Regulation of derivative trading - Security Analysis and Investment Management

The SEBI Board in its meeting on June 24, 2002 considered some important issues relating to the derivative markets including:

  • Physical settlement of stock options and stock futures contracts.
  • Review of the eligibility criteria of stocks on which derivative products are permitted.
  • Use of sub-brokers in the derivative markets.
  • Norms for use of derivatives by mutual funds

The recommendations of the Advisory Committee on Derivatives on some of these issues were also placed before the SEBI Board. The Board desired that these issues be reconsidered by the Advisory Committee on Derivatives (ACD) and requested a detailed report on the aforesaid issues for the consideration of the Board.

In the meantime, several other important issues like the issue of minimum contract size, the segregation of the cash and derivative segments of the exchange and the surveillance issues in the derivatives market were also placed before the ACD for its consideration.

The Advisory Committee therefore decided to take this opportunity to present a comprehensive report on the development and regulation of derivative markets including a review of the recommendations of the L. C. Gupta Committee (LCGC).

Four years have elapsed since the LCGC Report of March 1998. During this period there have been several significant changes in the structure of the Indian Capital Markets which include, dematerialization of shares, rolling settlement on a T+3 basis, client level and Value at Risk (VaR) based margining in both the derivative and cash markets and proposed demutualization of Exchanges. Equity derivative markets have now been in existence for two years and the markets have grown in size and diversity of products. This therefore appears to be an appropriate time for a comprehensive review of the development and regulation of derivative markets.

Regulatory Objectives

The LCGC outlined the goals of regulation admirably well in Paragraph 3.1 of its report. We endorse these regulatory principles completely and base our recommendations also on these same principles. We therefore reproduce this paragraph of the LCGC Report:

"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 behavior. It has been guided by the following objectives:

  1. Investor Protection: Attention needs to be given to the following four aspects:
    1. 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.
    2. 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.
    3. 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.
    4. Market integrity: The trading system should ensure that the market’s integrity is safeguarded by minimizing the possibility of defaults. This requires framing appropriate rules about capital adequacy, margins, clearing corporation, etc.
  2. 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.
  3. 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."

All rights reserved © 2018 Wisdom IT Services India Pvt. Ltd Protection Status

Security Analysis and Investment Management Topics