Exploring the Possibilities of Entering in OTC Structured Products Market in India

Present Legal Framework

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, up to 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. 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.
Way Forward

Possible actions to increase trading of standardized OTC derivatives on exchanges or electronic
platforms could involve mandatory requirements, incentives, targets, or a combination of these or other
tools. Any such action should take into account that organized platform trading may be unsuccessful
unless there is a sufficient level of underlying liquidity in the product concerned.
Authorities could place mandatory trading requirements on products that are already traded on
organized platforms, expecting the amount of the overall derivatives market covered by such
requirements to gradually expand as market participants bring more and more standardized OTC
derivatives to exchanges or electronic trading platforms. Alternatively, authorities could mandate that
certain standardized OTC derivatives be traded on an organized platform based upon common principles
that apply across products or on a product by product basis.
Organized platform trading only can be created in particular products if organized exchanges and
electronic trading platforms are willing and able to trade these products, which is based in no
insignificant part on market demand for these products in sufficiently standardized form. If however,
market participants are reluctant to move OTC derivatives contracts onto organized platforms in the
The principal hindrance lurking before the hedgers and
speculators is taxation on derivatives transactions. 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
first place, this approach may not allow authorities to achieve the level of organized platform trading
they desire.
Under another approach, authorities could make a determination regarding the factors which would
make trading the specific standardized OTC derivative product on an organized platform appropriate.
This could apply to all products across asset classes or on a product-byproduct basis based upon factors
specific to each product. The approach would have to address circumstances where there is insufficient
liquidity to support organized platform trading.
Another approach would be to use incentives or targets to encourage organized platform markets to be
created by market participants before, if necessary, mandating that an OTC derivative must be traded
on an organized platform. Some of the benefits of exchange trading (e.g., transparency and efficiency of
price formation, open and fair access, operational efficiency and risk reduction, and liquidity) are subject
to economies of scale and scope, as well as network externalities. Increased price and volume public
transparency for all derivatives transactions, as discussed in more detail in Section 4.4, may decrease the
incentives to trade OTC.
In addition to the steps outlined above that authorities could take to encourage exchange or electronic
platform trading and hence increased public transparency of derivatives transactions, authorities could
act to increase the level of transparency, in a globally consistent manner, not only for those derivatives
products traded on organized platforms, but for all derivatives transactions, including for non-
standardized products traded in the OTC markets. Requiring prices and volumes of such transactions to
be disclosed to the market may counter the incentive that market participants have to develop
needlessly complex and non standardized products to evade organized platform trading and central
clearing requirements.
A cost-benefit analysis of possible measures to increase public price and volume transparency would
need to address, among other things, whether and how meaningful disclosure can be provided to
market, particularly where products are highly customized and complex, and the impact on the
effectiveness of OTC derivatives products as hedging instruments.
Authorities also are encouraged to explore how increased public transparency could be implemented,
including potentially through requiring public disclosure by market participants or TRs.
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 endeavors 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.
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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.

Conclusion
Increasing convertibility on the capital account would accelerate the process of integration of Indian
financial markets with international markets. Some of the necessary preconditions to this as suggested
by the Tarapore committee report are already being met. Increasing convertibility does carry the risk of
removing the insularity of the Indian markets to external shocks like the South East Asian crisis, but a
proper management of the transition should speed up the growth of the financial markets and the
economy. Introduction of derivative products tailored to specific corporate requirements would enable
corporate to completely focus on its core businesses, de-ricking the currency and interest rate risks
while allowing it to gain despite any upheavals in the financial markets.
Increasing convertibility on the rupee and regulatory impetus for new products should see a host of
innovative products and structures, tailored to business needs, The possibilities are many and include
INR options, currency futures, exotic options, rupee forward rate agreements, both rupee and cross
currency swaptions, as well as structures composed of the above to address business needs as well as
create real option.