Derivatives in India: Structure & Legal Concerns
by Aakash Choubey*
Cite as : (2004) PL WebJour 2
Indian capital market finally acquired the much-awaited international flavour when it introduced trading in futures and options on its premier bourses, National Stock Exchange (NSE) in 2000 and on Bombay Stock Exchange (BSE) in 2001. Financial markets are systemically volatile and so, it is the prime concern of all the financial agents to balance or hedge the related risk factors. Risks can be of various kinds, including price risks, counter-party risks and operating risks. The concept of derivatives comes into frame to reduce the price-related risks.1
The term derivative itself indicates that it has no independent value. The value of a derivative is entirely derived from the value of a cash asset. A derivative contract, product, instrument or simply derivative is to be sharply distinguished from the underlying cash asset, which is an asset bought or sold in the cash market on normal delivery terms.2 A simple derivative instrument hedges the risk component of an underlying asset. For example, rice farmers may wish to sell their harvest at a price which they consider is safe at a future date to eliminate the risk of a change in prices by that date. To hedge their risks, farmers can enter into a forward contract and any loss caused by fall in the cash price of rice will then be offset by profits on the forward contract. Thus, hedging by derivatives is equivalent of insurance facility against risk from market price variations.
The agreed future price of rice is known as the strike price and the prevailing market price of rice on the future date is known as the spot price, which is also the underlying asset. A derivative is essentially a contract for differences the difference between the agreed future price of an asset on a future date and the actual market price on that date. Thus, settlement in a derivative contract is by delivery of cash.
The article endeavours to elucidate on the structure and legal concerns of derivatives that are traded on the stock exchanges. OTC derivatives, though are in existence since 1999 when RBI allowed Forward Rate Agreements (FRAs) and Interest Rate Swaps (IRSs), are not the subject-matter of this article. Derivatives have been around from the days when people began to trade with one another, though not as comprehensively as it is done today. The highest traded forms of derivatives are futures, options and swaps. The jargon is confusing because it is non-legal and imprecise, the varieties of transaction are numerous and the contracts themselves are often complex in detail. However, the transactions themselves are relatively simple in outline.
Genre of Derivatives
The primary purpose behind investing in derivative instruments is to enable individual or corporate investors to either increase their exposure to certain specified risks in the hope that they will earn returns more than adequate to compensate them for bearing these added risks, known as speculation, or reduce their exposure to specific financial risks by transferring these risks to other parties who are willing to bear them at lower cost, known as hedging.3 There are two principal markets for derivative products. A derivative product can be traded in an organized securities and commodities exchange and also, through an over-the-counter (OTC) market that are essentially private transactions.4 Further, there are three participants in derivative markets, namely, hedgers, speculators and arbitrageurs. Hedgers are operators who want to transfer a risk component of their portfolio and thus, hedge it with buying or selling other instruments. Speculators are operators who intentionally take risk from hedgers in pursuit of profits. Arbitrageurs are operators who operate in different markets simultaneously, in pursuit of profit and eliminate mis-pricing in securities across different markets.
The three most popular derivative instruments are forwards, futures and options. There are many further divisions of these instruments. A forward contract is a customized contract between two entities, where settlement takes place on a specified date in the future at todays pre-agreed price. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are standardized exchange-traded contracts whereas forwards are customized OTC instruments. Thus, futures are more liquid in nature and afford greater commercial convenience. Furthermore, only daily margins are payable to the stock exchange, which are fixed by the concerned stock exchange.5 The stock exchange acts as a counter-party, which has the effect of a guarantor and less chances of default.
Options are instruments that give the buyer the right but not the obligation to buy or sell an asset. Options are of two types, namely, calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Generally, options lives upto one year but majority of the options traded on exchanges have a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter. LEAPS is another kind of options having a maturity of upto three years. LEAPS is an acronym for Long-Term Equity Anticipation Securities. Baskets are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options.
Another kind derivative product is swap. A swap, an OTC derivative, is nothing but a barter or an exchange but it plays a critical role in international finance. Currency swaps help eliminate the differences between international capital markets. Interest rate swaps help eliminate barriers caused by regulatory structure. While currency swaps result in exchange of one currency with another, interest rate swaps help exchange a fixed rate of interest with a variable rate. Swaps are private agreements between two parties and are not traded on exchanges but they do have an informal market and are traded among dealers. Swaptions is an option on a swap that gives the party the right, but not the obligation to enter into a swap at a later date. The above illustrated categories of derivative instruments comprehensively develop a conceptual understanding of equity derivatives.
Benefits of Derivatives
Constant risks have stimulated market participants to manage it through various risk management tools. Derivative products is a one such risk management tools. With the increase in awareness about the risk management capacity of derivatives, its market developed and later expanded. Derivatives have now become an integral part of the capital markets of developed as well as emerging market economies. Benefits of derivative products can be enumerated as under:
- Derivatives help in transferring risks from risk-averse people to risk-oriented people.
- Derivatives assist business growth by disseminating effective price signals concerning exchange rates, indices and reference rates or other assets and thereby, render both cash and derivatives markets more efficient.
- Derivatives catalyze entrepreneurial activities.
- By allowing transfer of unwanted risks, derivatives can promote more efficient allocation of capital across the economy and thus, increasing productivity in the economy.
- Derivatives increase the volume traded in markets because of participation of risk-averse people in greater numbers.
- Derivatives increase savings and investment in the long run.
Tracing History of Derivatives in India
It is a fallacy that derivatives trading was previously absent in India. Forward trading in securities was the antecedent of derivatives. It was traded in the form of teji (call options), mandi (put options), fatak (straddles), etc.6 During this time, the Securities Contracts (Regulation) Act, 1956 (hereinafter referred to as the Act) was promulgated, which was essentially a legislation to prevent undesirable transactions in securities. Forward trading was seen as inherently speculative and was banned in year 1969.7 Nevertheless, forward trading continued on the BSE in an informal manner in the form of badla, which allowed carry forward between two settlement periods. The Securities and Exchange Board of India (SEBI) banned the badla operations on the recommendations of the Joint Parliamentary Committee on Irregularities in Securities and Banking Transactions, 1992.8 In 1995, the ban on badla was, however, lifted subject to certain safeguards.9 Apart from badla, there was another form of forward trading, namely, ready forward contracts or repo transactions which was also permitted by the Supreme Court.10
Thus, a strange situation emerged where forward trading was banned by virtue of the 1969 notification but some forms of forward trading, like badla and ready forward contracts, were prevalent. The Government of India realized that derivatives were gaining ground world over as one of the most sought after capital market hedging instruments. With this in mind, it was felt that the 1969 notification is redundant and should be repealed. To begin with, prohibition on options in securities was omitted by the Securities Laws (Amendment) Act, 1995, w.e.f. January 25, 1995. This was the first step towards the introduction of derivatives trading in India.
Even after removal of the prohibition in options, its market did not take off. This was largely by reason of lack of regulatory framework for governance of trading in derivatives. SEBI took up the task for putting in place such a regulatory framework and constituted L.C. Gupta Committee (Committee) in November 1996.11 The Committee observed that development of futures trading is advancement over forward trading which has existed for centuries and grew out of need for hedging the price-risk involved in many commercial operations. The foremost recommendation of the Committee was to include derivatives within the definition of securities under the Act. It was intended that once derivatives are declared as securities under the Act, SEBI, the regulatory body for trading in securities could also govern trading of derivatives. In 1998, SEBI appointed Prof. J.R. Verma Working Group to recommend risk containment measures for derivatives trading. These reports laid the foundation of theoretical and practical aspects of derivative trading in India.
Consequently, the Securities Contracts (Regulation) Amendment Bill, 1998 was introduced in the Lok Sabha and was referred to the Parliamentary Standing Committee on Finance. And finally in December 1999, Securities Law (Amendment) Act, 1999 was passed by the Parliament permitting a legal framework for derivatives trading in India.
Present Legal Framework
The present legal framework and piecemeal approach adopted by SEBI is based on the recommendations of the L.C. Gupta Committee. On the recommendations of the Committee, definition of securities under the Act was modified to include derivatives.12 The 1969 notification was also repealed on March 1, 2000. Derivatives trading finally went underway at NSE and BSE after getting nod from SEBI to commence index futures trading in June 2000. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE 30 (Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. At BSE, trading in index options based on BSE Sensex commenced in June 2001, the trading in options on individual securities commenced on July 2001 and futures on individual stocks were launched in November 2001. At NSE too, trading in index options based on S&P CNX Nifty commenced in June 2001, trading in options on individual securities commenced in July, 2001 and single stock futures were launched in November 2001.
The Act renders a comprehensive definition on derivatives and even permits derivatives trading on derivatives.13 Only those derivative products which are traded on a recognized stock exchange and are settled on the clearing house of the recognized stock exchange are legal and valid.14 Section 18A of the Act is a non-obstante clause and was recommended by the Parliamentary Standing Committee on Finance, which examined the Securities Contracts (Regulation) Amendment Bill, 1998. The object of this provision is that since derivatives, particularly index futures, are cash-settled contracts, they can be entangled in legal controversy by being classified as wagering agreements under Section 30, Indian Contract Act, 1872 and thereby, declared null and void.
For trading in derivatives, permission from SEBI is mandatory.15 However, this permission is required for trading in only those derivatives contracts that are tradable and hence, no prior permission is mandatory for OTC derivatives. The Act further prescribes punishment of imprisonment for a term which may extend to one year, or with fine, or with both, in case of contravention of the Section 18A and rules made there under by SEBI or Central Government.16 Trading and settlement in derivative contracts is done in accordance with the rules, byelaws and regulations of the NSE and BSE and their clearing houses, duly approved by SEBI and notified in the Official Gazette. The minimum contract size for a derivatives transaction is Rs. 2 lakhs.
Thus, the enactment of Securities Law (Amendment) Act, 1999 and repeal of the 1969 notification provided a legal framework for securities based derivatives on stock exchanges in India, which is co-terminus with framework of trading of other securities allowed under the Act. However, these attempts are not sufficient for developing a buoyant derivatives market. The principal hindrance lurking before the hedgers and speculators is taxation on derivatives transactions. There is no apparent provision dealing with taxation of derivatives transactions. Section 73(1) read with Section 43(5) of the Income Tax Act, 1961 are two provisions which are of significant concern. Section 73(1) prescribes that losses of a speculative business carried on by the assessee can be set-off only against profits and gains of another speculative business, upto a maximum of eight years. Under Section 43(5) a transaction is a speculative transaction where (a) the transaction is in commodity, stocks or scrips, (b) the transaction is settled otherwise actual delivery, (c) the participant has no underlying position and (d) the transaction is not for jobbing or arbitrage to guard against losses which may arise in the ordinary course of his business.
Derivatives are not commodities, stocks or scrips but are a special class of securities under the Act. Also, derivatives transactions, particularly index futures are never settled by actual delivery.17 And most importantly, under Section 43(5) a hedging or arbitrage transaction in which settlement is otherwise than actual delivery is regarded as non-speculative only when the participant has an underlying position, but in derivatives contracts hedgers and speculators have no underlying position in such transactions. In the light of these readings, derivatives contracts may be construed as speculative transactions and will be hit by Section 73(1). It is, therefore, imperative to declare derivatives transactions as non-speculative and it should be taxed as normal business income or capital gains, as the case may be.
The initiatives of the Government and SEBI for growth of derivatives market are admirable, however, there is still much leeway for improvement. This market is embryonic, which is manifest from the low trading volumes compared with that of developed capital economies. Still it is felt by market observers that contrary to the initial promise derivatives never picked up. SEBI has to address many issues. Foremost is clarity on taxation and accounting front. The number of derivatives trading exchanges should be increased.
These instruments are designed to reallocate risks among market participants in order to improve overall market efficiency. But while the new instruments create new hedging opportunities, they also entail legal risks because the newer instruments tend to be more difficult to understand and value than existing instruments and thus, more prone to occasional large losses. Therefore, it is imperative that SEBI endeavours to create awareness about derivatives and their benefits among investors.
Further, due to its complex nature, tough norms and high entry barriers, small investors are keeping away from derivative trading. The issue of higher contract size in derivatives trading is proving to be an impediment in increasing retail investors participation. The Parliamentary Standing Committee on Finance in 1999 observed that because of the swift movement of funds and technical complexities involved in derivatives transactions, there is a need to protect small investors who may be lured by the sheer speculative gains by venturing into futures and options. Pursuant to this object, the present threshold limit of Rs. 2 lakhs has been prescribed for derivatives transactions. However, the contract size of Rs. 2 lakhs is not only high but is also beyond the means of a typical investor. The heartening development in this regard is that the Ministry of Finance has decided to halve the contract size from the current level of Rs. 2 lakhs per contract to Rs. 1 lakh and SEBI will decide when to introduce the reduced contracts.18
Another roadblock is the restriction on Foreign Institutional Investors (FIIs) to invest only in index futures. It is accepted that SEBI must have regulatory powers for trading in securities, however, for increase in trading volumes, SEBI should lay down only broad eligibility criteria and the exchanges should be free to decide on stocks and indices on which futures and options could be permitted. Derivatives bring vibrancy in capital markets and Indian investors can gain immensely from them. Therefore, it is vital that necessary changes are brought in at the earliest. Also, stringent disclosure norms on mutual funds for investing in derivatives should be relaxed to revitalize Indian mutual funds by enabling diversification of risks and risk-hedging.