Regulated Entry For Mutual Funds In Derivatives Markets Recommended

The L C Gupta committee on derivatives has recommended the removal of the regulatory prohibition on the entry of mutual funds in the derivatives markets.

In its final report yet to be submitted to the Securities and Exchange Board of India, the panel says the mutual funds need hedging facility but should only be allowed to use financial derivatives for this hedging purposes, including anticipated hedging and portfolio rebalancing within the policy framework laid down by the board of trustees of the funds who would specify the types, schemes and limits of the use of derivatives. They should not be allowed to speculate.

 

The final report of the committee, a copy of which is available with Business Standard, has generated some controversy, since it does not deal with detailed regulations and stock exchange bylaws, which the panel will now address.

In its 47-page report, the panel has suggested far-reaching changes in the capital market system to usher in derivatives, including a separate clearing corporation and the eventual move towards a single national clearing corporation, restricted entry of mutual funds into the derivatives sector, and has laid down detailed criteria for stock exchanges seeking to get into derivatives trading. The panel has also recommended two layers of membership clearing members and non-clearing members, where the former becomes the guarantor for the latter.

The report also dwells on issues relating to the strengthening of the cash market and thereby talks of bringing in a uniform settlement cycle and speeding up dematerialisation of stocks. It also favours all three types of derivatives equity, currency and interest rate derivatives.

While favouring the setting up of a separate exchange for derivatives trading, the panel says considering the constraints in infrastructure facilities, existing bourses having cash trading may be allowed to trade in derivatives, provided they meet certain minimum criteria. These include online screenbased trading with a disaster recovery site. The per half hour capacity of the computers and the network should be at least four to five times the anticipated peak load in any half hour, or of the actual peak load seen in any half hour during the past six months. This condition would be reviewed periodically.

The clearing of the derivatives market should be done by a separate clearing corporation. The bourse must also have online surveillance capacity monitoring positions, prices, volumes on a realtime basis.

Information about trades, quantities and quotes should also be disseminated by the exchange realtime over at least two information vending networks available in the country. The exchange should also have at least 50 members to start derivatives trading, the panel says. In case an exchange dealing in cash market starts derivatives trading, it would have to be done in a separate segment with separate membership.

The derivatives market should have a separate governing council with representation from trading members within what Sebi decides to be the percentage. The council chairman should be a non-broker executive director of the exchange or sponsoring exchange or a non-broker governing council member (this point has been stiffly opposed by a number of members in the panel). The bourse should also have arbitration and investor redressal machinery from all the four regions of the country and should have adequate inspection capability. No trading or clearing member should sit on the governing councils of both derivatives and cash markets.

The panel has recommended two-level regulation exchange-level and Sebi-level. The panels main emphasis is on exchange-level regulation by ensuring that the derivative exchanges operate as effective self-regulatory organisations under the overall supervision of Sebi. The panel has also called for a ``much stricter governance system for derivative exchanges to ensure it is a totally disciplined marketplace.

It recommends that Sebi set up a derivatives cell and encourage its staff to undergo derivatives training and recruit specialised personnel. A derivatives advisory council has also been suggested. Besides, it says Sebi should create an economic research wing to address complex questions arising out of derivatives and its impact on the cash market volatility and price discovery.

Advocating the two-tier system of clearing and non-clearing members as exists in the Singapore International Monetary Exchange, the panel says networth requirement for clearing members would be higher and the non-clearing member would have to depend on the clearing member for the settlement of the trades. The clearing member has to take responsibility for the non-clearing members position as far as the clearing corporation is concerned. The clearing member should have a minimum net worth of Rs 3 crore as per Sebi definition and would have to deposit Rs 50 lakh with the exchange/clearing corporation in liquid form.

The dealers/brokers in the derivatives market would have to pass a certification programme considered adequate by Sebi. They would also have to register with Sebi, in addition to registering with the stock exchanges.

Sales persons at derivatives brokerages may also be registered by Sebi, the panel says.

This, the panel feels, is central to derivatives trading. To be eligible, the corporation should satisfy criteria including full novation, meaning that the corporation should interpose itself between the two legs of every trade, becoming the legal counterparty to both. It should also have the capacity to monitor the overall positions of members across cash and derivatives markets for those members participating in both. The level of initial margin should be related to the risk of loss on the position and the concept of ``value at risk should be used in calculating initial margin.

The corporation, the panel says, should also charge special margins in case of unusual positions. The corporation should also establish electronic funds transfer for swift movement of funds. It should be able to promptly transfer client positions to another member or close out all open positions. Sebi, the panel says, should nudge the system to go for a single national clearing corporation for all bourses.