Legal and Regulatory Environment

1The Securities Contracts (Regulation) Act, 1956

The SCRA aims to prevent undesirable transactions in securities. Section 2(h) defines securities to include:

• shares, scrips, stocks, bonds, debentures and similar marketable securities of a company or body corporate;
• derivatives;
• units of collective investment schemes and of mutual funds (but not unit-linked insurance policies);
• security receipts under the SARFAESI Act, 2002;
• certificates showing an investor's interest in securitised debt or receivables;
• government securities;
• other instruments the Central Government declares to be securities (for example rupee bonds issued in India by the ADB and IFC);
• rights or interests in securities.

Derivatives under the Act include a security derived from a debt instrument, share, loan, risk instrument, contract for differences or other security; a contract that derives its value from the prices or index of prices of underlying securities; commodity derivatives; and other instruments the government declares.

Section 18A: derivative contracts are legal and valid (whatever any other law says) only if they are traded on a recognised stock exchange and settled through its clearing house, under its rules and bye-laws.

Remember

• Securities definition: Section 2(h). Legality of derivatives: Section 18A.
• ULIPs are not securities.

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2The SEBI Act, 1992

The SEBI Act set up SEBI with statutory powers to protect investors, develop the securities market and regulate it. Its reach covers companies issuing capital and transferring securities, and all intermediaries and persons connected with the market. SEBI's powers include:

• regulating stock exchanges and other securities markets;
• registering and regulating stock brokers and other intermediaries;
• promoting and regulating self-regulatory organisations;
• prohibiting fraudulent and unfair trade practices;
• calling for information, and inspecting, inquiring into and auditing exchanges, mutual funds, intermediaries and SROs;
• exercising SCRA powers delegated by the Central Government.

Remember

• SEBI's three aims: protect investors, develop the market, regulate it.

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3Trading regulations

SEBI set up a committee under Dr L. C. Gupta to design the framework, accepted its recommendations on 11 May 1998 and allowed derivatives in phases, starting with stock index futures. Amending the SCRA to bring derivatives into "securities" made this possible. Key rules:

• An exchange meeting the committee's criteria applies to SEBI for recognition under Section 4 of the SCRA. The derivatives exchange or segment needs a separate governing council, on which trading or clearing members can be at most 40%. The exchange regulates its members' sales practices and needs SEBI approval before launching any contract.
• The exchange must have at least 50 members.
• Members of the existing cash segment do not become derivatives members automatically.
• Clearing is through a SEBI-approved clearing corporation.
• Derivatives brokers, dealers and clearing members must register with SEBI, in addition to their existing broker registration.
• Clearing members need a minimum net worth of ₹300 lakh.

Formula Net worth = capital + free reserves − non-allowable assets (fixed assets, pledged securities, the member's card, unlisted securities, bad deliveries, doubtful debts and advances, prepaid expenses, intangible assets, and 30% of marketable securities)

• Minimum contract value: originally ₹5 lakh; from 20 November 2024, ₹15–20 lakh.
• Margins and exposure limits are set by SEBI and the exchanges from time to time.
• Strict know your customer rules: every client must be registered with the derivatives broker and must sign the Risk Disclosure Document, which explains the risks of derivatives; the broker keeps a signed copy.
• Members need approved users and sales staff who have passed a SEBI-approved certification.

Collateral is split into a cash component (cash, bank guarantees, fixed deposit receipts, T-bills and dated government securities) and a non-cash component (mainly approved demat securities).

Net worth for clearing members is set by SEBI; for trading members and limited trading members (members of the derivatives segment who are not cash market members) by the exchanges.

Other points:

• Trading members keep trade confirmation slips and exercise notices for 5 years.
• Every derivatives broker is inspected by the exchange at least once a year, to check that its books are kept as required.
• A default in the derivatives segment counts as a default in all segments of that exchange and on all exchanges where the member trades.
• Recognition of a stock exchange under the SCRA is granted by the Central Government, which has jurisdiction over exchanges, contracts in securities and listing.

A broker's registration can be penalised or suspended (under the SEBI Stock Broker Regulations) if it violates the Act, breaks the code of conduct, fails to resolve investor complaints, manipulates or corners the market, suffers a serious decline in finances, fails to pay fees, breaches registration conditions, or is suspended by an exchange.

Position limits are set by SEBI. The clearing member sets trading limits for each of its TMs; a TM at its limit can only reduce its exposure, not add to it.

Remember

• Members on the governing council: at most 40%. Minimum 50 members.
• Records kept 5 years; inspection at least yearly.
• A default anywhere is a default everywhere.

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4Clearing, settlement and risk management rules

Membership options include the cash market and F&O segments together, or cash, wholesale debt and F&O together; an existing cash member can add F&O. A TM can also become a clearing member by meeting extra requirements, and some members are clearing members only.

• Initial and exposure margins are paid upfront by clearing members, in cash, bank guarantees, FDRs or approved securities.
• A CM can set a daily collateral limit for each TM and custodial participant it clears for.
• Failing to pay margin, in whole or part, is a violation and attracts penalties and action such as withdrawal of trading or clearing facilities, close-out, extra deposits or invoking bank guarantees.
• A CM's liquid assets must be at least 50% cash component.

The clearing corporation's responsibilities: collecting margins on time, running daily clearing and settlement, being the legal counterparty to every contract, monitoring positions in derivatives and cash segments, fixing daily settlement prices, keeping client-level margin records and ensuring client margins are not used against the broker's dues. On a member's default it can transfer client positions to another member.

Reports the derivatives segment gives SEBI include occasions when the 99% VaR limit was breached, broker defaults, and daily market activity reports.

Trade Guarantee Fund (TGF) objectives: guarantee settlement of members' bona fide trades, build confidence, and protect investors. All active members contribute initially.

Remember

• Liquid assets: at least 50% cash.
• On default, client positions can move to another solvent member.

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5Membership eligibility

• Net worth: ₹3 crore for clearing members (with an auditor's certificate every 6 months); ₹1 crore for self-clearing members. SEBI sets no net worth for trading members.
• Liquid net worth: at least ₹50 lakh for every clearing member, including self-clearing members.
• Certification: members must pass a SEBI-approved certification, and every TM must have at least two approved users who have passed it. Only approved users may operate the derivatives terminal.

Remember

• CM ₹3 crore; SCM ₹1 crore; liquid net worth ₹50 lakh; two approved users.

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6SOP when a TM or CM may default

SEBI's Standard Operating Procedure tells exchanges, clearing corporations, depositories and the TM's clearing member what to do on warning signs of a default, to protect non-defaulting clients. As an interim step, clients with credit balances below ₹25 lakh are paid in full from available unencumbered deposits; those above ₹25 lakh are paid pro rata from what remains.

Remember

• Small investors (below ₹25 lakh) are paid first.

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7SOP for an exchange outage

SEBI's January 2023 SOP:

• The affected exchange emails SEBI immediately.
• It informs participants and other MIIs within 15 minutes, by broadcast and on its website.
• Unaffected segments, and other exchanges, keep trading.
• It works to restore operations quickly, including moving to its disaster recovery site.
• It gives at least 15 minutes' notice before trading resumes.

Remember

• Inform within 15 minutes; 15 minutes' notice before resuming; extension of 1½ hours.

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