Regulatory Environment for Exchange Traded IRD

Regulatory Environment for Exchange Traded IRD (Part 1)

Introduction to Regulatory Framework: The Indian securities market is regulated by various entities, including SEBI (Securities and Exchange Board of India), RBI (Reserve Bank of India), IRDAI (Insurance Regulatory and Development Authority of India), PFRDA (Pension Fund Regulatory and Development Authority), and IFSCA (International Financial Services Centres Authority).
Role of Regulators:
- SEBI: Regulates the securities market and commodity derivatives market.
- RBI: Regulates and monitors the banking sector, and has primary and fundamental role in regulation of government securities.
- IRDAI: Regulates the insurance sector.
- PFRDA: Regulates the pension fund sector.
- IFSCA: Unified authority for development and regulation of financial products, services, and institutions in IFSCs.
Regulatory Framework for Exchange Traded Interest Rate Derivatives (ETIRD):
- SEBI and RBI Regulations: ETIRD are jointly regulated by SEBI and RBI.
- Statutory Regulations and Operational Rules: Exchanges and Clearing Corporations frame operational rules and procedures under their bye-laws for ETIRD.
Key Concepts:
- Securities Contracts (Regulation) Act, 1956: Provides direct and indirect control over securities trading and stock exchanges.
- Definition of Securities: Includes shares, debentures, bonds, derivatives, and government securities.
- Derivatives: Defined as a security derived from a debt instrument, share, loan, or contract for differences.
RBI-SEBI Standing Technical Committee:
- Established: To coordinate regulatory roles of RBI and SEBI in regard to trading of currency and interest rate futures.
- Terms of Reference: Include evolving norms, overseeing implementation, suggesting eligibility norms, and reviewing product design and risk mitigation measures.
RBI Guideline on ETIRD:
- Rupee Interest Rate Derivatives (Reserve Bank) Directions, 2019: Applicable to rupee interest rate derivatives transactions on recognized stock exchanges and OTC markets.
- Important Definitions: Include interest rate derivative, interest rate futures, interest rate option, recognized stock exchange, regulated entity, non-resident, and non-retail users.

Regulatory Environment for Exchange Traded IRD (Part 2)

Eligible Entities: The following entities are eligible to participate in IRDs:
- Companies
- Mutual funds, pensions funds, and other collective investment vehicles
- All India Financial Institutions (AIFIs) such as Exim Bank, NABARD, NHB, and SIDBI
- Companies or entities with a net worth of ₹5 billion or above
Eligible Participants: Any person resident in India and non-residents (to the extent specified) are eligible to participate in IRDs. Regulated entities must participate with the permission of their respective regulators.
Trading Venues: IRD contracts can be transacted on Recognized Stock Exchanges or Over-the-Counter (OTC), including Electronic Trading Platforms (ETPs).
Interest Rate Derivatives on Recognized Stock Exchanges: Exchanges are permitted to offer standardized IRD products, with prior approval from the Reserve Bank for new products or modifications.
Non-Resident Participation: Non-residents can undertake Rupee interest rate derivatives transactions for hedging interest rate risk using products transacted on recognized stock exchanges.
SEBI Regulation and Guidelines: SEBI plays a major role in regulating exchange-traded interest rate derivatives, with guidelines on trading, clearing, and settlement, risk management, surveillance, and investor protection.
SEBI Guidelines for Trading: SEBI provides guidelines on contract specification, position limits, surveillance systems, and market integrity for trading in IRDs.
SEBI Guidelines for Clearing Corporation: SEBI provides guidelines on clearing and settlement, risk management, and core settlement guarantee funds for clearing corporations.
Participation of Various Entities: Banks, primary dealers, mutual funds, and other entities can participate in ETIRD, with guidelines provided by RBI and SEBI for their participation.
Banks and Primary Dealers: Banks and primary dealers are permitted to participate in IRD for hedging and trading purposes, subject to certain conditions and guidelines.
Mutual Funds: Mutual funds are allowed to participate in ETIRD, with guidelines provided by SEBI for their participation, including norms for investment and disclosure.

Regulatory Environment for Exchange Traded IRD (Part 3)

Introduction to G-Sec Market: The primary objectives of the PD system are to strengthen the infrastructure in the G-Sec market, develop underwriting and market-making capabilities for G-Sec, improve the secondary market trading system, and make PDs an effective conduit for open market operations (OMO).
Regulatory Guidelines: For additional details, participants can refer to the SEBI master circular for Mutual Funds dated June 27, 2024.
Imperfect Hedging: In case the IRF used for hedging the interest rate risk has different underlying security(s) than the existing position being hedged, it would result in imperfect hedging.
Exemption from Gross Exposure: Imperfect hedging using IRFs may be considered exempt from the gross exposure, up to a maximum of 20% of the net assets of the scheme, subject to certain conditions, including:
- Exposure to IRFs is created only for hedging the interest rate risk based on the weighted average modified duration of the bond portfolio or part of the portfolio.
- The correlation between the portfolio or part of the portfolio and the IRF is at least 0.9 at the time of initiation of the hedge.
- At no point in time should the net modified duration of part of the portfolio being hedged be negative.
- The portion of imperfect hedging in excess of 20% of the net assets of the scheme should be considered as creating exposure and shall be included in the computation of gross exposure.
Mutual Funds: Mutual Funds adhere to other norms for investment and disclosure in derivatives as specified by SEBI from time to time.
Insurance Companies: IRDAI has provided guidelines for insurance companies' participation in Interest Rate Futures only, and it is only for long hedge.
Foreign Portfolio Investors: A non-resident may undertake Rupee interest rate derivatives transactions in India for hedging purposes or for purposes other than hedging, subject to certain conditions.
NBFCs: Applicable NBFCs can participate in the designated interest rate futures (IRF) exchanges recognized by SEBI as clients, for the purpose of hedging their underlying exposures.
Role of FIMMDA: The Fixed Income Money Market and Derivatives Association of India (FIMMDA) is an association of Scheduled Commercial Banks, Financial Institutions, Primary Dealers, and Insurance Companies, and it plays a crucial role in the development of the fixed income and derivatives market in India.
Role of Financial Benchmarks India Private Ltd. (FBIL): FBIL is responsible for administering benchmarks relating to the money market, government securities, and foreign exchange in India, and it plays a crucial role in the interest rate market and interest rate derivatives market.

Regulatory Environment for Exchange Traded IRD (Part 4)

Introduction: The regulatory environment for exchange-traded IRD is governed by SEBI regulations and stock exchange rules.
Clearing Member Requirements:
- The clearing member/self-clearing member must have a minimum net worth and deposit a minimum sum specified by SEBI or the stock exchange.
- The net worth and deposit requirements are reckoned for all segments/stock exchanges.
- The quantum of deposit is separately calculated segment-wise.
Registration Requirements:
- New entities must apply to SEBI through the stock exchange or clearing corporation to register as a stock broker or clearing member.
- A single registration with any stock exchange/clearing corporation is required, and approval is needed from the concerned stock exchange or clearing corporation for operating in other segments.
Eligibility Criteria for Trading Members:
- Admission as a trading member is based on criteria like age, capital adequacy, financial track record, education, experience, and fulfillment of "fit & proper person" criteria.
- Exchanges may stipulate additional requirements over and above SEBI-prescribed rules.
Base Minimum Capital (BMC):
- Definition: BMC is the deposit given by the member against which no exposure for trades is allowed.
- Categories and Deposit Requirements:
  - Proprietary trading without algorithmic trading: Rs 10 Lacs
  - Trading on behalf of clients without proprietary trading and algorithmic trading: Rs 15 Lacs
  - Proprietary trading and trading on behalf of clients without algorithmic trading: Rs 25 Lacs
  - All brokers with algorithmic trading: Rs 50 Lacs
- Key Points:
  - The BMC deposit meets contingencies in any segment of the exchange.
  - The highest BMC deposit across segments is applicable for members registered on multiple segments.
  - No exposure is granted against the BMC deposit.
  - Stock exchanges can prescribe additional deposit requirements based on risk perception.
  - At least 50% of the deposit must be in cash and cash equivalents.
Eligibility Criteria:
- Individual Trading Membership:
  - Age: Minimum 21 years
  - Status: Indian citizen
  - Education: At least HSC or equivalent qualification
  - Experience: At least 2 years' experience in securities dealing
- Partnership Firms:
  - Age: Minimum 21 years for designated partners
  - Status: Registered partnership firm under the Indian Partnership Act, 1932
  - Education: Designated partners must have at least HSC or equivalent qualification
  - Experience: Designated partners must have at least 2 years' experience in securities dealing
- Limited Liability Partnership (LLP):
  - Status: Registered LLP under the Limited Liability Partnership Act, 2008
  - Designated Partners: At least two partners must be identified, with minimum age 21 years, HSC or equivalent qualification, and 2 years' experience in securities dealing
- Corporations/Companies/Institutions:
  - Status: Registered company under the Companies Act, 2013
  - Minimum Paid-up Equity Capital: As specified by SEBI (currently Rs 30 lakhs)
  - Designated Directors: At least two directors must be identified, with minimum age 21 years, HSC or equivalent qualification, and 2 years' experience in securities dealing
Other Criteria:
- The applicant must ensure that either the proprietor, designated director, partner, or compliance officer meets SEBI-specified certification requirements.
- Members must satisfy minimum net worth and deposit requirements as specified by SEBI, exchanges, or clearing corporations.
- Exchanges may specify standards for investor service and infrastructure.
Ineligibility: Certain entities or individuals may be ineligible to become members, as per SEBI regulations and exchange rules.

Regulatory Environment for Exchange Traded IRD (Part 5)

Disqualification Criteria: The following entities shall not be admitted as a member/partner or director of the member:
- Those adjudged bankrupt or have a receiver order in bankruptcy against them
- Those who have compounded with creditors for less than full discharge of debts
- Those convicted of an offence involving fraud or dishonesty
- Those engaged in a business other than securities or commodity derivatives as a principal or employee
- Those expelled or declared a defaulter by any other Stock Exchange or debarred from trading in securities by Regulatory Authorities
- Those disqualified under the Securities Contract (Regulations) Act, 1956 or Rules made there-under
Fit and Proper Person: SEBI considers the following criteria to determine if an applicant or intermediary is a fit and proper person:
- Integrity, reputation, and character
- Absence of convictions and restraints order
- Competence, including financial solvency and net worth
- Absence of categorisation as a wilful defaulter
Authorized Person (AP): An AP is an individual or entity appointed by a Stock Broker to operate the trading workstations of the Currency Derivatives Segment, with the approval of the exchange. The AP should:
- Satisfy the criteria specified by SEBI/stock exchanges
- Have the necessary infrastructure, office space, equipment, and manpower
- Enter into a written agreement with the Trading Member, covering scope of activities, responsibilities, confidentiality, commission sharing, and termination clause
- Be responsible for all acts of omission and commission, with the Trading Member deemed responsible for the AP's actions