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The term 'Derivative' indicates that it is a security which has no independent value - it is so 'derived' from the value of an underlying asset. It is a contract of a future date entered into with the objective of avoiding the risk of rise or fall in market price, by fixing a rate in the present, hence providing leverage to the investors. Its value is affected by the volatility in the rates of the underlying asset. Some of the widely recognized underling assets are :
Section (2) (ac) of The Securities Contracts Regulation Act, 1956, inserted by the Securities Laws (Amendment) Act, 1999 (with effect from 22.2.2000) defines Derivatives as under:
'Derivatives' includes -
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;
The various Derivative instruments are forwards, futures, options, swaps, warrants, LEAPS, baskets and swapations. Of these the most commonly used Derivatives are forwards, futures and options.
Forwards: A forwards contract is a customized contract between two entities, where settlement takes place on a specified date in the future at the current days pre-determined price.
Futures: A Futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a specified price. Future contracts are special types of forward contracts in the sense that they are standardized, exchange traded contracts.
Options: Options are of two types - namely calls and puts.
Calls give the buyer the right, but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date.
Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.
Trading in Derivatives
Derivatives are broadly classified into two categories on the basis of the manner in which they are traded:
Over the Counter Derivatives (OTC)
Exchange traded Derivatives
OTC Derivatives are contracts which are privately negotiated and traded between two parties, without going through an exchange or intermediary.
Exchange traded Derivatives are those contracts that are traded via a specialized Derivative exchange, that is, a market where investor's trade standardized contracts that have been defined by the given exchange. The Derivatives exchange is an intermediary to all transactions mediated by it and takes out an initial margin from both sides of the trade to act as a guarantee.
In the cases of trading of Futures and Options, an investor purchases a contract for a pre-determined number of shares, that is, a 'lot' of shares depending upon contract specifications. A Futures contract is purchased by payment of a margin categorically prescribed by the exchange as opposed to the actual value of the contract. Similarly, in an Options contract, an option premium is paid as consideration for the right to buy/sell a specified 'lot' of shares.
Therefore an investor can make a profit or loss in proportion to the fluctuation of the value of the underlying asset by paying a fraction of the total value of the asset.
Derivatives are primarily hedging tools, that is, instruments of risk management in a volatile market. By fixing a pre-determined price of the underlying asset in the present, the investor secures himself against any unforeseen rise/fall in the market rate in the future. However, in practicality, the operation of exchange-traded Derivatives is such that they facilitate profit maximization with a minimum investment.
There are different kinds of traders in the Derivatives market, namely:
Hedgers: Traders who are interested in transferring a risk element of their portfolio.
Speculators: Traders who deliberately go for risk components from hedgers in look out for profit.
Arbitragers: Traders who work in various markets at the same time in order to gain profit.
Futures and Options are popular in comparison with trading in the cash segment for a number of reasons:
Margin Payment : Since Derivatives require only a margin amount to be paid, they allow investors to trade in high volumes with relatively low investments.
Short Selling: Referred to as the practice of selling shares without title (ownership rights), thereby enabling the sale at a higher rate and the purchase at a lower rate, if it is believed that the prices are likely to fall. The practice of margin payments encourages short selling in the trade of Futures and Options.
In addition, Futures allow investors to wait until the expiry date (usually the last Thursday of every month), as opposed to mandating a square-off of transactions by market closing time each day. The cash segment, on the other hand, tolerates this practice only during business hours of any given working day by requiring traders to square their transactions.
No Delivery: In the cash segment, investors receive their shares directly in their Demat accounts. As for Derivatives, there is no delivery and a Demat account is not required. (Interestingly, in the case of indices and interest rates as underlying assets, no delivery is indeed possible)
Lower brokerage: The brokerage in Futures is only 0.03-0.05% of the value of the transaction, whereas, in the cash segment it is 0.25-0.75% of the transaction.
Growth and Development of Derivative Trading in India
Prior to the advent of exchange traded Derivatives in Indian markets, similar systems of 'forward trading' were in existence, namely, Teji-Mandi and Fatak transactions. In these contracts, for a consideration a person acquired a right to purchase or sell goods to his advantage, in accordance with a market rise or fall. Subsequently, The Securities Contract Regulation Act, 1956 (SCRA) was enacted to regulate these types of trade and prevent any undesirable transactions of such contracts. Such contracts for 'clearing' commonly known as 'forward trading' were prohibited by the Central Government vide a notification dated 27th June, 1969 in exercise of the powers conferred on it by Section 16(1) of the SCRA.
This move led to a significant reduction in stock market activity. Subsequently, in 1972, the Bombay Stock Exchange (BSE) evolved an informal system of forward trading - called Badla trading. Badla was a mechanism to avoid the discipline of spot market trading. It is a process of buying stocks with borrowed money where the Stock Exchange acts as an intermediary between investors and lenders. Thus, if an investor intuitively believes that the price of a particular share may rise or fall; he is allowed to participate in such a fluctuation without giving or taking the delivery of the shares. In addition, the demand for that particular stock in Badla trading determined the interest rate for borrowing.
The Joint Parliamentary Committee on Irregularities in Securities and Banking Transaction, 1992 (JPC of 1992) considered the issue of 'Carry Forward trades' and observed that there were a number of irregularities in the stock exchange with respect to non enforcement of margins, non- reporting of transactions and illegal trading outside the stock exchange. Furthermore, approximately one-fourth of the outstanding position at the end of the settlement typically got settled by actual delivery, while the remaining bulk got carried forward to the next settlement. The community of brokers contended that the system provided liquidity but it was the view of the Committee that the carry forward system was unjustifiable and an unhealthy practice in economic terms.
Liquidity created by speculators who neither pay nor take delivery of the shares could not be considered as genuine.
Similarly, SEBI was of the opinion that:
Carry forward transactions must be prohibited;
Transactions should be conducted strictly on the basis of delivery;
Separate markets may be allowed for trades in the nature of Futures and Options.
Consequently SEBI banned Badla operations vide Circular dated December 23, 1993. This decision was later reviewed and reversed, thereby allowing Carry Forward transactions, on the basis of the recommendations of the G. S. Patel Committee in 1995. However, the revised carry forward system was subject to a number of restrictions which made it unattractive to investors.
In March 1997, the Supreme Court allowed Ready Forward contracts (Repo) which were earlier declared null and void (by a Special Court in December 1993) as violating the provisions of the SCRA and the Banking Regulation Act.
Thus, there existed an anomalous situation in which forward trading was banned by the Central Government notification of 1969, but forms of the same such as Carry Forward trading and Repos continued to exist. At this juncture, the Government of India began to appreciate the utility of Derivative instruments as risk minimizing tools, which were gaining impetus the world over, and took steps to introduce an appropriate regulatory framework for the trade of Derivatives in India.
The first step towards the introduction of Derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995 through which the prohibition on 'options in securities' was lifted.
The L.C. Gupta Committee was set up by SEBI vide a resolution dated November 18, 1996 in order to develop an 'appropriate regulatory framework' for Derivatives trading in India. It submitted its report in March, 1998.
The Committee's primary concern was that of financial Derivatives trading and it studied the concept of Derivatives and their operation in Indian markets. It made various important recommendations which were adopted and presently govern the operation of Derivatives trading in India.
The Committee recommended that the definition of 'securities' under section 2(h) of the SCRA be expanded expediously so as to include within its purview Derivative based on index of prices of securities and other Derivative contracts. Thus vide the Securities Law (Amendment) Act, 1999 the definition of securities was so expanded by insertion of section 2(h) (ia). Section 2(ac) defining Derivatives was also added.
On its recommendation the Central Government Notification of 1969 was revoked in March 2000.
From a regulatory angle the committee suggested a separate exchange for Futures trading as an ideal arrangement. Considering constraints in infrastructure facilities it opined that existing stock exchanges engaged in cash trading, may be permitted to trade in Derivatives upon meeting certain eligibility criteria.
The Committee envisaged a two-level regulatory system, at both the level of the exchange and SEBI, with considerable emphasis on self regulatory competence of the various Derivative exchanges. SEBI approves rules, bye-laws, regulations and even new contracts to be traded. Thus every stock exchange has a comprehensive set of such SEBI approved rules and bye-laws which govern Derivative trading.
The Committee also made suggestions with regard to requirements to be fulfilled by brokers and margins to be maintained.
The Committee recommended that the introduction of Derivatives be carried out in phases, (as a gradual process shaped by market forces) under the over-all supervision of SEBI. It favoured stock index futures as the best starting point for equity Derivatives, with other types of equity Derivatives following later. Thus index Futures trading began at the NSE and BSE in June 2000. Trading in index options commenced in June 2001, trading in options on individual securities commenced in July 2001 and Futures on individual stocks were launched in November 2001.
Coercing Derivatives into the Indian Legal Framework
The legal environment for Derivative trading in India today is determined by the SCRA, the Indian Contract Act, 1872, Exchange Control Manual (ECM), Foreign Exchange Management Act, 1999 and the Reserve Bank of India Act, 1934.
The J.R Varma Committee was constituted in 1998 in order to recommend guidelines for the effective implementation of the L. C. Gupta Committee report. The Varma Committee Report had noted that the mere declaration of cash settled futures as securities under SCRA would not put them on a sound legal footing. It suggested that the provisions of the Indian Contract Act, 1872 would either have to be amended or explicitly over-ridden.
Similarly the Parliamentary Standing Committee on Finance to which the Securities Laws (Amendment) Act, 1999 was referred for examination and report thereon, was of the opinion that since cash settled contracts could be classified as "wagering agreements" which are null and void under section 30 of the Indian Contracts Act, 1872, Futures contracts would be subject to legal controversy. Therefore it suggested an overriding clause stating, "Notwithstanding anything contained in any other Act, contracts in Derivatives as per the SCRA shall be legal and valid".
However, since the Committee was convinced that stock exchanges would be better equipped to undertake trading in Derivatives, it would be prudent to allow trading unilaterally by such stock exchanges. This lead to the insertion of Section 18A in the SCRA which provides as follows:
"Contracts in Derivative - Not withstanding anything contained in any other law for the time being in force, contracts in Derivative shall be legal and valid if such contracts are-
traded on a recognized stock exchange;
settled on the clearing house of the recognized stock exchange, in accordance with the rules and bye-laws of such stock exchange"
Furthermore, in India, currency Derivatives' trading is governed by the RBI Act and FEMA together. The RBI Act was amended by the RBI (Amendment) Act 2006 to facilitate the trade of currency Derivatives, by the insertion of section 45V which provides as follows : "Notwithstanding anything contained in the SCRA or any other law for the time being in force, transactions in such Derivatives, as may be specified by the RBI from time to time, shall be valid if at least one of the parties to the transaction is the RBI, a scheduled bank or such other agency falling under the regulatory purview of the RBI under the RBI Act, the Banking Regulation Act, 1949, the Foreign Exchange Management Act, 1999, or any other Act or instrument having the force of law, as may be specified by the RBI from time to time"
In addition, it provides that transactions in such Derivatives, (as specified by the RBI at regular intervals), shall always be deemed to be valid.
The Act gives further powers to the RBI under section 45W to "determine the policy interest rate or interest rate products and give directions on that behalf to all agencies or any of them, dealing in securities, money market instruments, foreign exchange, Derivatives, or other instruments of like nature as the Bank may specify from time to time"
Thus, it is in this manner that the provisions on the Indian Contract Act, 1872 were circumvented so as to provide for the trading of Derivatives in India.
Derivative Contracts: A Wager? - Analysis of M/s Rajshree Sugars and Chemicals Ltd. V. M/s Axis Bank Ltd.
In the recent past, there have been numerous occasions in which companies, having entered into Derivative transactions in banks, have challenged the validity of the very same contracts under Section 30 on the Indian Contract Act (Wagering Agreements), when faced with claims.
The first of such cases was M/s Rajshree Sugars and Chemicals Ltd. V. M/s Axis Bank Ltd., C.S. No. 240/2008 decided on October 14th, 2008 by the High Court of Judicature at Madras. The legal battle was concerning a Derivative contract sold by Axis Bank, which resulted in losses for Rajashree Sugars and Chemicals Ltd., to the tune of 50 crore rupees. In the present case the Hon'ble High Court upheld the validity of Derivative contracts, recommending the bank to seek the assistance of the Debt Recovery Tribunal for recovery of the loan. Following is an analysis of the judgement-
Section 30 of the Indian Contract Act provides:
"Agreements by way of wager, void - Agreements by way of wager are void; and no suit shall be bought for recovering anything alleged to be won on any wager, or entrusted to any person to abide the result of any game or other uncertain event on which any wager is made."
The section thus declares wagering agreements to be void, without providing a definition of a wager per se. The most authoritative clarification made by a Court on this subject has been provided by Lindley LJ, Bowen LJ and A.L. Smith LJ, in the case of Carlill v. Carbolic Smoke Ball Co.
"A wagering contract is one by which two persons professing to hold opposite views touching the issue of a future uncertain event, mutually agree that, dependent on the determination of that event, one shall win from the other, and that other shall pay or hand over to him, a sum of money or other stake; neither of the contracting parties having any other interest in that contract than the sum or stake he will so win or lose, there being no other real consideration for the making of such contract by either of the parties."
Therefore, as per the judgement there are three conclusive tests to determine if a contract is a wager.
There must be two persons holding opposite views regarding a future uncertain event.
One of the parties must possess leverage over the other upon the determination of the event (that is, there must be a win-lose situation)
Finally, both the parties must not have any real interest in the happening or not happening of the event, but only an interest in the stake vested in it.
In the view of the Madras High Court the first test was satisfied in this particular case. Furthermore it held the opinion that the second test may not necessarily be satisfied as either party would be compensated by hedging. Therefore neither party can be a winner or loser in absolute terms. The Hon'le High Court has held that the third test is certainly not satisfied in the case at hand, as both the parties clearly have an actual interest because the very intention of the transaction is to hedge an underlying exposure in the rate of exchange.
However, it is humbly submitted that Derivatives can most certainly be classified as wagering contracts.
Derivatives' trading facilitates maximum profits even with minimum investment. As a direct consequence of this type of behaviour, speculative trading is done in large volumes. Speculative Derivative trading is widely known to be a risky business and has resulted in numerous payment crises such as that of the Barings Bank, Lehman Brothers and various others. Hedging only provides for a minimum margin (to be set aside) and in most cases cannot recover the large amounts of money that stand to be lost by the companies. On the other hand, if the process could compensate companies, there would be no cases such as Rajshree appearing before the Court. Thus, Derivatives truly fulfil the second criteria where one party emerges as the absolute winner and the other party suffers losses in any given scenario.
Furthermore, although Derivatives emerged as risk management tools, investors are currently exploiting them for profit maximisation via speculative trading. As a practical observation of the market will suggest, speculators have no interest in the happening or non-happening of the event but only in the stakes.
In the case of M/s Rajshree Sugars and Chemicals Ltd. V. M/s Axis Bank Ltd., the Hon'ble High Court has taken the view that the contract confers a right to seek delivery and if actual delivery can be compelled, it cannot be termed as a wager.
It is submitted herein that a very miniscule proportion of the Derivatives traded actually end in delivery in the market at present. A majority of the contracts are settled by the mere difference in price, also known as cash settlement. In fact, in the case of Derivative based on stock indices physical settlement is not materially possible and can only be settled by a difference in price.
A contract for differences is a contract intended by both parties to end in the payment of differences. For this purpose, a difference is the difference between a sale or purchase price at the time when a contract is made and the corresponding purchase or sale price when it is closed. An agreement to settle differences arising out of a nominal agreement for sale, is really a gamble, and is no less void than an original wagering agreement.
In view of this it is submitted that Derivatives are not excluded from the purview of wagers due to the 'so-called' delivery of shares.
Further, the court has taken the view that a wager must involve a common intention to wager by both the parties. It is the authors' submission that Derivative contracts, in the manner of their operation give ample scope for trade by such parties (that is, those with a common intention to wager). Indeed, that is seen repeatedly in the form of synchronized trading in the markets.
Lastly, the Court has opined that as per the Black-Scholes Model, Derivative prices are determined on the basis of
(i) Stock price of the underlying asset
(ii) Amount of time until expiration
(iii) Strike price of the option
(iv) Volatility of the underlying asset (how much it moves up or down during a given period)
(v) Risk free rate of return (usually the interest rate paid by Govt to banks on guaranteed investments)
Thus, implying that, Derivatives transactions have ceased to be purely speculative transactions as the pricing of the deals, follows a scientific pattern on the basis of Financial Mathematics.Â
However, some of the values on the basis of which these calculations are made, that is, stock price of under lying asset and volatility of the asset, are in themselves fluctuating values contingent on some uncertain future events that control the market. It is therefore submitted that, Derivatives are as much subject to speculation as the value of their underlying asset.
Derivative Trading and the Right to Equality
Article 14 embodies one of the most important rights granted to citizens by the Constitution of India. The right to Equality is not only a Fundamental Right in Part III of the Constitution but is an integral part of the basic structure of the Constitution. Article 14 provides as follows :
"The State shall not deny to any person Equality before the law or equal protection of the laws within the territory of India"
The concept of equal protection of the law envisages equality of treatment in equal circumstances. Any treatment of equals unequally or unequals as equals, will be a violation of Article 14. In other words, where persons or groups of persons are not situated equally, to treat them as equals would itself be violative of Article 14, as this would result in inequality.
The stock market, as it was originally conceived was designed to incentivize the public at large to invest in companies, providing liquidity to the companies and returns (in the form of dividends) to investors thus creating a win-win situation for both parties. It was never intended as a medium for speculation.
Futures trading has facilitated short selling by speculators, paying only a fraction of the price of the asset invested in. Investors in the cash segment on the other hand, pay the full price of the securities traded, accept delivery of the same and cannot short sell with the same ease. Despite this glaring difference, both kinds of investors make profits or losses in the same proportion with respect to the rise and fall of the market making it a classic example of equal treatment of unequals.
It is therefore submitted that trading in Derivatives is highly unfair to investors in the cash segment, with whose genuine investment a company generates profits. Investors trading in Derivatives are merely parasites and sponge off such profits on a daily basis.
Derivative Trading - The Disastrous Possibilities
Warren Buffett, CEO, Berkshire Hathaway, had as early as in 2002 termed Derivatives as "financial weapons of mass destruction". As it turns out, the disastrous economic meltdown of 2008, proved him right. It was Derivatives of mortgages (sub-primes) sold by banks that led the world to this financial fiasco.
Initially in the secondary mortgage market, banks combined hundreds of loans with the help of Wall Street (which received a commission for facilitating the transaction), and sold the package to very large investors, such as insurance companies, mutual funds and foreign companies as an asset. In the nineties Wall Street greed began to rear its ugly head and these packages were further sold as Derivatives called as collateralized debt obligations (CDO's). As a result, unpaid loans were sold to various large investors at a fraction of the total price. It was only when the real estate sector began to destabilise, and the common home owners (who had refinanced their property) defaulted on their loans, that this bubble which was blown out of proportion by pumping in money (which was not available with such over confident investors), finally burst resulting in the crash of major financial institutions, the world over.
Though this was a result of a more complex (and risky) form of Derivatives namely, CDO's, it is submitted that a similar scenario could easily arise due to a spectators default in the case of Futures and Options on securities and currency. There have been numerous such instances - the loss of $1.2 billion in equity Derivatives in 1995 by Barings Bank; Deustche Banks loss of $ 400 million in equity Derivatives and Caisse d'Epargne, a French bank which sustained a loss of euro 600 million, also by trading in equity Derivatives.
Derivative trading allows investors with little capital to invest in large volumes of securities. It thus facilitates large earnings at little cost, but there is an equal possibility of it resulting in a tremendous loss. Speculative trading may not only end as a bad investment, but may also result in gross destabilization of entire markets merely for short-term gains.
In conclusion, it is submitted that the Contract Act and the Constitution embody laws that lay down the fundamental principles based on which the Indian legal system is structured. Though the legislature in its capacity may make over riding provisions, (such as those made in the SCRA and the RBI Act), and side step these basic legislations, for the purpose of legalizing Derivative trading, it is necessary to consider whether Derivatives, as they are today, truly fit into the purview of the Indian legal system.
Similarly, it is equally important to consider their long term implications on the economy. In 2006-07 when inflation began to ring alarm bells, one of the first measures undertaken was a temporary ban Futures trading in certain commodities. Indeed, the heat is being felt again, with the recent rise in onion prices, and a similar ban is being considered by the Government. The spurt in sugar prices too, is attributable to futures trading in the same. The reason for this is that speculators participating in Futures trading are able to manipulate and spike prices, the brunt of which is borne by the common man.
Jawaharlal Nehru, in his wisdom said, "The forces in a capitalist society, if left unchecked, tend to make the rich richer and the poor poorer." Hence, the question of whether Derivatives are truly creating opportunities in the market or merely incentivizing greed is one that requires careful thought and consideration in today's perspective.