The Doubtful Legality of OTC Derivative Markets in India

Neerja Kapur Partner ALG India Law Offices

In this years budget speech before Parliament, the Honble Finance Minister made an observation concerning OTC (Over the Counter) Derivatives. OTC Derivatives (OTC), he said, play a crucial role in mitigating the risks of corporates, banks and other financial entities. There is, however, some ambiguity regarding the legality of OTC derivative contracts which has inhibited their growth. I, therefore, propose to take measures to provide for clear legal validity of such contracts. Notwithstanding such a clear statement of policy and intent, no such measures have yet been taken. Why is there ambiguity regarding the legal validity of OTC Derivatives? Legislation on derivatives by Parliament is referable to the subject Future Markets in Entry 48 of List I of Schedule VII under Article 246 of the Constitution. Parliament has enacted various laws on the subject from time to time and amended them. Section 30 of The Indian Contract Act, 1872 renders agreements by way of wager as void. Suits founded on such agreements are unenforceable in Indian Courts.

Section 43 (5) of The Income Tax, 1961 read with section 73 thereof, prevents loss of a speculation business from being set off except only as against the profits of another speculation business. A transaction in which

a contract for the purchase or sale of any commodity, including stocks and shares, is settled otherwise than by the actual delivery or transfer of the commodity or scrips is a speculation transaction. Section 2 (ac) of the Securities Contract Regulation Act, 1956, defines a derivative to include a contract for differences (CFD) or other contract which derives its value from the p rices, or index of prices, of underlying securities. A security is defined as including a derivative. Under Section 2 (j) of the 1956 Act a stock exchange is for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities. A stock exchange is a forum for trading in securities. In relation to derivatives, it is a forum for trading in derivatives that are created with it or anyone else as a Counter-party. Also, a stock exchange must have members which compulsorily provide intermediation between the stock exchange and clients/customers. This is clear from the framework of the 1956 Act. CFD and other margined Products based on Equity, Index, Commodity, Interest Rates, FX (Foreign Exchange) and FRA (Forward Rate viz. Future : Agreements on Interest Rates linked to FX), would be subsumed within the meaning of security and of derivative. A speculating entity (also a hedging or arbitraging entity) -acting as a derived-price (instead of public original-pric e) -screen-based (or through other modes) -real-time (or even with time lag) -online (or even offline) -order-driven (or even a quote-driven) market maker of such margined products (derivatives), itself acting as a Counter-party, possibly without compulsory intermediation of any type of brokers,

that permits to its clients the creation of such derivative-contracts with itself and then their settlement with itself, without a framework in which they can be traded or contracted -in with third parties nor permitting such third partiess claim for settlement on the strength of any such contract in derivative, -would not be a forum for trading in securities. It would be for itself contracting-in (in contradistinction to assisting, regulating or controlling the business of buying, selling or dealing in) securities. Such an entity would not be organising a stock exchange for the purpose of entering into or performing any contracts in securities within the meaning of the prohibition of section 19 and the penalty prescribed therefore in section 23 (1) ( c) of the 1956 Act.

There is one possible interpretation that can presently save the OTC Derivatives market from the offence cum prohibition of section 18 of the 1956 Act read with section 23 thereof. This rests on a distinction between a derivative-contract and a contract-in-derivative. A derivative-contract (in contradistinction to a contract in derivative) with (in contradistinction to traded on) such an Over The Counter (OTC) entity, unrecognised by the Government under section 4 as a stock exchange, would not fall under section 18A. It would not have the benefit of section 18A which lifts the pale of section 30 (supra) of the 1872 Act and legalises what would otherwise be void contrac ts. Nor would it bear the burden of the penalty for contravention of section 18A which is provided in section 23 (1) (d). The client of such an OTC entity cannot enter into any contract in derivative with any third party and the OTC entity does recognise any such trade and does not accept any such transfer or subrogation on its basis. Thus derivative contracts are void under section 30 of the 1872 Act but entering into of such contracts with (and by) the OTC entity, on this interpretation, is not an offence under section 23 (1) (d) of the 1956 Act. The derivative-contracts (in contradistinction to sale or purchase thereof though contracts in derivatives) are also outside the pale of the prohibition notification No. S.O. 573 (E) dated 30th July, 1992 read with st S.O. No. 183 (E) dated 1 March 2000 issued by SEBI under section 16 (1) of the 1956 Act. Needless, to add there is ambiguity here and the Finance Ministers observation were clearly necessitated by the fact that the OTC Derivatives are sought to be nurtured but the changes in the law necessary to do so consume energy and time.

The interpretation is res integra. It has not been tested in any Court yet. The Finance Minister would, it appears, favour the interpretation to save a burgeoning market from the taint of illegality and the attendant fetters on its growth. But real the answer lies in amending the law if only to clarify this position. Until then, participants in OTC Derivatives markets can only rely on this interpretation to imagine themselves as being on the right side of the strict letter of the law. This interpretation is not just a possible one, it is consistent with other policy objectives of regulating the OTC Derivatives market. The play of other statutes in this regard is untrammelled. Section 2 (1) (i) of The Securities and Exchange Board of India Act, 1992 adopts the definition of securities from the 1956 Act. The Securities and Exchange Board of India (SEBI) acting as the regulatory body for the securities market in India currently permits trading -in Futures (and O ptions) in select approved stocks (currently 41 odd) -and in Futures (and Options) in select approved indexes (currently 2 in number: of the BSE Bombay Stock Exchange and of the NSE- National Stock Exchange) -and in Futures in select Interest Rates- on approved government securities (currently 2 in number: Long Bond futures and National Treasury Bills). on, respectively, the BSE Derivatives Segment and on the NSE Futures and Options (F&O) Segment, which are recognised for this. Although the 1992 Act does not require any registration or licensing or other regulatory compliances for such an OTC entity or in relation to its business with its Introducing Brokers or its Clients, it does vest SEBI with the power of oversight in relation thereto as being a part of the SEBIs general functions and responsibility for the securities market in India under section 11. Other general Rules and Regulations under the 1992 Act such as the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to the Securities Market) Regulations, 2003 also apply.

Of the various margined products - FX Futures and FRAs : are governed also by The Foreign Exchange Management Act, 1999 with RBI (Reserve Bank of India) as the regulator - and the Commodity Futures : are governed also by The Forward Contracts (Regulation) Act, 1952 with FMC (Forward Markets Commission) as the regulator. Thus the position that emerges is that there exist multiple and overlapping regulators for different kinds of Derivatives even as the market itself is converging rapidly. Furthermore, OTC Derivatives markets unanticipated by the regulatory regime cast half a century ago are flourishing and if trends in more developed financial markets are any indicator, here to stay and grow. It is high time the Finance Minister acted on his speech.

Neerja Kapur neerja.kapur@algindia.com Partner ALG India Law Offices