Introduction

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.
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. 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 endeavors 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. 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. 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 today’s 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. 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 up to 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 are another kind of options having a maturity of up
to three years. LEAPS are 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 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. 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. 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. In
1995, the ban on badla was, however, lifted subject to certain
safeguards. 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.
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. 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. 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. 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. 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. 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. 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 assesses 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.

Conclusion
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.
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.