SEBI Guidelines in Derivatives Market

Securities and Exchange Board of India (SEBI) is the regulatory authority for securities markets in India. As part of its mandate to ensure investor protection, transparency, and integrity in the markets, SEBI has laid down detailed guidelines for the functioning of the derivatives market. These guidelines cover various aspects such as product approval, trading, clearing and settlement, risk management, investor protection, and market surveillance. SEBI’s regulations aim to develop a robust and secure derivatives market that aligns with global standards.

Eligibility of Derivatives Products:

SEBI ensures that only suitable products are introduced into the market. The eligibility criteria include:

• The underlying asset must be widely traded and liquid.

• There should be sufficient historical price data available.

• The asset must have broad-based participation and low concentration risk.

• SEBI allows derivatives on equities, indices, currencies, commodities, interest rates, and volatility indices.

Before any new derivative product is introduced, SEBI’s approval is required, and the product must pass certain risk and liquidity parameters.

Participants Eligibility:

SEBI has categorized participants into:

• Hedgers: those who use derivatives to manage risk.

• Speculators: those who trade to profit from price movements.

• Arbitrageurs: those who exploit price differentials across markets.

Eligibility criteria for trading in derivatives include:

• Investors must meet minimum net worth requirements (for institutional investors and brokers).

• SEBI-mandated KYC norms and PAN-based registration must be fulfilled.

• SEBI also introduced client suitability assessments and risk disclosures to ensure that retail investors are aware of risks before entering the derivatives market.

Risk Management Framework:

Risk management is a key focus area under SEBI’s regulations. Guidelines include:

• Margining System: SEBI mandates a stringent margining system which includes Initial Margin, Exposure Margin, Mark-to-Market Margin, and Special Margins (if necessary).

• Daily Settlement: Positions must be marked-to-market daily to reflect actual gains/losses.

• Position Limits:

  • Client-level, member-level, and market-wide position limits are specified to prevent excessive exposure.

  • For instance, index futures and options have limits based on a percentage of open interest.

• Cross-Margining: Allowed for offsetting positions across various segments to reduce overall margin requirements.

Clearing and Settlement Regulations:

SEBI ensures robust clearing and settlement processes through registered clearing corporations such as NSCCL, ICCL, and Indian Clearing Corporation.

Key guidelines:

• Novation of Trades: Clearing corporations become the counterparty to both buyer and seller, mitigating counterparty risk.

• Timely Settlement: All obligations must be settled within specified timeframes (T+1 or T+2).

• Collateral Management: SEBI mandates acceptable collateral forms (cash, government securities, approved shares) and haircuts based on risk evaluation.

Investor Protection Mechanisms:

SEBI has implemented several mechanisms to safeguard retail and institutional investors:

• Mandatory Risk Disclosure Documents: Every participant must receive a document outlining the risks involved in derivatives trading.

• Grievance Redressal Systems: SEBI operates a robust grievance redressal mechanism through SCORES (SEBI Complaints Redress System).

• Investor Education: SEBI conducts awareness programs on derivative risks and opportunities.

• Suitability Assessments: Brokers must evaluate an investor’s financial knowledge before permitting derivatives trading.

Transparency and Reporting:

To enhance transparency and reduce market manipulation:

• Order-Level Surveillance: Exchanges and SEBI have real-time surveillance systems to detect abnormal patterns.

• Trade Reporting: All trades in derivatives are recorded electronically and must be disclosed to the regulator.

• Disclosures by Market Participants: SEBI mandates regular disclosure of derivative exposures, especially from large market players such as mutual funds and FII/FPIs.

Code of Conduct for Brokers and Exchanges:

SEBI has framed detailed codes of conduct for market intermediaries:

• Fair Dealing: Brokers must ensure that they act in the best interests of their clients.

• No Conflict of Interest: Market participants must disclose potential conflicts.

• Segregation of Client Accounts: Clear distinction between proprietary and client trades is mandated.

• Audit and Compliance: Regular internal and external audits are compulsory, and compliance reports must be submitted to SEBI.

Product Surveillance and Suitability:

• Derivative Watchlist: SEBI monitors contracts with abnormal volatility or low liquidity and may ban them temporarily.

• Ban Periods: Securities that breach market-wide position limits are subject to trading bans.

• Contract Specifications: Exchanges must standardize contract size, tick size, expiry, and other elements as per SEBI’s framework.