Regulation
of
Exchange
Traded Financial Derivatives
in
LL.M. (Securities and Financial Regulations)
Visiting Faculty, Indian Institute of Management,
Ahmedabad
Advocate, P.H. Parekh & Co.
30 School Lane, Bengali Market,
New Delhi 110 001
Introduction[1]
The
Indian capital markets have metamorphosized over the
last few years. A sea change in the stock markets have seen dematerialized
stocks, faster settlements, increased transparency, reduced fraud and competitive
costs. The introduction of derivatives in the market required the existence of
a clean, efficient and paperless cash market[2],
which was delivered just in time. Introduction of exchange traded derivatives
in June 2000 was preceded by parleys for over 5 years, involving a lot of
serious deliberations for introducing the best practices from around the world.
This
paper states, interprets and studies the various regulations of exchange traded
financial derivatives, the interplay of one regulation with another, the impact
that such regulations have on market participants, the issues they address and
explores any shortcomings or weaknesses in the markets. Finally, the paper
explores international issues on the subject and suggests policy issues.
The first part of the paper discusses the structure of
the capital market before the introduction of derivatives. The evolution of various aspects of the stock exchange over the past
decade are mentioned leading to the addition of derivatives segments in
these exchanges. The constitutional and statutory scheme of securities
regulations is briefly touched, before the amended machinery of regulations for
derivatives is introduced into the scheme of regulations. Further, the
structure of the derivatives segment and its participants is outlined in some detail.
The second part of the paper titled ‘market regulations’,
explores the regulations in force which are intended to govern the market by
reducing systemic risk to the exchange. Though they may in fact regulate the
market by regulating the intermediaries, the focus of this part is towards
regulation of systemic risk. Thus starting with definitional issues, settlement
and clearance, exchange guarantee of trades, exposure limits, capital
requirements, the margining system regulations and default are studied in
detail. Because of the relatively recent developments, there are no case laws
of higher courts or the Securities Appellate Tribunal, therefore this paper
mainly relies upon the regulations as stated by the exchanges. To the extent
the derivatives segment is in pari materia with the cash
segment, case law has been used.
The third part deals more specifically with regulation of
the members and other intermediaries and includes restrictions on such entities
which assist in protecting the end client. Thus supervision regulations, audit
trails, internal reviews, suitability and anti-fraud regulations are in focus.
The last part deals with cross border regulations of
derivatives and issues in cooperation between regulators across various
jurisdictions and the role of international bodies like IOSCO[3] in
coordinating regulations to reduce excessive or overlapping regulations by
national regulators of cross border transactions. Like any other country the
regulations are framed keeping in mind domestic issues and their resolutions.
Thus the international aspects will probably evolve with time as more
transnational deals occur and as more regulators try to extend their turf in
attempts to protect their constituents.
I. STRUCTURE
OF THE MARKET
Overview of the stock market in India
The
stock market in
Competition
amongst the two largest exchanges has brought enormous benefits to shareholders
in terms of providing better and more cost effective service. As if that were
not enough, a competing depository (established by the BSE) has brought down prices
in that industry by over 80%. 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 the cash
segment). The last few months have seen a movement in the cash segment to a T +
5[7]
settlement and beginning 1st 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 in terms 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 a tepid start, have seen double digit growth almost every month over the
last year[8].
The exchanges are clamoring for a smaller contract size[9]
and therefore access to more investors[10]. With
growing evidence[11] 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.
Derivatives Regulations[12] - A
brief conspectus
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 meant
that 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[13]
for exploring issues in introduction of, making a case for or against early
introduction of and creating a regulatory framework for a derivatives market.
After
the committee report was tabled, the first action taken was to wet nurse the
derivatives market by 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[14].
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 to the introduction of futures
on individual stocks in the
Technology
The
derivatives segment of the two exchanges are fully
screen based. There are no market pits, no gesticulating people, no scraps of
paper, and no market makers in any derivatives contract. Bid-ask spreads are
under 0.2% on an average[17],
which indicates the efficiency of the markets even without market makers.
Trading terminals are spread over 100 cities in the country. People enter their
trades through Trading Members who use their computer terminals which are
connected to each other through VSATs (Very small
aperture terminals). These computers use the exchange’s proprietary system and
are not connected through the internet – though one can trade in derivatives through
the internet.
The Participants and their role in the structure of the
exchange[18]
The trading system is comprised of the following
components: The Exchange at the top – which is governed by the three governing
bodies, Clearing House (which is currently part of the Exchange), Clearing
Bank, Clearing Member, Trading Member and the client. Also, part
of the risk reduction scheme are the Trade Guarantee Fund and the
Investor Protection Fund. Structurally, the exchange performs several functions
like order matching, clearance and settlement, risk management including
default management and investor protection.
A
graphic representation of the structure of the exchange is given in the next
page[19].
The Clearing House of the BSE is a part of the exchange currently though it may
in the future be spun off into an independent company[20].
The clearing banks are banks who have agreed to clear the trades through their
branches and transfer payments efficiently and often automatically after order
execution. The banks work under the terms of an agreement signed with the
Clearing House of the 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.
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
should be a member of the exchange i.e. of the cash segment of the Exchange[21].
A Trading Member must clear through a Clearing Member and a Clearing Member may
refuse or restrict the trading rights of any or all its trading members
clearing under it (even if legitimate under extant 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 functions independently.
Membership
of the derivatives segment is a personal privilege and cannot be transferred[22].
In the event of default the terms of the Rules and Bye-laws override the
insolvency laws of the land and the clearing house has the first right not only
over the capital invested in the clearing house, but also the right of his
membership – which can be auctioned to pay for his market debts before external
creditors are satisfied.
Products available.
The
first product available was Index Futures. Subsequently, Options on Index
Futures, Futures on single stocks and options on single stocks were introduced.
Only 31 stocks have been permitted for individual future/option trading based
on fairly stringent measures for introduction. 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 in the games of 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[23],
if currency and interest rates are introduced the regulatory bodies may have
some overlap as to regulations. There are also parley going on with commodities
futures exchanges to introduce commodities derivatives trading on the two
bourses.
The regulatory framework and the existing infrastructure
of the markets were suitably modified and most issues around the cash segment
were resolved by the time the derivatives contracts were introduced. Further
improvements, later, in the settlement of the cash segment have seen a
correlated increased confidence in the markets and thus better volumes and
reduced arbitrage opportunity. What has worked most in favour
of the derivatives market however is the checks and balances and the systemic
strength of the structure of the markets and the regulations which have
translated into volumes. This structure is discussed in further detail in the
next part.
II. MARKET
REGULATIONS
Statutory provisions
The
primary laws in relation to derivatives are not legislative, but are created by
the 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, the 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 below. Before that we will briefly
introduce the statutory background of the Markets.
The
Indian Constitution permits long arm statutes. Thus a tax on citizens of a
foreign country would pass a constitutional challenge[24]
even if connected with
The
relevant Acts and statutory provisions are contained in the Securities Contract
(Regulations) Act, 1957, Securities and Exchange Board of
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 the derivatives segment.
Derivatives are defined under the Securities
Contracts (Regulations) Act 1956.
(aa) "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. a
contract which derives its value from the prices, or index or prices, of
underlying securities;
Securities
are now defined as:
(h) "Securities"
include-
(i ) shares, scrips, stocks,
bonds, debentures, debenture stock or other marketable securities of a like
nature in or of any incorporated company or other body corporate;
(ia) derivative;
(ib) units or any other instrument
issued by any collective investment scheme to the investors in such schemes;
(ii)
Government securities;
(iia) such other instruments as may
be declared by the Central Government to be securities; and
(iii) rights
or interests in securities;
Wagering Proscription
One
area of some concern is the anti-wagering provision in the Indian Contract Act,
1872 which declares as void any contract which is entered into by way of wager.
Section 30 of the Act states:
30. "Agreements by way of wager are void; and no suit shall
be brought for recovering anything alleged to be won on any wager, or entrusted
to any person to abide the result of any game or other uncertain event on which
any wager is made".
In
Pollock and Mulla's Contract Act[27],
"wager" is described thus: -
"What is wager? "A wager has been defined as a contract
by A to pay money to B on the happening of a given event, in consideration of B
paying to him money on the event not happening.
But Sir William Anson's definition, "a promise to give money or
moneys worth upon the determination or ascertainment of an uncertain event,"
is nearer and more accurate. To
constitute a wager "the parties must contemplate the determination of the
uncertain event as the sole condition of their contract. One may thus distinguish a genuine wager from
a conditional promise or a guarantee".
Anson, Law of Contract, 17th Ed., 221, 222)".
In
Alamia v. Positive Government Security Life
Assurance Co.[28],
a case of life insurance, Fulton J. said:
"What is the meaning of
the phrase "agreements by way of wager" in S. 30 of the Contract Act?
... Can it be that the words mean
something different in
Wagering contracts may assume a
variety of forms, and a type with which the Courts have constantly dealt is
that which provides for the payment of differences in stock transactions, with
or without colourable provisions for the completion
of purchases. Such provisions, if
inserted, will not prevent the court from examining the real nature of the
agreement as a whole. (RE: Gieve, 1988. 1Q.B 794,
Speculative transactions must
be distinguished from agreements by way of wager. "There is no law against
speculation as there is against gambling[29]..
In
an article "Are Swaps Gambling
Contracts? " by Gillian Hogarth
(Baker and Mckenzie, London, June 1993), it is stated
that there has always been a residual doubt as to whether a contract for
differences, such as an interest rate or currency swap could constitute
"Gaming or Wagering" contracts.
The author resolves this doubt with the following statement:-
"the case of Morgan
Grenfell & Company Limited V. Welwyn Hatfield
District Council and Islington London Brough
Council (as a third party) 30th April,
1993, in the Commercial Court before Mr.Justice Hobhouse, addresses this question. Mr. Justice Hobhouse
handed down his decision on
For
a contract to be void under Section 30 of the Act,
there must be an absence of an underlying to the transaction. To quote Anson (p.280, 21st Ed), a recognised
authority on Contracts Law: The parties must however contemplate the
determination of the uncertain event as the sole condition of their contract
and not as a mere incident in the larger transaction of a contract for the sale
of goods on certain terms. To distil the
law into a single sentence a wager requires a) speculation on both sides that would be determined by a future
uncertain event b) absence of
underlying c) settlement of
differences by a set-off payment. In the event of a legal challenge to a
contract as void under the Act, the defendant would need to prove each of the
three conditions above. It has been a regulatory shortcoming not to exclude
exchange traded derivatives from the wagering proscription. The courts would do
a major service to the market by declaring that all exchange traded derivatives
have an underlying and therefore lay at rest any legal risk of entering into
transactions in the market. Till the time such a matter reaches the court, we
must live with the marginal legal risk that a specific contract can be found to
be a wager.
Entry barriers to trade in derivatives
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 can be considered for membership to trade in
the derivatives segment. There appear no restriction
as to residence of the individual or the country of registration of a company
so long as they abide by all Indian regulations and furnish their annual books
as required. The person must further satisfy the net worth requirement of the
derivatives segment and pay in a base capital and other amounts which are
called its liquid net worth to be used as security not merely for its own
default, but partly also that of other members[30].
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 set exposure
limits for them.
A Clearing Member is not required to be a member of the
cash segment of the Exchange, but must satisfy net worth and capital
requirements set by the exchange and shall have two members in its exclusive
employ who are certified in a manner described above.
At the time of admission to either membership the
Clearing/Trading Member shall provide security for trading - such security can
be cash, bank guarantee and securities as approved. The security deposit is
utilized not merely in temporary margin shortfalls but also provides a buffer
in the event of a default by the member. Part of the contribution goes towards
the Trade Guarantee Fund which guarantees the trades in the exchange from
default. The exchange has a primary lien over the security deposited – superior
to that of external creditors[31].
Before a Trading Member starts to trade, it must be
associated with a Clearing Member who is willing to clear its trades. The Clearing
Member in its absolute discretion may allow a particular Trading Member to
trade and set limits for trades for that Trading Member. A Clearing Member may
ask to be disassociated from a Trading Member and can ask the exchange to so
do. Similarly a Trading Member in good standing may apply to be disassociated from
a Clearing Member if it can find another Clearing Member to clear its trades.
Order Execution
Market integrity depends in part upon fair and efficient
execution of orders. Order execution in the Indian context is part of the
algorithm of the trading system. The system executes orders by price, time and
size in that order. Thus the best price will always have priority – and there
is no human intervention or margin for error in the market. Thus rules are
clearly defined and applied consistently - ensuring transparency and enhancing
confidence in the order execution and the marketplace. Derivatives orders must
be executed through
the market and off exchange trades are not permitted. As far as allocation of
securities (or final settlement) upon exercise of an option before its maturity
is concerned, the search for a writer of the option is done randomly by the
trading system – without any human intervention – and the person so chosen is
expected to deliver his/her obligation under the terms of the call/put contract.
Surveillance
The surveillance division of the exchange attempts to ensure
market integrity. The fact that the derivatives market is inherently connected
with the cash segment means that surveillance needs to be unified in its
approach – which they are. Ideally, surveillance should be coordinated between
all exchanges and to the extent possible between exchanges in different
countries for the same contract[32].
Large positions are monitored by the surveillance divisions and they regularly
send notices to members they consider might be involved in suspicious activity.
Since large transactions are automatically marked for review by the
surveillance division, a more cumbersome review of every trade would only be
required where small trades are reported to be in violation of some regulation.
Risk Structure of the market
A
large part of the risk is delegated by the derivatives segment to the Clearing
Member. If a Trading Member defaults in its obligations, the Clearing Member
needs to make up for the shortfall and recover the balance from the Trading
Member. Because of this burden, a Clearing Member is given a lot of powers over
the workings of Trading Members clearing under him/her. A Clearing Member can
restrict the exposure levels or even stop the trading rights of any of its Clearing
Members. Of course the derivatives segment too maintains collateral power over
the trading member.
Clearing guarantees are given by the Clearing House (in
the case of NSE, the clearing corporation stands as a
counterparty to each trade), so that if either side of the trade
defaults, the Clearing House would make good the shortfall in the settlement.
Because of the daily settlement nature of the market, the guarantee needs to be
fulfilled before the beginning of the next trading day (T+1). Thus the
guarantee is akin to the counter party obligations of the exchange/clearing
corporation in the NSE.
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 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
out contracts of a client who has exceeded exposure limits. In case of any
shortfall, the margin and other amounts can be utilized to pay off the dues of
such constituents[33].
The exchange has first lien over every property of a member in its possession.
The exchange also has right of suspension or declaration of default of the
member in case the member is not able to satisfy the shortfall within a
specified time.
There are position limits in each contract set by SEBI
and/or the exchange for one participant and also market wide limits for one
particular contract. Such restrictions are necessary to observe and restrict
potential manipulation in the derivatives market. Special limits were also
prescribed for Foreign Institutional Investors and Mutual Funds. These limits
are constantly reviewed and changed as liquidity demands change[34].
Capital requirements
To
be admitted to trading/clearing a member must make certain deposits besides the
admission fee charged. The member shall contribute an initial contribution to
capital. The initial contribution is non refundable. It can be in the form of
cash, bank guarantee and securities as prescribed. The member will be entitled
to interest and corporate benefits like dividend and bonus shares on the
deposit so long as they are not dilutive of the contribution.
The
member shall also be obliged to pay on a continuous basis a capital
contribution – such contribution would normally be a small percentage of the
member’s turnover. The initial contribution to capital, the member’s continuous
contribution and the contribution of the exchange to the corpus of the Trade
Guarantee Fund shall form the basis of “General Access Funds”. General Access
funds can be utilized towards the default of any member of the exchange. The
member may also be required to pay additional capital contribution if so
required by the exchange[35].
Specific Access Funds, are those funds which may be
used only for the default of the defaulting member and on account of no other
person.
Clearance and settlement
The
clearing house acts as the common agent of the Members for clearing contracts
between Members and for delivering securities (if required) to and receiving
securities (if required) from and for receiving or paying any amounts payable
to or payable by such Members in connection with any contracts and to do all
things necessary or proper for carrying out the foregoing purposes.
The
clearing house stands as a counterparty[36]
in the trade. Therefore in the event of default of any member, the settlement
is completed by pulling 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 lien. The extent of loss
is usually limited in the event of default because of the daily settlement and
the margin deposited by the member. A second protection is the fact that if a
client or a Trading Member defaults the Clearing Member is responsible for its actions.
The third line of defense of course is the fact that the clearing house stands
as a guarantor/counterparty to each trade. Payment for the
guarantee/counterparty is made out of a Trade Guarantee Fund, described in more
detail subsequently in the paper. The last line of defense is the insurance
cover on the Trade Guarantee Fund if it gets completely depleted. Because of
the algorithm fed into the trading system, there is a real time/continuous surveillance
of positions of members and there is little systemic risk involved as far as
the solvency of the exchange is concerned.
The primary aspects of
work of the clearing house are:
2.2.1[37] monitor the
overall positions of Members across all segments of the Exchange.
2.2.2 establish facilities
for electronic funds transfer
2.2.3 specify the types of margins to be collected,
the person by whom margin/s are to be paid in terms of Bye-law 4.7, manner of
payment of margin the amount of margin, the method of computation of margin,
valuation of collateral, the time of payment of margin and the manner and
circumstances in which margin is to be adjusted, appropriated, applied or
returned,
2.2.4 monitor and
supervise the collection of margin, collect margins and initiate and take
action for non-payment of margin.
Margining structure
Margins are collected with only
one purposes in mind - as a collateral for due settlement of trades keeping in
mind a worst case scenario. They contribute to the amount of leverage a person
can use. Thus lower margins would increase leverage and therefore increase the
risk of a person defaulting[38].
However higher margins would suck away liquidity from the market. To determine
a safe margin which would balance with the costs associated with higher margin,
statisticians calculate the worst case scenario loss – and provide for a
reasonable degree of safety.
The computation of Worst
Scenario Loss has two components. The first is the valuation of the portfolio
under sixteen scenarios. At the second stage, these Scenario Contract Values
are applied to the actual portfolio positions to compute the portfolio values
and the initial margin (Worst Scenario Loss). For computational ease, exchanges
are permitted to update the Scenario Contract Values only at discrete time
points each day and the latest available Scenario Contract Values is applied to
member/client portfolios on a real time basis.
Normally, a 3 sigma standard is
used in futures contracts – so that margin levels would cover approximately 99%
of scenarios, so that in case of default, the margin would be sufficient to
meet with the shortfall. Options attract a higher standard since only one
person, the writer/short, takes up more risk.
Margin Collection and Enforcement
The mark to market settlement
of Futures and Options is collected before the start of the next day’s trading,
in cash. The members in turn collect the initial margin from their clients. The
members can collect excess margin either for convenience[39]
or for extra safety of their position from his client. The margin money, and
mark to market margin (daily settlement price) typically moves from the client
to the Trading Memberto the Clearing Member to the
clearing bank on account of the clearing house and down the chain on the other
side down to the client level. If any part of the chain doesn’t pay its
obligations the chain is made whole by another element. For a client’s default
the Trading Member pays, for the Trading Member’s obligation, the Clearing
Member is still obliged to pay (and then take process against the Trading
Member). If the Clearing Member defaults in paying, the clearing house invokes
the trade guarantee fund to pay down the other side of the chain of persons.
The collection of margin is done electronically by the trading system and
communicated to the clearing house which intimates the clearing bank to
debit/credit the accounts of various members.
Methodology of calculating
Margins
are collected on a gross basis between persons,
however, the position of one person is calculated considering his/her entire
portfolio. Thus some securities may reduce the margin requirements created by
other positions.
Initial Margin
Initial
margin is collected by the clearing house at the time when a contract is
entered into. It may be collected in cash, bank guarantees and securities in
various percentages as mentioned from time to time. Till the time the long of a
contract pays the Initial Margin or the premium, the amount is deducted from
the liquid net worth of the member on a real time basis.
Mark to market
The trades are settled on a daily basis, thus any profit
or loss made during the day is passed on to the respective counterparty through
the clearing house. Such payments are known as mark to market margins. They are
not really margins but daily clearance amounts for settlement of a trade.
Typically these are collected at the end of the business day, but the exchange
has the power to collect advance daily settlement amounts on expectations of
excess volatility. These settlement margins are always collected in cash.
Funds
for settlement are automatically debited and credited to the respective
accounts of the Clearing Members. Each Clearing Member must open an account
with one of the clearing banks and sufficient funds must be available for the
process of settlements and margins – at the risk of default proceedings.
Cross margining with cash segment
Portfolio
based margining approach which takes an integrated view of the risk involved in
the portfolio of each individual client comprising of positions in all
derivatives contracts i.e. index futures, index options, stock options and
single stock futures. However, the cash segment and derivatives segment are not
allowed to be treated as a single portfolio and exposure in one does not reduce
the liability in another on the basis of a unified portfolio. However, this
author strongly recommends cross margining be allowed between the two segments.
Doing so will allow easy arbitrage and a more efficient market in both the cash
and the derivatives segment. The
physical settlement of stock option contracts is proposed to be introduced to
provide inter linkages in the prices of the stock in
the cash and the derivative markets.
Closing Out
On
default the exchange may close out open positions of the defaulting member.
However, such close out creates a problem for people clearing or trading
through such member. Their positions would also normally be closed out. This is
a weak part of the regulations because clients or trading members are faced
with a close out of their entire portfolio despite the fact that they were in
good standing. However, the exchange leaves the possibility of transfer of
positions of such member to other clearing/trading member. If the default of
the Clearing Member is due to the default of its Trading Member or the Trading
Member’s client, then the clearing house can exercise lien over such defaulting
cause’s properties.
Closing out is usually effected by auction or placing an
order or using a formula to come to a price.
Suspension and default
A
member can be declared defaulter if it defaults on any payment obligations, or
any other obligations imposed according to the regulations, or if an
arbitration order is not followed, or if it is declared defaulter in another
segment or another exchange. Suspension of membership entails a temporary bar
on trading/clearing rights of the person while expulsion is a permanent
exclusion of the persons from membership. Default in one segment will
automatically make a person a defaulter in all segments of the exchange.
Suspension in one segment will similarly entail suspension from all segments of
the exchange.
In the event of declaration of default of a member, all
its positions can be either closed out or at the discretion of the clearing
house transferred to another member willing to accept the exposure. The
shortfall is met by the Clearing House by invoking the Trade Guarantee Fund.
The Trade Guarantee Fund[40]
(TGF) was created with an initial contribution by the exchange and has pooled
into it the non-refundable part of its member’s capital contribution and
continuous contribution by members based on their turnover. Further amounts may
be demanded by the exchange to pad the resources of the fund in the event of
necessity.
Use of the Trade Guarantee Fund
In
the event of any default, the TGF shall pay to the clearing house the amount of
money that the member had defaulted in the settlement in which the default was
made. Such payments are made before the beginning of the next settlement cycle
– which is in the absence of holidays – the next day. Such settlements can be
withdrawn after giving notice, if evidence of fraud or collusive behaviour are evident in the claim. The TGF funds can be used for the
settlement of the defaulting member in the settlement in which it defaulted and
no other. Further all dues of the defaulter are not covered by the fund but
only the settlement dues of the member.
The Investor Protection Fund[41]
The
fund was established to protect such investors who suffer not as a result of a
member defaulting its settlement dues, but for making
whole an investor who despite a proper settlement is not paid his/her due by
the member.
Appropriation of defaulting member’s assets
As
discussed above the case law is clear that the assets of a defaulter in the
custody of the exchange can be utilized by the exchange before any third party
creditor can lay a claim to it. The application of a
defaulters assets are specified in Bye-law 15.36. In short, it lays down
eight categories of application of defaulters assets before the assets can be
paid back to the defaulter i.e. his other creditors if they exist.
Suspension of Trading in a
contract or several contracts.
The
provision for suspension of a contract or of the market is self explanatory:
A contract in a particular
derivative or the entire market can be suspended for the following reasons[42]:
a) suspension
of trading in the underlying securities ;
b)
for protection of the interests of investors ;
c) for
the purpose of maintaining a fair and orderly market.
Dispute settlement
Dispute
settlement between Trading Member(s) and other members are resolved by
arbitration as per the terms of the Bye-laws of the exchange. It has been held
that the terms of the Arbitration under the Stock Exchange Bye-laws will
overrule to the extent of conflict the terms of arbitration set by the Indian
Arbitration and Conciliation Act 1996[43]. The
Arbitrators are selected from a panel of arbitrators, most of whom have
significant knowledge of the markets. The venue of the arbitration is set in
Mumbai and the jurisdiction is that of the Mumbai courts.
In
case of dispute between members, the provisions are somewhat different from the
case of resolution of dispute between a member and non member. For instance the
appeal provisions for a member – member dispute is more restrictive than that
of a member – non-member dispute.
III. MEMBER
REGULATIONS
Segregation of client accounts
Each
client has a client ID assigned so that that clients assets
are segregated from those of the member.
2.4[44] The Clearing House shall segregate
upfront and initial margins deposited by Clearing
Members for trades on their own account, on account of Trading Members and on
account of Clients of the Clearing or Trading Members. The Clearing House shall
hold the Clients’ and Trading Members’ margin money in trust for the purpose of
meeting the obligations of the Clients and the Trading Members only and shall
not allow its diversion for any other purpose.
Not
only are the monies of a client not permitted to be pooled with that of a
member, but the monies of one client are not permitted to be pooled with that
of other clients. Similarly a Clearing Member cannot pool the assets of Trading
Members clearing under it or mix its own assets with those of the Trading
Member. A similar segregation is ordered in the books of the members who must
maintain separate accounts for proprietary[45]
trades from those of its clients[46].
Supervision obligations of a member
Every member has an obligation to
supervise[47] its
business and the activities of its employees to achieve compliance with extant
regulations. Further any unauthorized trade entered into on the terminals of
the member shall be the responsibility of that member.
Audit Trails and internal review
Annual Review
6.12 Every Member shall conduct a review, at least
annually, of the business in which he engages, which shall be reasonably
designed to assist in compliance with and detecting and preventing violations
of the provisions contained in the Rules, Bye Laws, Regulations of the
Derivatives Segment, any circulars, notices, notifications, decisions, etc. of
SEBI, the Derivatives Segment and/or the Clearing House.
An
audit is mandated to be carried out every year by each member and the audit
report is to be submitted to the exchange. The exchange also has the right to
inspect the books of any member by surprise[48] and
visit the place of recordkeeping of such member.
Recordkeeping
Most records are required to be
maintained for a period of at least 5 years. In the event of dispute, the
records must be maintained for 5 years after the resolution of the dispute.
Suitability
The
following suitability requirements are mentioned in the bye-laws of the
exchange:
6.21 When establishing a relationship with a new
Client, the Trading Member shall take reasonable steps to assess the
background, genuineness, beneficial identity and financial soundness of such
person, and his investment objectives and such other matters as the Derivatives
Segment may specify by asking the new Client to fill in a “Client Registration Form” as may be specified by the Derivatives
Segment.[49]
6.24 A Trading Member shall not recommend to a Client sale
or purchase of any Derivatives Contracts unless he has reasonable grounds to
believe that such recommendation is suitable for the Client on the basis of
facts, if any, disclosed by the Client, whether in writing or orally, regarding
the objectives of the Client in entering into Derivatives Contracts, holding of
underlying securities, and his financial soundness and investments.
The
member is required to enquire the client’s background and get its clients to
read a generic boilerplate known as a Risk Disclosure Document which explains
briefly the risks involved in trading in derivatives. It is anybody’s guess how
much the generic boilerplate protects anyone in case of a dispute, however,
giving the client such a document has become an international norm.
Fiduciary
duty to use derivatives.
On the other hand in some parts of the world people are
being sued for non-use of derivatives[50].
There may often arise situations where a person
actually violates his/her fiduciary duty by not using derivatives, when
prudence of a reasonable person dictates otherwise. Modern portfolio theory, has invalidated the traditional tests for
distinguishing speculation from prudent investment. For instance, a mutual fund
which has collected money for the fund will not be able to invest the money in
a short period of time. Thus as a fiduciary of the owners of the fund units,
and its duty to be invested in the stock market, the fund should buy index
futures till the time it is fully invested in the markets as per its mandate to
invest.
Fraudulent and manipulative
activities
A
member is proscribed from various forms of fraudulent and manipulative conduct under
the exchange bye-laws. These include[51]
front running, churning, issuing misleading
information, creating a false market, wash sales, any misconduct fraud or
unprofessional behavior. Undisclosed markups are also proscribed i.e.
undisclosed commission or other charge is not permitted.
Besides disciplinary action
against the member the exchange has the right to annul[52]
trades and declare them as void if there is fraud, willful misrepresentation or
material mistake. Collaterally, SEBI can impose its own arsenal of penalties
and fines or initiate criminal proceedings.
Developing issues
Though at this stage no real
frauds by way of manipulation have been unearthed – the potential of
manipulation always remains high. It is known that not only does the cash
market affect the derivatives because derivatives are dependent on their value,
but also the derivatives market affect the cash
market. This raises the ogre of people manipulating the derivatives market –
because of the ease with which positions can be leveraged; affecting the market
becomes a serious issue not just with manipulation but also insider trading.
Though a person can lose
money manipulating markets, it is nearly impossible to lose money doing insider
trading on material information. A typical insider would most likely buy futures
on individual stocks, though buying options on the stock would also be an
attractive strategy albeit a little more expensive. With a margin of
approximately 10%, leverage would help the person purchase the equivalent of 10
times what he/she could purchase in the cash market.
Though no ready solutions
exist to remedy these issues – effective and decisive punishment would send the
right signals in the market. Effective surveillance is the key to limiting
these malpractices. Sharing surveillance methods and tactics across regulators
in different countries would bring about enforcement on an international scale
and cross border operators would be wary of the regulatory eye of several
regulators.
IV. INTERNATIONAL PERSPECTIVE
Though
Cross border transactions
A
person authorized to trade in the Indian markets, for instance FIIs, can
maintain a trading terminal outside
Internet trading of derivatives
Trading
in derivatives through the internet has not yet fully taken off and once
trading is offered through the internet[53]
further issues of cross border enforcement would arise. The misuse of the
internet to enter into cross border trades without following the regulations of
both countries would arise. Though the systemic integrity of the derivatives
market is not expected to be compromised by such improper trades, violations of
‘offer’ and broker-dealer regulations of foreign countries are likely. Such
violations are likely to raise issues of enforcement. For instance if an FII or
other foreign body registered in India starts trading in derivatives through
the internet, and then places some trades from its home country without
specific permission from its home country, the Indian broker might be found to
have violated the broker-dealer regulations of that country even though the
broker actually offered the internet access to the client for legitimate
trades. Several similar issues of regulations and enforcement would arise and
would need to be coordinated by the respective countries’ regulators. One of
the best ways to coordinate regulations of different countries is for the
countries to come to an agreement as to the extent of regulations which would
amount to acceptable regulations by the other countries and therefore minimize
duplicity of cross border regulations.
Role of IOSCO
IOSCO,
for one, has played a pivotal role in getting regulators of different countries
together. They document the various regulations in various countries and set a minimal
framework to be followed by all countries. One such framework was the Report of
the Technical Committee of the IOSCO on “Principles
for the Oversight of Screen Based Trading Systems for Derivatives Products –
Review and Additions” which states the benefits of cross border markets:
Potential benefits of cross-border markets
Properly
regulated, electronic trading systems offering market participants the
opportunity to enter directly into the trading process from anywhere in the
world have the potential to contribute materially to increasing the efficiency
of the market process. In particular,
they may:
·
make more instruments accessible to
larger pools of liquidity, thus helping to promote the efficient allocation of
resources;
·
enable investors more easily to
deploy their savings internationally, also helping to promote the efficient
allocation of resources;
·
give intermediaries the opportunity
to enhance their operating efficiency by enabling them to participate in
markets in which otherwise they might not, and/or to centralize their regional
or global trading operations;
·
give the operators of trading
platforms greater opportunity to increase volumes, and to achieve economies of
scale; and
open the trading process to more
vigorous competition and innovation.
Regulatory issues
However,
systems with participants in multiple jurisdictions also raise fundamental
questions as to how regulators in each of those jurisdictions should best:
·
discharge and coordinate their
individual regulatory responsibilities arising from the operation of the
market;
·
address any additional regulatory
risks that arise from the cross-border nature of the market;
·
promote effective regulation while avoiding unnecessary costs.
Annexure
IOSCO Technical
Committee 1990 Principles for the Oversight of Screen-Based Trading Systems for
Derivative Products
1. The
system sponsor should be able to demonstrate to the relevant regulatory
authorities that the system meets and continues to meet applicable legal
standards, regulatory policies, and / or market customer or practice where relevant.
2. The
system should be designed to ensure the equitable availability of accurate and
timely trade and quotation information to all system participants and the
system sponsor should be able to describe to the relevant regulatory
authorities the processing, prioritization, and display of quotations within
the system.
3. The
system sponsor should be able to describe to the relevant regulatory
authorities the order execution algorithm used by the system, i.e. the set of
rules governing the processing, including prioritization, and execution of
orders.
4. From
a technical perspective, the system should be designed to operate in a manner
which is equitable to all market participants and any differences in treatment
aiming classes of participants should be identified.
5. Before
implementation, and on periodic basis thereafter, the system and system
interfaces should be subject to an objective risk assessment to identify
vulnerabilities (e.g. the risk of unauthorized access, internal failures, human
errors, attacks, and natural catastrophes) which may exist in the system
design, development, or implementation.
6. Procedures
should be established to ensure the competence, integrity, and authority of
system users, to ensure that systems users are adequately supervised, and that
access to the system is not arbitrarily of discriminatorily denied.
7. The
relevant regulatory authorities and the system sponsor should consider and
additional risk management exposures pertinent to the system, including those
arising form interaction with related financial systems.
8. Mechanisms
should be in place to ensure that the information necessary to conduct adequate
surveillance of the system for supervisory and enforcement purposes is
available to the system sponsor and the relevant regulatory authorities on a
timely basis.
9. The
relevant regulatory authorities and / or the system sponsor should ensure that
system users and system customers are adequately informed of the significant
risks particular to trading through the system.
The liability of the system sponsor, and / or the system providers to
system users and system customers should be described,
especially any agreements that seek to vary the allocation of losses that
otherwise would result by operation of law.
10. Procedures
should be developed to ensure that the system sponsor, system providers, and
system users are aware of and will be responsive to the directives and concerns
of relevant regulatory authorities.