Regulatory objectives 

1. The Committee believes that regulation should be designed to achieve specific, well-defined goals. It is inclined towards positive regulation designed to encourage healthy activity and behaviour. It has been guided by the following objectives :

1. Investor Protection: Attention needs to be given to the following four aspects:

1. Fairness and Transparency: The trading rules should ensure that trading is conducted in a fair and transparent manner. Experience in other countries shows that in many cases, derivatives brokers/dealers failed to disclose potential risk to the clients. In this context, sales practices adopted by dealers for derivatives would require specific regulation. In some of the most widely reported mishaps in the derivatives market elsewhere, the underlying reason was inadequate internal control system at the user-firm itself so that overall exposure was not controlled and the use of derivatives was for speculation rather than for risk hedging. These experiences provide useful lessons for us for designing regulations. 
2. Safeguard for clients' moneys: Moneys and securities deposited by clients with the trading members should not only be kept in a separate clients' account but should also not be attachable for meeting the broker's own debts. It should be ensured that trading by dealers on own account is totally segregated from that for clients.  
3. Competent and honest service: The eligibility criteria for trading members should be designed to encourage competent and qualified personnel so that investors/clients are served well. This makes it necessary to prescribe qualification for derivatives brokers/dealers and the sales persons appointed by them in terms of a knowledge base. 
4. Market integrity: The trading system should ensure that the market's integrity is safeguarded by minimising the possibility of defaults. This requires framing appropriate rules about capital adequacy, margins, clearing corporation, etc. 

1. Quality of markets: The concept of "Quality of Markets" goes well beyond market integrity and aims at enhancing important market qualities, such as cost-efficiency, price-continuity, and price-discovery. This is a much broader objective than market integrity. 
2. Innovation: While curbing any undesirable tendencies, the regulatory framework should not stifle innovation which is the source of all economic progress, more so because financial derivatives represent a new rapidly developing area, aided by advancements in information technology. 

1. Of course, the ultimate objective of regulation of financial markets has to be to promote more efficient functioning of markets on the "real" side of the economy, i.e. economic efficiency.  
2. Leaving aside those who use derivatives for hedging of risk to which they are exposed, the other participants in derivatives trading are attracted by the speculative opportunities which such trading offers due to inherently high leverage. For this reason, the risk involved for derivative traders and speculators is high. This is indicated by some of the widely publicised mishaps in other countries. Hence, the regulatory frame for derivative trading, in all its aspects, has to be much stricter than what exists for cash trading. The scope of regulation should cover derivative exchanges, derivative traders, brokers and sales-persons, derivative contracts or products, derivative trading rules and derivative clearing mechanism. 
3. In the Committee's view, the regulatory responsibility for derivatives trading will have to be shared between the exchange conducting derivatives trading on the one hand and SEBI on the other. The committee envisages that this sharing of regulatory responsibility is so designed as to maximise regulatory effectiveness and to minimise regulatory costs. 

Major issues concerning regulatory framework

4. The Committee's attention had been drawn to several important issues in connection with derivatives trading. The Committee has considered such issues, some of which have a direct bearing on the design of the regulatory framework. They are listed below : 

1. Should a derivatives exchange be organised as independent and separate from an existing stock exchange? 
2. What exactly should be the division of regulatory responsibility, including both framing and enforcing the regulations, between SEBI and the derivatives exchange? 
3. How should we ensure that the derivatives exchange will effectively fulfill its regulatory responsibility.  
4. What criteria should SEBI adopt for granting permission for derivatives trading to an exchange?  
5. What conditions should the clearing mechanism for derivatives trading satisfy in view of high leverage involved? 
6. What new regulations or changes in existing regulations will have to be introduced by SEBI for derivatives trading?

1. A major issue raised before the Committee for its decision was whether regulations should mandate the creation of a separate exchange for derivatives trading, or allow an existing stock exchange to conduct such trading. The Committee has examined various aspects of the problem. It has also reviewed the position prevailing in other countries. Exchange-traded financial derivatives originated in USA and were subsequently introduced in many other countries. Organisational and regulatory arrangements are not the same in all countries. Interestingly, in U.S.A., for reasons of history and regulatory structure, futures trading in financial instruments, including currency, bonds and equities, was started in early 1970s, under the auspices of commodity futures markets rather than under securities exchanges where the underlying bonds and equities were being traded. This may have happened partly because currency futures, which had nothing to do with securities markets, were the first to emerge among financial derivatives in U.S.A. and partly because derivatives were not "securities" under U.S. laws. Cash trading in securities and options on securities were under the Securities and Exchange Commission (SEC) while futures trading was under the Commodities Futures Trading Commission (CFTC). In other countries, the arrangements have varied. 
2. The Committee examined the relative merits of allowing derivatives trading to be conducted by an existing stock exchange vis-a-vis a separate exchange for derivatives. The arguments for each are summarised below. 

1. The most weighty argument in this regard is the advantage of synergies arising from the pooling of costs of expensive information technology networks and the sharing of expertise required for running a modern exchange. Setting-up a separate derivatives exchange will involve high costs and require more time. 
2. The recent trend in other countries seems to be towards bringing futures and cash trading under coordinated supervision. The lack of coordination was recognised as an important problem in U.S.A. in the aftermath of the October 1987 market crash. Exchange-level supervisory coordination between futures and cash markets is greatly facilitated if both are parts of the same exchange.  

1. The trading rules and entry requirements for futures trading would have to be different from those for cash trading.  
2. The possibility of collusion among traders for market manipulation seems to be greater if cash and futures trading are conducted in the same exchange. 
3. A separate exchange will start with a clean slate and would not have to restrict the entry to the existing members only but the entry will be thrown open to all potential eligible players.

Recommendation  

1. From the purely regulatory angle, a separate exchange for futures trading seems to be a neater arrangement. However, considering the constraints in infrastructure facilities, the existing stock exchanges having cash trading may also be permitted to trade derivatives provided they meet the minimum eligibility conditions as indicated below :

1. The trading should take place through an online screen-based trading system, which also has a disaster recovery site. The per-half-hour capacity of the computers and the network should be at least 4 to 5 times of the anticipated peak load in any half hour, or of the actual peak load seen in any half-hour during the preceding six months. This shall be reviewed from time to time on the basis of experience. 
2. The clearing of the derivatives market should be done by an independent clearing corporation, which satisfies the conditions listed in a later chapter of this report. 
3. The exchange must have an online surveillance capability which monitors positions, prices and volumes in realtime so as to deter market manipulation. Price and position limits should be used for improving market quality. 
4. Information about trades, quantities, and quotes should be disseminated by the exchange in realtime over at least two information vending networks which are accessible to investors in the country. 
5. The Exchange should have at least 50 members to start derivatives trading. 
6. If derivatives trading is to take place at an existing cash market, it should be done in a separate segment with a separate membership; i.e., all members of the existing cash market would not automatically become members of the derivatives market. 
7. The derivatives market should have a separate governing council which shall not have representation of trading/clearing members of the derivatives Exchange beyond whatever percentage SEBI may prescribe after reviewing the working of the present governance system of exchanges. 
8. The Chairman of the Governing Council of the Derivative Division/Exchange shall be a member of the Governing Council. If the Chairman is a Broker/Dealer, then, he shall not carry on any Broking or Dealing Business on any Exchange during his tenure as Chairman. 
9. The exchange should have arbitration and investor grievances redressal mechanism operative from all the four areas/regions of the country. 
10. The exchange should have an adequate inspection capability. 
11. No trading/clearing member should be allowed simultaneously to be on the governing council of both the derivatives market and the cash market.
12. If already existing, the Exchange should have a satisfactory record of monitoring its members, handling investor complaints and preventing irregularities in trading.