LEGAL AND REGULATORY ENVIRONMENT

Securities Contracts (Regulation) Act, 1956

The Securities Contracts (Regulation) Act, 1956, aims to prevent undesirable transactions in securities and governs the trading of securities in India. The key concepts related to this act are:

• Definition of Securities: Includes:
  • 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
  • Derivatives
  • Units or any other instrument issued by any collective investment scheme to the investors in such schemes
  • Security receipt as defined in clause (zg) of section 2 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002
  • Units or any other such instrument issued to the investors under any mutual fund scheme
  • Any certificate or instrument (by whatever name called), issued to an investor by any issuer being a special purpose distinct entity which possesses any debt or receivable, including mortgage debt, assigned to such entity, and acknowledging beneficial interest of such investor in such debt or receivable, including mortgage debt, as the case may be
  • Government securities
  • Such other instruments as may be declared by the Central Government to be securities
  • Rights or interests in securities
• Definition of Derivatives: 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 contract which derives its value from the prices, or index of prices, of underlying securities
  • Commodity derivatives
  • Such other instruments as may be declared by the Central Government to be derivatives
• Legality and Validity of Derivative Contracts: According to Section 18A, contracts in derivatives are legal and valid if they are:
  • Traded on a recognized stock exchange
  • Settled on the clearing house of the recognized stock exchange, in accordance with the rules and bye-laws of such stock exchanges

Securities and Exchange Board of India Act, 1992

• Establishment: The SEBI Act, 1992 provides for the establishment of the Securities and Exchange Board of India (SEBI) with statutory powers.
• Objectives: The main objectives of SEBI are to:
  • Protect the interests of investors in securities
  • Promote the development of the securities market
  • Regulate the securities market
• Regulatory Jurisdiction: SEBI's regulatory jurisdiction extends over:
  • Corporates in the issuance of capital and transfer of securities
  • All intermediaries and persons associated with the securities market
• Powers of SEBI: SEBI has the power to:
  • Regulate stock exchanges and other securities markets
  • Register and regulate stock brokers, sub-brokers, etc.
  • Promote and regulate self-regulatory organizations
  • Prohibit fraudulent and unfair trade practices relating to securities markets
  • Conduct inspections, inquiries, and audits of stock exchanges, mutual funds, and other persons associated with the securities market
  • Perform functions delegated by the Central Government under the Securities Contracts (Regulation) Act, 1956

Regulations in Trading

• Introduction to Derivatives Trading: The L.C. Gupta committee was set up by SEBI to develop a regulatory framework for derivatives trading in India. The committee's recommendations were accepted by SEBI on May 11, 1998, and derivatives trading was introduced in a phased manner, starting with stock index futures.
• Regulatory Framework: The provisions in the SCRA and the regulatory framework developed thereunder govern trading in securities. The amendment of the SCRA to include derivatives within the ambit of ‘securities’ made trading in derivatives possible within the framework of that Act.
• Eligibility Criteria for Exchanges: Any exchange fulfilling the eligibility criteria as prescribed in the L.C. Gupta committee report can apply to SEBI for grant of recognition under Section 4 of the SCRA, 1956 to start trading derivatives. The derivatives exchange/segment should have a separate governing council and representation of trading/clearing members shall be limited to a maximum of 40% of the total members of the governing council.
• Membership Requirements:
  • The Exchange should have a minimum of 50 members.
  • The members of an existing segment of the exchange would not automatically become the members of the derivative segment.
  • The members of the derivative segment would need to fulfill the eligibility conditions as laid down by the L.C. Gupta committee.
• Clearing and Settlement: The clearing and settlement of derivatives trades would be through a SEBI-approved clearing corporation. Clearing corporations, complying with the eligibility conditions as laid down by the committee, have to apply to SEBI for grant of approval.
• Registration Requirements: Derivative brokers/dealers and clearing members are required to seek registration from SEBI. This is in addition to their registration as brokers of existing stock exchanges.
• Net Worth Requirements: The minimum net worth for clearing members of the derivatives clearing corporation shall be Rs.300 Lakhs. The net worth of the member shall be computed as follows:
  • Capital + Free reserves
  • Less non-allowable assets such as fixed assets, pledged securities, member’s card, non-allowable securities (unlisted securities), bad deliveries, doubtful debts and advances, prepaid expenses, intangible assets, and 30% marketable securities.
• Contract Value and Margin Requirements:
  • The minimum contract value shall not be less than Rs 5,00,000 (subject to change as per SEBI and Exchange rules).
  • The initial margin requirement, exposure limits linked to capital adequacy, and margin demands related to the risk of loss on the position will be prescribed by SEBI/Exchange from time to time.
• Risk Disclosure and Client Registration: The L.C. Gupta committee report requires strict enforcement of the “Know your customer” rule and requires that every client shall be registered with the derivatives broker. The members of the derivatives segment are also required to make their clients aware of the risks involved in derivatives trading by issuing to the client the Risk Disclosure Document and obtaining a copy of the same duly signed by the client.
• Qualification and Approval: Trading members are required to have qualified approved users and sales persons who have passed a certification program approved by SEBI.
• Collateral Deposits: Members and authorized dealers have to fulfill certain requirements and provide collateral deposits to become members of the F&O segment. All collateral deposits are segregated into cash component (cash, bank guarantee, fixed deposit receipts, T-bills, and dated government securities) and non-cash component (all other forms of collateral deposits like deposit of approved demat securities).
• Inspection and Default:
  • The broker is required to get a Risk Disclosure Document signed by the client at the time of client registration.
  • Trading Members are required to maintain trade confirmation slips and exercise notices from the trading system for a period of 5 years.
  • All member brokers in the derivative segment are required to be inspected by the exchange at least once a year.
  • A default by a member in the derivatives segment is treated as a default in all segments of that exchange and as a default on all exchanges where he is a member.
• Recognition and Regulatory Jurisdiction: The recognition to a stock exchange under the Securities Contract (Regulation) Act 1956 can be granted by the Central Government. It provides for direct and indirect control of virtually all aspects of securities trading and the running of Stock Exchanges and aims to prevent undesirable transactions in securities.
• Penalty and Suspension: A penalty or suspension of registration of a stock broker under the SEBI (Stock Broker) Regulations, 1992 can be ordered if the stock broker violates the provisions of the Act, does not follow the code of conduct, fails to resolve the complaints of the investors, indulges in manipulating, or price rigging or cornering of the market, and more.
• Position Limits: Position limits are the maximum exposure levels which can be assumed by each investor or Clearing Member or the market as a whole. Such position limits are defined by SEBI. Once a Trading Member reaches his position limit, he will not be able to enter any fresh transactions which have the impact of increasing his exposure.

Eligibility Criteria for Membership on Derivatives Segment

• Balance Sheet Net Worth Requirements: SEBI has prescribed a net worth requirement of Rs. 3 crores for clearing members. The clearing members are required to furnish an auditor's certificate for the net worth every 6 months to the exchange. The net worth requirement is Rs. 1 crore for a self-clearing member. SEBI has not specified any net worth requirement for a trading member.
• Liquid Net Worth Requirements: Every clearing member (both clearing members and self-clearing members) has to maintain at least Rs. 50 lakhs as Liquid Net Worth with the exchange / clearing corporation.
• Certification Requirements: The members are required to pass the certification programme approved by SEBI. Further, every trading member is required to appoint at least two approved users who have passed the certification programme. Only the approved users are permitted to operate the derivatives trading terminal.

Standard Operating Procedure in the case of default by TM or CM

• Definition: A set of actions to be taken by stock exchanges, clearing corporations, and depositories in the event of a possible default by a Trading Member (TM) or Clearing Member (CM).
• Details: The actions are outlined in the Standard Operating Procedure (SOP) to protect the interests of non-defaulting clients of the TM.

Key Actions in the SOP

• The Clearing Member of the TM is required to take necessary actions as per the SOP.
• As an interim measure, stock exchanges and clearing corporations are required to:
  • Settle credit balances of small investors (those with balances less than Rs.25 lakh) using unencumbered deposits.
  • Pay investors with credit balances exceeding Rs.25 lakh on a pro-rata basis from the remaining funds.