Legal, Accounting & Investor Protection Services - Chapter 5

Regulatory Framework for derivatives trading in India

The regulatory framework for derivatives trading in India is governed by the following.

• Securities Contract Regulation Act (SCRA) 1956
• Securities & Exchange Board of India (SEB)I Act 1992
• Recommendations of the LC Gupta Committee
• Recommendations of the J R Verma Committee

Securities Contracts Regulation Act (SCRA) 1956

This Act is the broad framework for trading in all kinds of securities on the exchange platform. It was only after the SCRA classified derivatives (futures and options) as a security that they were permitted to be traded on the exchange. The main purpose of this act is to prevent undesirable transactions in securities and governs the trading of securities in India.

Securities & Exchange Board of India (SEBI) Act 1992

This is the act that led to the creation of SEBI as the nodal regulator for all securities trading activity in India. The SEBI Act is principally aimed at protecting the interests of investors in securities, promoting the developing of capital markets in India and the creation of a proper regulatory and monitoring framework to make the securities market safer and sounder. Between the SCRA and the SEBI Act, all aspects of securities investing including the trading, clearing and settlement are monitored.

Key Recommendations of the L C Gupta Committee

This was the committee that formed the basis for setting up derivatives market and forms the basis for trading in futures and options. Some of the key recommendations are:

• Margins to be based on Value at Risk Methodology (VAR) with 99% confidence
• All exposures and volatility impact should be monitored online and real time
• Daily collection of mark to market (MTM) margins only in cash.
• Strict entry norms for brokers, dealers, traders, advisors in the market
• Stock exchanges should be the first level of regulation leading into SEBI regulation
• Member’s exposure to be linked to liquid assets held with the clearing corporation
• No broker funding of margins and such margins to be only collected from clients
• All clients to be identified by their client code while entering the trade itself
• Uniform F&O settlements across all the exchanges
• No broker members permitted on the governing councils of clearing corporations.

Key Recommendations of the J R Verma Committee

The Verma committee focused on ways the margins were statistically designed to manage risk with minimum burden on the trader. Here are the key recommendations:

• Calendar spreads to attract lower margins due to in-built risk mitigation
• Volatility to be based on standard deviation of logarithmic daily returns
• Initial margin to be dynamic and calculated on a real time basis
• Liquid assets with clearing members can include cash, cash equivalents, G-Secs, FDs, Treasury Bills, bank guarantees and even equity securities with 15% haircut

These two Acts and the two committee reports form the basis of regulation of the equity and index derivatives market in India.

Accounting and taxation of derivatives transactions

There are different ways of accounting for forwards, futures and options.

Accounting for forwards

• When forward contract is for hedging purpose, the premium or discount of futures over spot is amortized over the life of the contract
• When a forward contract is for trading or speculation (no underlying exposure), the premium or discount is not recognized
• Any gain or loss on the forward contract (whether for hedging or otherwise) is recognized in the profit & loss account
• Exchange difference (difference between the value of settlement date/ reporting date and value at previous reporting date/ inception of the contract) is recognized in Profit & Loss statement of the
• Any profit loss arising out of cancellation or renewal of the forward contract are also recognized in the profit & loss account of the business entity

Accounting for equity index and equity stock futures

• There is no accounting entry on the date of the futures transaction is entered into since no real transaction takes place other than entering into a contract
• On the balance sheet date, any amount that is lying in the futures account (initial margin, special margins, MTM and exposure margins) are shown as current assets in the balance sheet of the business
• When margins are paid for futures in the form of bank guarantee, no entry in the balance sheet is required. It must be mentioned in the notes to accounts.
• If there is a loss on the margin account, then a provision must be made in the Income Statement as a prudent practice, at least to the extent of the current loss
• On the date of closure of contract (either by exercise or by square up) any profits or losses that arise on the transaction must be adjusted as profits or losses in the Income Statement. Profits are the difference between the final settlement price and contract price.
• Complete details of the contracts that are open and any contingent liability arising due to a bank guarantee must be presented separately for clarity purposes.

Accounting for equity index and equity stock futures

• The seller or the writer of the option has to pay initial margins just like a buyer or seller of futures. Such margins are maintained in a separated margin account and any balance on the balance sheet day will be shown as a current asset.
• Any deposit paid by the options trader for regular trading with the broker is also maintained in a separate deposit account and is shown under currents in the balance sheet
• Any contingent liability arising out of sold options must be mentioned in the notes to accounts as also any margin paid by way of bank guarantees
• Any profit or loss arising on the settlement day will be adjusted to the profit and loss account and this applies to the buyer and to the seller also.

Taxation of derivatives transactions

One of the basic questions that we need to answer in the taxation front is whether any profits made on derivatives transactions should be treated as speculative income. Under the Income Tax Act, any income arising other than by delivery is classified as speculative. That is why intraday trading in equities is classified as speculative income.

Treatment of profits/losses on futures and options

However, there is a slight difference in case of futures and options. The Finance Act 2005 has clearly stated that any transaction in derivatives that is conducted on a recognized stock exchange will not be taxed as speculative income.  From a taxation perspective, this has few important implications.

• Transactions in derivatives are not speculative in nature. So the question is whether it should be treated as capital gains / losses or as part of business income or other income.
• Capital gains are only possible when there is buying and selling of a security which can be owned. Since derivative contracts cannot be owned, capital gains are ruled out
• The thumb rule is the intensity of transactions and whether it forms a core part of your core business volumes
• If derivatives transactions are just a handful and small in size, you can classify them as other income. However, if it is higher it is better to show it as business income.
• Any losses on derivatives can be set off against other business income and also such losses can be carried forward for a period of 8 years. Please not that this contrary to speculative income which can only be carried forward for a period of 4 years.

Securities Transaction Tax on futures and options

Since all futures and options are classified as securities under the SCRA Act, they are subject to securities transaction tax (STT). Remember that for futures the STT is charged on the notional value of the contract (lot size x futures price). However, in case of options, the STT is charged on the premium value of the contract (lot size x premium). The rates of STT on futures and options are as under:

Here are some of the highlights to remember:

• STT is applicable on all sell transactions for both futures and option contracts
• For the purpose of STT, each futures trade is valued at the actual traded price and option trade is valued at premium.
• STT payable by the clearing member is the sum total of STT payable by all trading members clearing under him. The trading member’s liability is the aggregate STT liability of clients trading through him.

Applicability of Prevention Money Laundering Act (PMLA)

Each registered broker should adopt written procedures to implement the anti money laundering provisions as envisaged under the Anti Money Laundering Act, 2002. Such procedures should include the following three specific parameters which are related to the overall Client Due Diligence Process:

• Policy for acceptance of clients
• Procedure for identifying the clients
• Transaction monitoring and reporting especially Suspicious Transactions Reporting (STR)

Understanding the KYC Process

KYC (Know Your Client) is a process that every client in the capital markets has to necessarily go through and that includes futures and options too. KYC is basically about collecting proper identity details of the individual and appropriate proof of address.

Valid documents for legal identification

An individual can give any of the following documents for identifying as a legal person. This includes:

• Passport
• PAN card
• Voter’s Identity Card
• Driving License
• Job Card issued by NREGA duly signed by an officer of the State Govt
• The letter issued by the Unique Identification Authority of India ( UIDAI) containing details of name, address and Aadhaar number
• Identity card (subject to the bank’s satisfaction) (viii) Letter from a recognized public authority or public servant verifying the identity and residence of the customer to the satisfaction of bank

Correct Permanent Address can be supported by any of the following documents:

• Telephone bill
• Bank account statement
• Letter from any recognized public authority
• Electricity bill
• Ration card
• Letter from employer (subject to satisfaction of the bank)