books as required. The person mustfurther satisfy the net worth requirement of the derivatives segment and pay in a

base capital and other amounts which are called as its liquid net worth to be used

as security not merely for its own default, but partly also that of other members.

The member must have at least two individuals who have passed a certification

course in its exclusive employment. And most importantly, the trading member

needs a clearing member who is willing to clear its trades. It is the clearing

member's prerogative to allow his trading members to trade and exposure limits

for them.

Important eligibility/regulatory conditions specified by

SEBI

• Derivative trading to take place through an online screen based trading

system.

• The derivatives exchange/segment should have on-line surveillancecapability 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.

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• 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 com-plaints and preventing irregularities in trading.

• The derivative segment of the exchange would have a separate Investor

Protection Fund.

• The clearing corporation/house will perform full novation, i.e., the clearing

corporation/house will interpose itself between both legs of every trade, becoming

the legal counterparty to both or alternatively should provide an unconditional

guarantee for settlement of ail trades.

• The clearing corporation/house should 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.

• 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 will 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 should have a separate Trade Guarantee Fund

for the trades executed on derivative exchange/segment.

Exposure limits

Further each member has exposure limits circumscribed by its capital/security

deposited. If for reasons of adverse price change, a member exceeds its exposure

limits beyond that afforded by its deposit, its trading terminal will not permit any

further trades which will increase its exposure. The member may be permitted to

enter trades which will reduce the exposure limit—since on a portfolio basis adding

further exposure can reduce overall exposure obligations. The member is also

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obliged to immediately furnish further deposit or reduce his/her exposure to be in

compliance with margin requirements. Such compliance measures are in very large

part taken by the trading system without human intervention. Failure to settle

margins within a short span of time would attract further action for compliance by

the exchange.

If a trading member defaults, action can be taken by the clearing member and the

exchange. The clearing member has an obligation to report the exposure violation

to the exchange. Further the clearing member's algorithms added to the trading

member's trading terminals would automatically limit that trading member's ability

to transact contracts which would increase its exposure liabilities. The clearing

member can also close out contracts of its trading members to reduce such excess

exposure. Similarly, the clearing house can close out individual contracts of a

clearing member, and a trading member can close of a client who has exceeded

exposure limits.

Clearance and settlement

The clearing house acts as the common agent of the members for

clearing contracts between member and for delivering securities

(if required) to and receiving securities (if required) from and for

receiving j saying any amounts payable to or payable by such

members in connection with any contracts and to d ill things

necessary or proper for carrying out the foregoing purposes. The

clearing house stands as counterparty in the trade. Therefore, in

the event of default of any member, the settlement is completed!

Hilling money out of the Trade Guarantee Fund and completing

the settlement. Subsequently the defaulting party is pursued by

the exchange which is holding the members' deposits and

margins in Iien. The extent of loss is usually limited in the event of

default because of the daily settlement and the margin deposited

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by the member. A second protection is the fact that if a client or a

trading member defaults | tearing member is responsible for its

actions. The third line of defense of course is the fact that |

tearing house stands as a guarantor/counterparty to each trade.

Payment for the guarantee/counterparty is made out of a TradeGuarantee Fund.

Regulatory Instruments

As we know that the derivatives are of different types and are managed by various

bodies like stock exchanges, trade associations, clearing houses, over-the-counter

bodies, etc. Thus, the issues relating to their implementation and regulation are also

different. A careful balancing of various considerations is necessary in deciding

these. We will discuss here the important instruments of regulation used for this

purpose by the different regulatory authorities and governing bodies from time to

time.

Margin variation: A margin is a proportion of the derivative contract value whichhas to be paid in cash or securities by the seller or the buyer or both, as the case

may be, in the futures market. The basic objective of such margin is to ensure the

safety of the contract or preventing from the defaults caused by one of the parties

to the contract. The higher the margin ratio the greater the amount of capital which

is locked up against a particular transaction. In other words, the higher margin will

have more safety for the parties but at the higher cost. Further, increase or

decrease in margin will affect the volume of trading in that asset. The regulatory

authority frequently use this instrument to check the high speculation and thinness

of the market

Imposition of special margins:

The special margins refer to those margins which are imposed by the

regulatory authorities over and above the ordinary margin as referred in

above paragraph. For example, if the volume of speculative trading in the

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market has crossed its normal limits, and the market has become explosive

then to check this excessiveness, the special margin in addition to normal

margin has to be levied. In general, special margins are imposed with

'threshold' prices, so that they are imposed only when prices are higher or

lower to specified limits.

Limits on open position:

The term open position relates to the limit on volume of trading for a

particular instrument/scrip for the traders in the market. The basic idea of

making such restriction on open positions of the market participants is just to

avoid manipulation or excessive speculation by the large operators. This limit

is normally imposed in case of speculative open positions.

Temporary suspension Of trading:

According to this measure, the regulatory authority Sops the trading in

particular asset temporarily for a particular period. The basic objective is to

kerb speculation because it has been noticed in the market that, sometimes,

over dose of speculative manipu- laiion which rendered the markets

completely out of tune with reality. As per this measure, the authority can

close out all the existing futures contracts at a fixed rate which does not give

the 'offending' parties ihe speculative gain for which such deals were

initiated

Changes in number and/or timing of contracts:

This measure is related to change in number and timings of the futures

contracts being traded because, sometimes, it is not well suited to the

seasonality of supply or demand of the particular asset or commodity. For

example, regulatory authority Biy change the trading months from February,

March to April and May, etc. However, this method is not B popular in the

futures market.

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Committees on Forward and Futures Markets

Kabra Committee Recommendations (1994)

• The commodity exchanges should enroll more members.

• Capital adequacy norms must be ensured for smooth functioning.

• The commodity exchanges should be computerized so that online

trading be ensured.

• Internal vigilance mechanism of the exchanges should be

strengthened.

• Non-transferable specific delivery forward contracts should be freed

from restrictions, if) Options and range forward contracts may be

introduced. However, this was not agreed by Chairman of thecommittee.

• The exchanges should be recognized on permanent basis.

• The exchanges should be developed into self-regulatory organizations.

• The Forward Markets Commission should be strengthened with more

powers.

• More commodities should be included in futures trading like basmati

rice, cotton seed, ground nut, rapeseed, linseed, copra, seasame seed,mustard seed, soyabean, etc.

Sodhani Committee group Recommendations

(1994)

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The forward contracts and options on foreign exchange are conducted through the

over-the-counter (OTC) markets arid regulate I by the Reserve Bank of India. In

November, 1994, the RBI constituted a Committee under the headship of O.P Sodhni

on foreign exchange market* functioning.

• Banks should offer range forward contracts.

• There should be no withholding taxes on derivatives

transactions.

• More liberty should be given to banks to use derivatives.

• More derivative instruments like caps, dollars, floors, FRAs,

swaps should be allowed to offer by the banks to the traders

without the approval of RBI.

• Different specific dealers should be allowed to offer derivative

instruments.

• Proper documentation and market practices should be evolved

for better functioning of the markets.

R.V Gupta Committee’s Recommendations (1997)

The main Recommendations were as follows :

• OTC instruments like vanilla swaps would only be permitted where

they have only efficient means of hedging.

• Use of options would not be allowed.

• The committee recommended a phased manner approach.

• In Phase-I, the hedging should ordinarily be through exchange traded

commodity futures.

• Phase-I would be a period of acclimatization. At this stage prior

approval would be required (i) to ensure existence of genuine

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underlying risk, (ii) the appropriateness of the hedging instrument, and

(iii) adequateness of risk management procedures.

• In Phase-II, no prior approval, as recommended in Phase-I should be

needed. Only periodic scrutiny of actual transactions and auditor's

certification adequacy of control are sufficient.

• The committee further recommends that hedging should be allowed

through foreign derivatives markets.

However, the futures markets experts observed that due to lack of

experience of the Indian corporate sector regarding the functioning of

international commodity derivatives and inadequate experience amongst

auditors, a longer 'acclimatization' period of at least three years is desirable

instead of one year as recommended by the committee.

Margining system

Mandating a margin methodology not specific margins:

The LCGC recommended that margins in the derivatives markets would be based on

a 99 percent Value at Risk (VAR) approach. The group discussed ways of

operationalizing this recommendation keeping in mind the issues relating to

estimation of volatility discussed in 2.1. It is decided that the SEB1 should authorize

the use of a particular VAR estimation methodology but should not mandate a

specific minimum margin level. The specific recommendations of the group are as

follows:

Initial methodology: The group has evaluated and approved a particular risk

estimation methodology that is described in Clause 3.2 . The derivatives

exchange and clearing corporation should be authorized to start index

futures trading using this methodology for fixing margins.

Continuous refining: The derivatives exchange and clearing corporation

should be encouraged to refine this methodology continuously on the basis

of further experience. Any proposal for changes in the methodology should

be filed with SEBI and released to the public for comments along withdetailed comparative backtesting results of the proposed methodology and

the current methodology. The proposal shall specify the date from which the

new methodology

effective and this effective date shall not be less than three months after the

date of filing with SEBI. At any time up to two weeks before the effective

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date, SEBI may instruct the derivatives exchange and clearing corporation

not to implement the change, or the derivatives exchange and clearing

corporation may on its own decide not to implement the change.

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