Effects of new rules: Domestic brokerages try to dodge derivatives curbs

Several domestic brokerages are asking their clients to shore up their incomes in the wake of the implementation of ‘product suitability’ framework in the derivatives market. Under the proposed framework, the exposure of an investor in the derivatives market will be directly linked to the income disclosed in his/her tax returns. 

Increased disclosure of agricultural income will boost the overall income of an investor without leading to an increased tax burden, as income earned from agricultural activities is tax-free in India.

This development comes at a time when a large number of small and mid-sized brokerages are expressing concerns about a significant drop in trading volumes because of curbs imposed 

by market regulator Securities and Exchange Board of India (Sebi) in the derivatives market.

Under-reporting of income to escape taxes is a common practice in India, and a rampant among businessmen. This could soon become an issue for investors who attempt to leverage large positions in the derivatives market by paying small margin money, brokers observe.

"Day traders are a key source of revenue for brokerages as they contribute large trade volumes. Many of them belong to the business community and their disclosed income is much less than their actual net worth. Hence, we have been advising people to increase their disclosed agricultural income to continue hassle-free trading," said a broker.

‘Product suitability’ is one of the measures announced by the Sebi to discourage retail investors from indulging in excessive speculative trading in the derivatives market, where individual investors account for nearly a fifth of the total volumes. 

While the derivatives market was originally introduced for hedging purposes, many individual investors use it for trading purposes. Also, the derivatives market is far more sophisticated than the equity market, and the risk of capital loss is high.

However, the broking community fears loss of business.

 “Product suitability is a thought in the right direction as missselling has become rampant in financial services. However, there are many practical implications of the proposed framework.  Tax compliance in India is still in an evolving stage and under-reporting of income is common practice. Hence, the new circular will affect several traders in the derivatives market,” said Alok Churiwala, managing director at Churiwala Securities.

Apart from product suitability, the Sebi has also made mandatory physical settlement of derivative contracts for certain stocks. 

Until now, all the contracts were settled in cash. The market regulator has also increased the security margins charged by brokers in the derivatives trade. In future, brokers will have to mandatorily levy exposure margin and calendar-spread margins on their clients. 

This is in addition to the initial margin that brokers charge now. These measures have been introduced by the Sebi to improve the risk management system of the derivatives market. Some of the new measures will come into effect from June 1.

Effects of new Rules 

Several retail investors to be hit by the “product suitability” framework introduced by the Sebi

According to the new rules, the amount of exposure an investor can expect in derivatives market will be determined on the basis of his/her disclosed income in tax returns

Under-reporting of income is a common practice in India as investors look to reduce their tax liability

In order to overcome the curbs, brokerages are asking their clients to shore up their disclosed agricultural incomes.This would help investors avoid any trading curbs

At the same time, it will not increase any tax outgo as income derived from agricultural activities is exempted from taxes