SEBIs L C Gupta Committee

SEBI appointed L.C.Gupta Committee on 18th November 1996 to develop appropriate regulatory framework for the derivatives trading and to recommend suggestive bye-laws for Regulation and Control of Trading and Settlement of Derivatives Contracts. The Committee was also to focus on the financial derivatives and equity derivatives. The Committee submitted its report in March 1998.

The Board of SEBI in its meeting held on May 11, 1998 accepted the recommendations and approved the introduction of derivatives trading in India beginning with Stock Index Futures. The Board also approved the "Suggestive Bye-laws" recommended by the LC Gupta Committee for Regulation and Control of Trading and Settlement of Derivatives Contracts. SEBI circulated the contents of the Report in June 98.

The LC Gupta Committee had conducted a wide market survey with contact of several entities relevant to derivatives trading like brokers, mutual funds, banks/FIs, FIIs and merchant banks. The Committee observation was that there is a widespread recognition of the need for derivatives products including Equity, Interest Rate and Currency derivatives products. However Stock Index Futures is the most preferred product followed by stock index options. Options on individual stocks is the third in the order of preference. The participants took interviews, mostly stated that their objective in derivative trading would be hedging. But there were also a few interested in derivatives dealing for speculation or dealing.

Goals of Regulation - Regulatory Objectives

LCGC believes that regulation should be designed to achieve specific and well-defined goals. It is inclined towards positive regulation designed to encourage healthy activity and behaviour. The Committee outlined the goals of regulation admirably well in Paragraph 3.1 of its report.

The important recommendations of L.C.Gupta Committee are reproduced hereunder.

Need for coordinated development
To quote from the report of the Committee -"The Committee's main concern is with equity based derivatives but it has tried to examine the need for financial derivatives in a broader perspective. Financial transactions and asset-liability positions are exposed to three broad types of price risks, viz:

"Equities "market risk", also called "systematic risk" (which cannot be diversified away because the stock market as a whole may go up or down from time to time).
"Interest rate risk (as in the case of fixed-income securities, like treasury bond holdings, whose market price could fall heavily if interest rates shot up), and
"Exchange rate risk (where the position involves a foreign currency, as in the case of imports, exports, foreign loans or investments).

"The above classification of price risks explains the emergence of (a) equity futures, (b) interest rate futures and (c) currency futures, respectively. Equity futures have been the last to emerge.

"The recent report of the RBI-appointed Committee on Capital Account Convertibility (Tarapore Committee) has expressed the view that "time is ripe for introduction of futures in currencies and interest rates to facilitate various users to have access to a wide spectrum of cost-efficient hedge mechanism" (p.24). In the same context, the Tarapore Committee has also opined that "a system of trading in futures ... is more transparent and cost-efficient than the existing system (of forward contracts)". There are inter-connections among the various kinds of financial futures, mentioned above, because the various financial markets are closely inter-linked, as the recent financial market turmoil in East and South-East Asian countries has shown. The basic principles underlying the running of futures markets and their regulation are the same. Having a common trading infrastructure will have important advantages. The Committee, therefore, feels that the attempt should be to develop an integrated market structure. SEBI-RBI coordination mechanism

"As all the three types of financial derivatives are set to emerge in India in the near future, it is desirable that such development be coordinated. The Committee recommends that a formal mechanism be established for such coordination between SEBI and RBI in respect of all financial derivatives markets. This will help to avoid the problem of overlapping jurisdictions."

Cash and Futures Market Relationship
The Committee felt that the operations of the cash market, on which the derivatives market will be based, needed improvement in many respects. It therefore suggested improvements to the Cash Market.

Derivatives Exchanges
The Committee strongly favoured the introduction of financial derivatives to facilitate hedging in a most cost-efficient way against market risk. There is a need for equity derivatives, interest rate derivatives and currency derivatives. There should be phased introduction of derivatives producs. To start with, index futures to be introduced, which should be followed by options on index and later options on stocks. The derivative trading should take place on a separate segment of the existing stock exchanges with an independent governing council where the number of trading members should be limited to 40 percent of the total number. Common Governing Council and Governing Board members not allowed. The Chairman of the governing council should not be permitted to trade (broking/dealing business) on any of the stock exchanges during his term. Trading to be based on On-line screen trading with disaster recovery site. Per half hour capacity should be 4-5 times the anticipated peak load. Percentage of broker-members in the council to be prescribed by SEBI. Other recommendations of the Committee about the structure of Derivative Exchanges are as under:

The settlement of derivatives to be through an independent clearing corporation/clearing house, which should become counter party for all trades or alternatively guarantee the settlement of all trades. The clearing corporation to have adequate risk containment measures and to collect margins through EFT. The derivative exchange to have both on-line trading and surveillance systems. It should disseminate trade and price information on real time basis through two information vending net works. It should inspect 100 percent of members every year. The segment can start with a minimum of 50 members. The Committee recommended separate membership for derivatives segment. Members of equity segment cannot automatically become members of derivative segment. Provision for arbitration and investor grievances cells to be set up in four regions. Provision of adequate inspection capability and all members to be inspected.

Regulatory framework
Regulatory control should envisage modern systems for fool-proof and fail-proof regulation. Regulatory framework for derivatives trading envisaged two-level regulation i.e. exchange-level and SEBI-level, with considerable emphasis on self-regulatory competence of derivative exchanges under the overall supervision and guidance of SEBI. There will be complete segregation of client money at the level of trading /clearing member and even at the level of clearing corporation. Other recommendations are as under:

Regulatory Role of SEBI
SEBI will approve rules, bye-laws and regulations. New derivative contracts to be approved by SEBI. Derivative exchanges to provide full details of proposed contract, like - economic purposes of the contract;likely contribution to the market's development; safeguards incorporated for investor protection and fair trading.

Specifications Regarding Trading
Stock Exchanges to stipulate in advance trading days and hours. Each contract to have pre-determined expiration date and time. Contract expiration period may not exceed 12 months. The last trading day of the trading cycle to be stipulated in advance.

Membership Eligibility Criteria
The trading and clearing member will have stringent eligibility conditions. The Committee recommended for separate clearing and non-clearing members. There should be separate registration with SEBI in addition to registration with the stock exchange. At least two persons should have passed the certification program approved by SEBI. A higher capital adequacy for Derivatives segment recommended than prescribed for cash market. The clearing members should deposit minimum Rs. 50 lakh with the clearing corporation and should have a net worth of Rs. 3 crore. A higher deposit proposed for Option writers.

Clearing Corporation
The Clearing System to be totally restructured. There should be no trading interests on board of the CC. The maximum exposure limit to be liked the deposit limit. To make the clearing system effective the Committee stressed stipulation of Initial and mark-to-market margins. Extent of Margin prescribed to co-relate to the level of volatility of particular Scrips traded. The Committee therefore recommended margins based on value at risk - 99% confidence (The initial margins should be large enough to cover the one day loss that can be encountered on the position on 99% of the days. The concept is identified as "Worst Scenario Loss"). It did not favour the system of Cross-margining (This is a method of calculating margin after taking into account combined positions in futures, options, cash market etc. Hence, the total margin requirement reduces due to cross-hedges). Since margins to be adjusted frequently based on market volatility margin payments to be remitted through EFT (Electronic Funds Transfer). To prevent brokers who fail/default to provide/restore adequate margin from trading further the stock exchange must have the power/facility to disable the defaulting member from further trading. Brokers/sub-brokers also to collect margin collection from clients. Exposure limits to be on gross basis. Own/clients margin to be segregated. No set off permitted. Trading to be clearly indicated as own/clients and opening/closing out. In case of default, only own margin can be set off against members' dues and the CC should promptly transfer client's margin in separate account. CC to close out all open positions at its option. CC can also ask members to close out excess positions or it may itself close out such positions. CC may however permit special margins on members. It can withhold margin or demand additional margin. CC may prescribed maximum long/short positions by members or exposure limit in quantity / value / % of base capital.

Mark to Market and Settlement
There should the system of daily settlement of futures contracts. Similarly the closing price of futures to be settled on daily basis. The final settlement price to be as per the closing price of underlying security.

Sales Practices

Risk disclosure document with each client mandatory
Sales personnel to pass certification exam
Specific authorisation from client's board of directors/trustees

Trading Parameters

Each order - buy/sell and open/close
Unique order identification number
Regular market lot size, tick size
Gross exposure limits to be specified
Price bands for each derivative contract
Maximum permissible open position
Off line order entry permitted

Brokerage

Prices on the system shall be exclusive of brokerage
Maximum brokerage rates shall be prescribed by the exchange
Brokerage to be separately indicated in the contract note

Margins From Clients

Margins to be collected from all clients/trading members
Daily margins to be further collected
Right of clearing member to close out positions of clients/TMs not paying daily margins
Losses if any to be charged to clients/TMs and adjusted against margins

Other Recommendations

Removal of the regulatory prohibition on the use of derivatives by mutual funds while making the trustees responsible to restrict the use of derivatives by mutual funds only to hedging and portfolio balancing and not for speculation.
Creation of derivatives Cell, a derivatives Advisory Committee, and Economic Research Wing by SEBI.
Declaration of derivatives as securities under section 2(h)(iia) of the SCRA and suitable amendment in the notification issued by the Central Government in June 1969 under section 16 of the SCRA
Consequent to the committee's recommendations the following legal amendments were carried out:

Legal Amendments

Securities Contract Regulation Act
Derivatives contract declared as a 'security' in Dec 1999
Notification in June 1969 under section 16 of SCRA banning forward trading revoked in March 2000.

In order to recommend a guideline for effective implementation of the recommendations of LC Gupta Committee Report, SEBI entrusted the task to another Committee , i.e. JR Verma Committee appointed by it.