Chapter 8: Legal and Regulatory Environment

LEARNING OBJECTIVES:
After studying this chapter, you should know about:
• Definition of securities and derivatives as per the Securities Contract
(Regulation) Act, 1956
• Functions of SEBI
• Regulatory framework for derivatives market trading, clearing, settlement
and risk management
• Eligibility criteria for membership on derivatives segment

The trading of derivatives is governed by the provisions contained in the Securities

Contracts (Regulation) Act, 1956; the Securities Exchange Board of India Act, 1992; the
rules and regulations framed there under and other rules and bye–laws of stock
exchanges.

8.1 Securities Contracts (Regulation) Act, 1956

The Act aims to prevent undesirable transactions in securities. It governs the trading of
securities in India. The term “securities” has been defined in the Section 2(h) of SCRA. The
term ‘Securities’ include:
• Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable
securities of a like nature in or of any incorporated company or other body corporate
• Derivatives
• Units or any other instrument issued by any collective investment scheme to the
investors in such schemes
• Security receipt as defined in clause (zg) of section 2 of the Securitisation and
Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002
• Units or any other such instrument issued to the investors under any mutual fund
scheme (securities do not include any unit linked insurance policy or scrips or any
such instrument or unit, by whatever name called which provides a combined benefit
risk on the life of the persons and investment by such persons and issued by an
insurer refer to in clause (9) of section 2 of the Insurance Act, 1938 (4 of 1938))
• Any certificate or instrument (by whatever name called), issued to an investor by any
issuer being a special purpose distinct entity which possesses any debt or receivable,
including mortgage debt, assigned to such entity, and acknowledging beneficial
interest of such investor in such debt or receivable, including mortgage debt, as the
case may be
• Government securities

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 • Such other instruments as may be declared by the Central Government to be
securities (including onshore rupee bonds issued by multilateral institutions like the
Asian Development Bank and the International Finance Corporation)
• Rights or interests in securities
According to the act “Derivatives” is defined as:
• A security derived from a debt instrument, share, loan whether secured or
unsecured, risk instrument or contract for differences or any other form of security.
• A contract which derives its value from the prices, or index of prices, of underlying
securities.
• Commodity derivatives, and
• Such other instruments as may be declared by the Central Government to be
derivatives.
• Section 18A provides that notwithstanding anything contained in any other law for
the time being in force, contracts in derivative shall be legal and valid if such
contracts are:
o Traded on a recognized stock exchange
o Settled on the clearing house of the recognized stock exchange, in accordance
with the rules and bye–laws of such stock exchanges.

8.2 Securities and Exchange Board of India Act, 1992

SEBI Act, 1992 provides for establishment of Securities and Exchange Board of India (SEBI)
with statutory powers for (a) protecting the interests of investors in securities (b)
promoting the development of the securities market and (c) regulating the securities
market. Its regulatory jurisdiction extends over corporate in the issuance of capital and
transfer of securities, in addition to all intermediaries and persons associated with
securities market. SEBI has been obligated to perform the aforesaid functions by such
measures as it thinks fit. In particular, it has powers for:
• Regulating the business in stock exchanges and any other securities markets;
• Registering and regulating the working of stock brokers, sub–brokers, etc.;
• Promoting and regulating self-regulatory organizations;
• Prohibiting fraudulent and unfair trade practices relating to securities markets;
• Calling for information from, undertaking inspection, conducting inquiries and
audits of the stock exchanges, mutual funds and other persons associated with the
securities market and intermediaries and self–regulatory organizations in the
securities market;
• Performing such functions and exercising according to Securities Contracts
(Regulation) Act, 1956, as may be delegated to it by the Central Government.

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8.3 Regulations in Trading
A committee under the chairmanship of Dr. L. C. Gupta was set by SEBI to develop the
appropriate regulatory framework for derivatives trading in India. On May 11, 1998, SEBI
accepted the recommendations of the committee and approved the phased introduction
of derivatives trading in India beginning with stock index futures.
The provisions in the SCRA and the regulatory framework developed there under govern
trading in securities. The amendment of the SCRA to include derivatives within the ambit
of ‘securities’ made trading in derivatives possible within the framework of that Act.
• Any Exchange fulfilling the eligibility criteria as prescribed in the L.C. Gupta committee
report can apply to SEBI for grant of recognition under Section 4 of the SCRA, 1956 to
start trading derivatives. The derivatives exchange/segment should have a separate
governing council and representation of trading/clearing members shall be limited to
maximum of 40% of the total members of the governing council. The exchange would
have to regulate the sales practices of its members and would have to obtain prior
approval of SEBI before start of trading in any derivative contract.
• The Exchange should have a minimum of 50 members.
• The members of an existing segment of the exchange would not automatically
become the members of derivative segment. The members of the derivative segment
would need to fulfil the eligibility conditions as laid down by the L.C. Gupta committee.
• The clearing and settlement of derivatives trades would be through a SEBI approved
clearing corporation. Clearing corporations, complying with the eligibility conditions
as laid down by the committee, have to apply to SEBI for grant of approval.
• Derivative brokers/dealers and clearing members are required to seek registration
from SEBI. This is in addition to their registration as brokers of existing stock
exchanges. The minimum net worth for clearing members of the derivatives clearing
corporation shall be Rs.300 Lakhs. The net worth of the member shall be computed
as follows:
➢ Capital + Free reserves
➢ Less non-allowable assets viz.,
o Fixed assets
o Pledged securities
o Member’s card
o Non-allowable securities (unlisted securities)
o Bad deliveries
o Doubtful debts and advances
o Prepaid expenses
o Intangible assets

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 o 30% marketable securities
• The minimum contract value shall not be less than Rs 5,00,000 and this subject to
change as per SEBI and Exchange rules. Effective Nov 20, 2024, SEBI has prescribed
minimum contract value in the range of Rs. 15 to 20 lakhs, Exchanges have to submit
details of the futures contract they propose to introduce.
• The initial margin requirement, exposure limits linked to capital adequacy and margin
demands related to the risk of loss on the position will be prescribed by SEBI/
Exchange from time to time.
• The L. C. Gupta committee report requires strict enforcement of “Know your
customer” rule and requires that every client shall be registered with the derivatives
broker. The members of the derivatives segment are also required to make their
clients aware of the risks involved in derivatives trading by issuing to the client the
Risk Disclosure Document and obtain a copy of the same duly signed by the client.
• The trading members are required to have qualified approved user and sales person
who have passed a certification programme approved by SEBI.
Members and authorized dealer have to fulfil certain requirements and provide collateral
deposits to become members of the F&O segment. All collateral deposits are segregated
into cash component and non-cash component. Cash component means cash, bank
guarantee, fixed deposit receipts, T-bills and dated government securities. Non-cash
component means all other forms of collateral deposits like deposit of approved demat
securities.
Net worth criteria for Clearing Members has been provided by SEBI, while net worth
criteria for Trading Members and Limited Trading Members have been decided by stock
exchanges. Few exchanges have a special category of members called Limited Trading
Members, who are not cash market members of exchange.
The broker is required to get a Risk Disclosure Document signed by the client, at the time
of client registration. This document informs clients about the kind of risks that
derivatives can involve for the client. It makes the client aware and informed about the
various risks associated with derivatives trading. Apart from other records, Trading
Members are required to maintain trade confirmation slips and exercise notices from the
trading system for a period of 5 years. All member brokers in the derivative segment are
required to be inspected by the exchange at least once a year.
A default by a member in the derivatives segment is treated as default in all segments of
that exchange and as default on all exchanges where he is a member.

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The purpose of inspection of stockbrokers’ records under the SEBI (Stock Broker)
Regulations, 1992 is to ensure that the books of accounts and other books are being
maintained in the manner required.
The recognition to a stock exchange under the Securities Contract (Regulation) Act 1956
can be granted by the Central Government. It provides for direct and indirect control of
virtually all aspects of securities trading and the running of Stock Exchanges and aims to
preventing undesirable transactions in securities. It gives the Central Government the
regulatory jurisdiction over:
(a) Stock Exchanges through a process of recognition and continued supervision
(b) Contracts in securities, and
(c) Listing of securities on Stock Exchanges
A penalty or suspension of registration of a stock broker under the SEBI (Stock Broker)
Regulations, 1992 can be ordered if:
• The stock broker violates the provisions of the Act
• The stock broker does not follow the code of conduct
• The stock broker fails to resolve the complaints of the investors
• The stock broker indulges in manipulating, or price rigging or cornering of the
market
• The stock broker’s financial position deteriorates substantially
• The stock broker fails to pay fees
• The stock broker violates the conditions of registration
• The stock broker is suspended by the stock exchange
Position limits are the maximum exposure levels which can be assumed by each investor
or Clearing Member or the market as a whole. Such position limits are defined by SEBI.
Each Clearing Member may have several Trading Members with him. The trading limits
for each such Trading Member are decided by Clearing Members on the computerized
trading system.
Once a Trading Member reaches his position limit, he will not be able to enter any fresh
transactions which have the impact of increasing his exposure. He will be able to enter
only those transactions which result in the reduction of his exposure. Thus, new positions
will not be permitted, but only squaring-off of existing positions will be permitted.

8.4 Regulations in Clearing & Settlement and Risk Management

Anybody interested in taking membership of F&O segment is required to take
membership of “Capital Market and F&O segment” or “Capital Market, Wholesale Debt
Market and F&O segment”. A membership for Capital Markets and F&O segment gives

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member the right to execute trades and to clear and settle the trades executed by the
members in these segments. Similarly, a membership for Capital Market, Wholesale Debt
Market and F&O segment gives the member a right to execute trades and to clear and
settle the trades executed by the members in these segments. An existing member of CM
segment can also take membership of F&O segment. A trading member can also be a
clearing member by meeting additional requirements. There can also be only clearing
members.
The initial and exposure margin is payable upfront by Clearing Members. Initial margins
can be paid by members in the form of Cash, Bank Guarantee, Fixed Deposit Receipts and
approved securities.
Clearing members who are clearing and settling for other trading members can specify
the maximum collateral limit towards initial margins, for each trading member and
custodial participant clearing and settling through them.
Such limits can be set up by the clearing member, through the facility provided on the
trading system up to the time specified in this regard. Such collateral limits once set are
applicable to the trading members/custodial participants for that day, unless otherwise
modified by clearing member.
Non-fulfilment of either whole or part of the margin obligations is treated as a violation
of the Rules, Bye-Laws and Regulations of clearing corporation and attracts penalty from
the Clearing Corporation.
In addition, the clearing corporation can initiate other disciplinary actions, such as
withdrawal of trading facilities and/or clearing facility, close out of outstanding positions,
imposing penalties, collecting appropriate deposits, invoking bank guarantees / fixed
deposit receipts, etc.
Clearing member is required to provide liquid assets which adequately cover various
margins and liquid Net-worth requirements. He may deposit liquid assets in the form of
cash, bank guarantees, fixed deposit receipts, approved securities and any other form of
collateral as may be prescribed from time to time. The total liquid assets comprise of at
least 50% of the cash component and the rest is non-cash component.
Responsibilities of the Clearing Corporation include:
• Collection of Margins on a timely basis
• Smooth operation of the daily clearing and settlement
• Acting as a legal counterparty for every contract
• Monitoring the positions in derivatives and cash segments
• Deciding Daily Settlement Prices

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 • Keeping a consistent record of margins at client level
• Ensuring that client margins are not appropriated against brokers’ dues
The Clearing Corporation can transfer client positions from one broker member to
another broker member in the event of a default by the first broker member.
Some of the reports / information which a derivatives segment of a Stock Exchange has
to provide to SEBI are:
• Occasions when the 99% Value at Risk limit has been violated
• Defaults by broker-members
• Daily market activity report
• Daily market report
Main objectives of Trade Guarantee Fund (TGF):
• To guarantee settlement of bonafide transactions of the members of the
exchange.
• To inculcate confidence in the minds of market participants.
• To protect the interest of the investors in securities.
All active members of the Exchange are required to make initial contribution towards
Trade Guarantee Fund of the Exchange.

8.5 Eligibility criteria for membership on derivatives segment

The eligibility criteria for becoming a member of the derivatives segment of an exchange
are as follows:
• Balance Sheet Net worth Requirements: SEBI has prescribed a net worth
requirement of Rs. 3 crores for clearing members. The clearing members are
required to furnish an auditor's certificate for the net worth every 6 months to the
exchange. The net worth requirement is Rs. 1 crore for a self-clearing member.
SEBI has not specified any net worth requirement for a trading member.
• Liquid Net worth Requirements: Every clearing member (both clearing members
and self-clearing members) has to maintain at least Rs. 50 lakhs as Liquid Net
worth with the exchange / clearing corporation.
• Certification requirements: The Members are required to pass the certification
programme approved by SEBI. Further, every trading member is required to
appoint at least two approved users who have passed the certification
programme. Only the approved users are permitted to operate the derivatives
trading terminal.

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8.6 Standard Operating Procedure in the case of default by TM or CM
SEBI has laid down the actions to be taken by stock exchanges, clearing corporations and
depositories whenever they see any warning signals of a possible default by a TM or CM.
On receiving any such warning signals, the exchanges, clearing corporations and
depositories are required to act in the manner laid down in the Standard Operating
Procedure (SOP), to protect the interests of the non-defaulting clients of the TM. The
Clearing Member of the TM is also required to take the necessary actions laid down in the
SOP. As an interim measure, the stock exchanges and clearing corporations are required
to settle the credit balances of small investors (those with balances less than Rs.25 lakh)
using the unencumbered deposits available with them. Investors with credit balances
exceeding Rs.25 lakh are to be paid on a pro-rata basis from the remaining funds.

8.7 Standard Operating Procedure (SOP) for handling stock exchange outage10
If the continuous trading on any stock exchange is disrupted due to any technical glitch,
it is vital that market participants and other Market Infrastructure Institutions (MIIs)
should be informed of the outage at the earliest and trading hours are extended to
ensure smooth closure of intraday positions. Therefore, SEBI has laid down the SOP to
handle cases of outage at any stock exchange.
• The exchange suffering from any outage (affected stock exchange) must inform
SEBI immediately on occurrence of the outage through an email.
• The market participants and other MIIs must be informed immediately or at
least within 15 minutes of the outage through broadcast message and by
publishing on its website.
• Even if trading in one or more market segments is disrupted due to the outage,
trading can continue in other segments unaffected by the outage.
• Trading can continue on other stock exchanges which are not affected by the
outage.
• The affected stock exchange must try to restore normalcy of operations at the
earliest, including activating its Disaster Recovery Site.
• The exchange must inform the market participants at least 15 minutes before
the resumption of trading.
Extension of trading hours by stock exchanges due to outages are applicable in the
following manner and the same needs to be intimated to all the market participants,
MIIs and SEBI within stipulated time.

10
Vide SEBI Circular SEBI/HO/MRD-TPD-1/CIR/P/2023/7 dated Jan 09, 2023 on Standard Operating Procedure for
handling Stock Exchange outages and extension of trading hours thereof.

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Scenarios Extension of trading hours
Resumption of normal trading atleast 1 No change of trading hours required
hour before scheduled market closure
Trading does not resume to normalcy All stock exchanges should extend their
within 1 hour before the scheduled trading hours by one and half hours for
market closure that day
Outage happens during the last trading All stock exchanges should extend their
hour of normal operation and latest trading hours by one and half hours for
before 15 minutes of normal scheduled that day
market closure

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Sample questions

1. On the Governing Council of the Clearing Corporation of the derivatives segment,

broker-members are allowed.
(a) True
(b) False

2. The main objective of Trade Guarantee Fund (TGF) at the exchanges is

_________________.
(a) To guarantee settlement of bonafide transactions of the members of the exchange
(b) To inculcate confidence in the minds of market participants
(c) To protect the interest of the investors in securities
(d) All of the above

3. A penalty or suspension of registration of a stock broker from derivatives

exchange/segment under the SEBI (Stock Broker) Regulations, 1992 can take place if
_______________.
(a) The stock broker fails to pay fees
(b) The stock broker violates the conditions of registration
(c) The stock broker is suspended by the stock exchange
(d) In any of the above situations

4. A defaulting member's clients’ positions could be transferred to ____________ by the

Clearing Corporation.
(a) Another solvent member
(b) The Exchange
(c) A suspense account
(d) Error account

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