Discussion Paper on Growth and Development of Equity Derivatives Market in India
1. To solicit the comments/views from stakeholders including on issues related to trading in derivatives, participant’s profile, product mix, stock eligibility, leverage related matters and product suitability framework to further strengthen the framework in line with the emerging trends and global best practices.
2. Derivatives market in India has been growing rapidly in recent years. Orderly growth, development and alignment of both cash and derivatives markets is important. Keeping this objective in mind, the discussion paper has been prepared to undertake an assessment of the derivatives market in India so as to evaluate whether there is a need to further strengthen the regulatory framework for derivatives in India.
3. SEBI constituted a committee under the chairmanship of Dr. L. C. Gupta in November 1996 to “develop appropriate regulatory framework for derivatives trading in India”. In March 1998, the L. C. Gupta Committee (LCGC) submitted its report recommending the introduction of derivatives market in a phased manner beginning with the introduction of index futures.
4. In addition to the above, SEBI had also constituted Derivative Market Review Committee under the Chairmanship of Prof M Rammohan Rao to review development of the derivatives market and suggest future course of action. The committee interalia recommended to widen the range of products such as option contracts with longer life or tenure, creation of Volatility index & F&O contacts on it, options of futures, exchange traded currency contracts and mini contracts on equity indices. The committee had also made recommendations on operational issues such as revision of eligibility criteria for introduction of F&O on stocks & upward revision on position limits etc.
Relevant extracts of L C Gupta Committee
5. The Committee strongly favours the introduction of financial derivatives in order to provide the facility for hedging in the most cost-efficient way against market risk. This is an important economic purpose. At the same time, it recognizes that in order to make hedging possible, the market should also have speculators who are prepared to be counter-parties to hedgers. A derivatives market wholly or mostly consisting of speculators is unlikely to be a sound economic institution. A soundly based derivatives market requires the presence of both hedgers and speculators.
6. The Committee is of the opinion that the entry requirements for brokers/dealers for derivatives market have to be more stringent than for the cash market. These include not only capital adequacy requirements but also knowledge requirements in the form of mandatory passing of a certification programme by the brokers/dealers and the sales persons. An important regulatory aspect of derivatives trading is the strict regulation of sales practices.
7. The objective of SEBI is to make both derivatives market and cash market fair, efficient and transparent. Economically, it is important to realise that equity cash market and equity derivatives market are of one piece. Their sound development is inter-related closely.
8. The Committee recognises that an efficient cash market is required for an efficient futures market. The Committee also recognises the danger that if the cash market behaviour is erratic or does not reflect fundamentals, a futures market, based on such a cash market, will fail to give a correct indication of future prices and its usefulness for price discovery will be reduced.
9. With regard to participation of individual investors it is pertinent to mention here that L C Gupta committee in its report has given emphasis on Regulation of Sales Practices and Disclosures for Derivatives. The committee has observed following:
“The Committee has identified broker-client relationship and sales practices for derivatives as needing special regulatory focus. The potential risk involved in speculating (as opposed to hedging) with derivatives is not understood widely. In the case of pricing of complex derivatives contracts, there is a real danger of unethical sales practices. Clients may be fooled or induced to buy unsuitable derivatives contracts at unfair prices and without properly understanding the risks involved”.