REGULATORY FRAMEWORK FOR EXCHANGE TRADED CURRENCY DERIVATIVES

Regulatory Framework for Exchange Traded Currency Derivatives

• Introduction: Exchange-traded currency derivatives are jointly regulated by the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI).
• Key Authorities:
  • RBI: Regulates the foreign exchange market, with powers conferred by the Foreign Exchange Management Act, 1999 (FEMA) and the Reserve Bank of India Act, 1934.
  • SEBI: Regulates exchange-traded derivative contracts, with powers conferred by the Securities Contracts (Regulation) Act, 1956 and the SEBI Act, 1992.
• Entity Regulations:
  • Exchanges and Clearing Corporations: Frame operational rules and procedures under their bye-laws for exchange-traded currency derivatives, within the statutory regulations of RBI and SEBI.

Key Concepts

• Securities Contracts (Regulation) Act, 1956:
  • Definition of Securities: Includes shares, bonds, debentures, derivatives, and other financial instruments.
  • Definition of Derivatives: Includes securities derived from debt instruments, shares, loans, and contracts for differences.
• RBI-SEBI Standing Technical Committee:
  • Purpose: Coordinates regulatory roles of RBI and SEBI in regard to trading of currency and interest rate futures on exchanges.
  • Terms of Reference: Includes evolving norms, overseeing implementation, suggesting eligibility norms, and reviewing product design and risk mitigation measures.
• Foreign Exchange Management Act, 1999:
  • Objective: Facilitates external trade and payments, and maintains the foreign exchange market in India.
  • Key Definitions: Includes authorized person, foreign exchange, foreign currency, and person resident in India.
• SEBI Regulation and Guideline:
  • SEBI Act, 1992: Establishes SEBI with statutory powers to protect investor interests, promote securities market development, and regulate the securities market.

Regulatory Framework for Exchange Traded Currency Derivatives

• Introduction: The regulatory jurisdiction for exchange-traded currency derivatives in India extends to corporates, intermediaries, and persons associated with securities, with the Securities and Exchange Board of India (SEBI) playing a major role in regulation and development.
• SEBI Powers: SEBI has full autonomy and authority to regulate and develop an orderly securities market, with powers to:
  • Regulate the business in stock exchanges and other securities markets.
  • Register and regulate stock brokers, authorized persons, etc.
  • Promote and regulate self-regulatory organizations.
  • Prohibit fraudulent and unfair trade practices.
  • Conduct inspections, inquiries, and audits of stock exchanges, mutual funds, and other persons associated with the securities market.

SEBI Guidelines for Exchange Traded Currency Derivatives

• Trading: SEBI guidelines related to trading, clearing, and settlement, risk management, surveillance, investor grievance, and protection are applicable for exchange-traded currency derivatives.
• Key Points:
  • A recognized stock exchange must obtain SEBI's approval to set up a currency derivatives segment.
  • The exchange must submit an application with details of the proposed currency derivatives product and proposed bye-laws.
  • Membership of the currency derivatives segment is separate from other segments of the exchange.
  • SEBI has allowed banks to take membership of exchange-traded currency derivatives subject to eligibility criteria.
  • Trading members must have approved users and sales personnel with applicable certifications.
  • SEBI provides guidelines on contract specifications, position limits, surveillance systems, and market integrity.

SEBI Guidelines for Clearing Corporations

• Clearing and Settlement: A clearing corporation must obtain SEBI's approval for undertaking clearing and settlement related to trades in currency derivatives.
• Key Points:
  • The clearing corporation must perform full novation, becoming the legal counterparty to both legs of every trade.
  • SEBI has allowed interoperability of clearing corporations for currency derivatives segments.
  • Guidelines are provided on clearing and settlement, risk management, and margining mechanisms.
  • A separate Core Settlement Guarantee Fund (CSGF) is required for the currency derivatives segment.

RBI Regulation and Guidelines

• Introduction: The Reserve Bank of India (RBI) has the power to make regulations to promote orderly development and maintenance of the foreign exchange market in India.
• Key Points:
  • RBI provides guidelines on currency futures, exchange-traded currency options, and foreign exchange derivative contracts.
  • Directions are given on eligible currency pairs, eligible participants, contract features, membership guidelines, position limits, and risk management measures.
  • RBI also provides regulations on foreign exchange management, including definitions, provisions for authorized dealers, and remittance-related matters.

Foreign Exchange Dealers’ Association of India (FEDAI)

• Introduction: FEDAI is a self-regulatory body incorporated under the Companies Act, 1956, to frame rules governing inter-bank foreign exchange business and liaison with RBI for reforms and development of the forex market.
• Key Functions:
  • Guidelines and rules for forex business.
  • Training of bank personnel in foreign exchange business.
  • Accreditation of forex brokers.
  • Advising/assisting member banks in settling issues.
  • Representing member banks on government/RBI/other bodies.
  • Announcement of daily and periodic rates to member banks.

Regulatory Framework for Exchange Traded Currency Derivatives (Part 3)

Introduction to Regulatory Guidelines

• Regulatory Guidelines: The regulatory framework for exchange-traded currency derivatives (ETCD) in India is governed by the Foreign Exchange Management Act, 1999, and the Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulations, 2000.
• Objectives: The primary objective of these regulations is to provide a framework for the participation of various entities in ETCD, ensuring that the market operates in an orderly and efficient manner.

Participation of Various Entities in ETCD

• Authorized Dealer Category I Banks: AD Category I banks are permitted to become trading and clearing members of the currency derivatives market, subject to fulfilling minimum prudential requirements such as a minimum net worth of Rs. 500 crores and a minimum CRAR of 10%.
• Person Resident in India: A person resident in India may enter into an exchange-traded currency derivatives contract on an exchange, subject to provisions of the Foreign Exchange Management Act, 1999, and regulations issued by RBI and SEBI.
• Foreign Portfolio Investor (FPI): FPIs may enter into an exchange-traded currency derivative contract on an exchange, subject to provisions of the Foreign Exchange Management Act, 1999, and regulations issued by RBI and SEBI.
• Non-Banking Financial Institutions: Applicable NBFCs may participate in the designated currency futures on exchanges recognized by SEBI as clients, subject to guidelines issued by the RBI.
• Primary Dealers: Standalone Primary Dealers (SPD) with a minimum Net Owned Fund of ₹250 crore may participate in currency futures, subject to guidelines issued by the RBI.

Position Limits for Various Entities

• Authorized Dealer Category I Banks: AD Category I banks may undertake trading in all permitted exchange-traded currency derivatives within their Net Open Position Limit (NOPL).
• Person Resident in India: A person resident in India may take positions up to a single limit of USD 100 million equivalent across all currency pairs involving INR.
• Foreign Portfolio Investor (FPI): FPIs may take positions up to a single limit of USD 100 million equivalent across all currency pairs involving INR.
• Primary Dealers: SPDs are subject to aggregate gross open position limits across all contracts in all stock exchanges in the respective currency pairs.

Reserve Bank of India Intervention in ETCD

• RBI Intervention: The RBI may intervene in the ETCD segment to manage excessive volatility and maintain orderly conditions in the market.
• Guidelines: The RBI has issued guidelines for users of currency derivatives, including position limits and requirements for hedging contracted exposures.

Eligibility Criteria for Members

• Membership: The membership of the Currency Derivatives Segment is separate from the membership of other segments of the exchange.
• Net Worth: Stock brokers and clearing members must have a minimum net worth and deposit a minimum sum with the stock exchange or clearing corporation to participate in the Currency Derivatives Segment.

Regulatory Framework for Exchange Traded Currency Derivatives (Part 4)

Net Worth and Deposit Requirements

• The net worth of a stock broker/clearing member shall be reckoned for all segments/stock exchanges.
• The deposit to be maintained by the stock broker/clearing member shall be separately calculated segment-wise.

Registration Requirements

• A single registration with any stock exchange/clearing corporation is required.
• For operating in any other stock exchange(s)/clearing corporation(s), approval is required from the concerned stock exchange or clearing corporation.

Eligibility Criteria for Trading Members

• Age: Minimum 21 years
• Capital Adequacy: Minimum Base Minimum Capital (BMC) requirements apply
• Financial Track Record: Minimum 2 years of experience in securities-related activities
• Education: At least HSC or equivalent qualification
• Fit and Proper Person criteria as laid down in the SEBI (Intermediaries) Regulations, 2008

Base Minimum Capital (BMC)

• Definition: The deposit given by the member of the exchange against which no exposure for trades is allowed.
• Categories and BMC Deposits:
  • Only Proprietary trading without Algorithmic trading (Algo): Rs 10 Lacs
  • Trading only on behalf of clients (without proprietary trading) and without Algo: Rs 15 Lacs
  • Proprietary trading and trading on behalf of clients without Algo: Rs 25 Lacs
  • All Brokers with Algo: Rs 50 Lacs

Eligibility Criteria for Membership

• Individual Trading Membership:
  • Age: Minimum 21 years
  • Status: Indian Citizen
  • Education: At least HSC or equivalent qualification
  • Experience: Minimum 2 years of experience in securities-related activities
• Partnership Firms:
  • Registered under the Indian Partnership Act, 1932
  • Minimum 2 designated partners with at least 2 years of experience in securities-related activities
• Limited Liability Partnership (LLP):
  • Registered under the Limited Liability Partnership Act, 2008
  • Minimum 2 designated partners with at least 2 years of experience in securities-related activities
• Corporations/Companies/Institutions:
  • Registered under the Companies Act, 1956 or 2013
  • Minimum paid-up equity capital of Rs 30 lakhs
  • Minimum 2 designated directors with at least 2 years of experience in securities-related activities

Other Criteria

• Certification Requirements: The applicant entity must have at least one proprietor/director/partner or Compliance Officer meeting the certification requirements specified by SEBI or the Stock Exchanges.
• Investor Service and Infrastructure: The Exchange may specify standards for investor service and infrastructure for any category of applicants.
• Ineligibility Criteria: Certain entities are not eligible to become members, including those that have been adjudged bankrupt, convicted of an offence involving fraud or dishonesty, or expelled or declared a defaulter by any other Stock Exchange.

Regulatory Framework for Exchange Traded Currency Derivatives

• Membership Eligibility: The Exchange may disqualify individuals from seeking membership if they have been disqualified under the Securities Contracts (Regulation) Act, 1956 or rules made thereunder.
• Disqualification Criteria: The Exchange may consider the following factors to determine if an individual is fit to be a member:
  • Incurrence of disqualification under the Securities Contracts (Regulation) Act, 1956 or rules made thereunder
  • Disqualification due to actions not in the public interest, as determined by the Exchange
  • Relevant experience, which may be modified or expanded by the Exchange from time to time

Fit and Proper Person

• Definition: A fit and proper person is determined by the SEBI Board, taking into account various considerations, including:
  • Integrity, reputation, and character
  • Absence of convictions and restraints orders
  • Competence, including financial solvency and net worth
  • Absence of categorization as a willful defaulter
• Applicability: The fit and proper person criteria apply to the applicant, stock broker, authorized persons, trading members, clearing members, principal officers, directors, promoters, and key management persons.

Authorized Person

• Definition: An authorized person is an individual, partnership firm, LLP, or body corporate appointed by a stock broker to provide access to the trading platform of a stock exchange.
• Requirements: Authorized persons must:
  • Be appointed by a stock broker (including trading members)
  • Obtain specific prior approval from the exchange for each person
  • Satisfy criteria specified by SEBI/stock exchanges from time to time
  • Have necessary infrastructure, such as office space, equipment, and manpower
• Note: The Authorized Person defined under FEMA and the Authorized Person as per SEBI are two different entities.

Sample Questions and Answers

• Question 1: Which act is mainly responsible for governing securities trading in India?
  • Answer: SC(R)A, 1956 (Securities Contracts (Regulation) Act, 1956)
• Question 2: Which market participants are allowed to trade in currency futures?
  • Answer: All of the above (Individual, NRIs, Corporates)
• Question 3: Which market participants are allowed to become members of the Currency Derivatives segment of an exchange?
  • Answer: All of the above (Individual, AD Category I Bank, Corporates)