Legal and Regulatory Environment — the whole chapter in plain English

Where the law comes from

Everything in this chapter hangs on one sentence from the workbook:

The trading of derivatives is governed by the provisions contained in the Securities Contracts (Regulation) Act, 1956; the Securities and Exchange Board of India Act, 1992; the rules and regulations framed thereunder and other rules and bye-laws of stock exchanges.

Four layers, in that order. Two Acts of Parliament, then the regulations SEBI makes under them, then each exchange's own rules and bye-laws. Nothing in derivatives trading sits outside that stack.

The 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" is defined in Section 2(h) of the SCRA. Learn that section number — it is asked directly.

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 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 investors under any mutual fund scheme
• Any certificate or instrument issued to an investor by an issuer being a special purpose distinct entity which possesses any debt or receivable, including mortgage debt, assigned to it, acknowledging the investor's beneficial interest in that debt or receivable
• Government securities
• 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

And the exclusion that gets tested: securities do NOT include any unit linked insurance policy, or any scrip, instrument or unit by whatever name called which provides a combined benefit of risk on the life of the person and investment by such person, issued by an insurer referred to in clause (9) of section 2 of the Insurance Act, 1938 (4 of 1938).

How the Act defines "derivatives"

Four limbs:

• 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
• Such other instruments as may be declared by the Central Government to be derivatives

Section 18A — the section that makes your trade legal

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:

• Traded on a recognised stock exchange, and
• Settled on the clearing house of the recognised stock exchange, in accordance with the rules and bye-laws of such stock exchanges

Both conditions, together. This is the legal foundation of the entire exchange-traded derivatives market in India.

The SEBI Act, 1992

The SEBI Act, 1992 provides for the establishment of the Securities and Exchange Board of India with statutory powers for:

• (a) protecting the interests of investors in securities
• (b) promoting the development of the securities market
• (c) regulating the securities market

Three objectives, always in that order. Protect, promote, regulate.

Its regulatory jurisdiction extends over corporates in the issuance of capital and transfer of securities, in addition to all intermediaries and persons associated with the securities market. SEBI is obligated to perform these functions by such measures as it thinks fit — deliberately broad wording.

In particular, SEBI 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, intermediaries and self-regulatory organizations
• Performing such functions and exercising such powers under the SCRA, 1956 as may be delegated to it by the Central Government

That last bullet matters, and it is a favourite trap. SEBI does not own the SCRA. It exercises those particular powers because the Central Government delegated them.

The L. C. Gupta committee and how derivatives arrived

A committee under the chairmanship of Dr. L. C. Gupta was set up by SEBI to develop the appropriate regulatory framework for derivatives trading in India.

On 11 May 1998, SEBI accepted the recommendations of the committee and approved the phased introduction of derivatives trading in India, beginning with stock index futures.

Two details in that sentence carry marks: the date, and the fact that the phased rollout began with stock index futures — not options, not stock futures.

But none of it would have worked without one legislative change: the amendment of the SCRA to include derivatives within the ambit of "securities" made trading in derivatives possible within the framework of that Act. Before derivatives were "securities", there was no legal home for them.

What an exchange must do to run a derivatives segment

Net worth: the numbers you must know cold

The minimum net worth for clearing members of the derivatives clearing corporation shall be ₹300 lakhs.

And the workbook gives you the exact recipe for computing it:

Net worth = Capital + Free reserves

Less non-allowable assets, namely:

• Fixed assets
• Pledged securities
• Member's card
• Non-allowable securities (unlisted securities)
• Bad deliveries
• Doubtful debts and advances
• Prepaid expenses
• Intangible assets
• 30% of marketable securities

That last line is the one candidates forget. Only 30% of marketable securities is deducted — not all of it, and not none of it.

Then the separate eligibility table in section 8.5:

Clearing members must furnish an auditor's certificate for the net worth every 6 months to the exchange.

Liquid net worth of at least ₹50 lakhs must be maintained with the exchange / clearing corporation by every clearing member — both clearing members and self-clearing members.

And a distinction that is pure exam material: net worth criteria for Clearing Members are provided by SEBI, while net worth criteria for Trading Members and Limited Trading Members are decided by the stock exchanges. A few exchanges have a special category called Limited Trading Members, who are not cash market members of the exchange.

Contract value

The minimum contract value shall not be less than ₹5,00,000, and this is subject to change as per SEBI and Exchange rules.

Effective 20 November 2024, SEBI has prescribed a minimum contract value in the range of ₹15 to 20 lakhs. Exchanges have to submit details of the futures contract they propose to introduce.

Know Your Customer and the Risk Disclosure Document

The L. C. Gupta committee report requires strict enforcement of the "Know your customer" rule and requires that every client shall be registered with the derivatives broker.

Members of the derivatives segment must make their clients aware of the risks involved in derivatives trading by issuing to the client the Risk Disclosure Document and obtaining a copy of the same duly signed by the client. The broker is required to get this signed at the time of client registration.

Trading members are required to have a qualified approved user and sales person who have passed a certification programme approved by SEBI.

On certification, the eligibility section adds the specifics: members are required to pass the certification programme approved by SEBI, every trading member is required to appoint at least two approved users who have passed it, and only the approved users are permitted to operate the derivatives trading terminal.

Collateral, records, inspection and default

All collateral deposits are segregated into cash component and non-cash component.

Note the counter-intuitive bit: a bank guarantee and an FDR are "cash component", even though neither is literally cash.

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.

The purpose of inspection of stockbrokers' records under the SEBI (Stock Broker) Regulations, 2026 is to ensure that the books of accounts and other books are being maintained in the manner required.

And the rule with the widest consequences:

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.

Who grants recognition, and over what

The recognition to a stock exchange under the Securities Contracts (Regulation) Act, 1956 can be granted by the Central Government. Not SEBI.

The Act provides for direct and indirect control of virtually all aspects of securities trading and the running of stock exchanges, and aims at preventing undesirable transactions in securities. It gives the Central Government regulatory jurisdiction over:

• (a) Stock Exchanges, through a process of recognition and continued supervision
• (b) Contracts in securities
• (c) Listing of securities on Stock Exchanges

When a broker can be penalised or suspended

A penalty or suspension of registration of a stock broker under the SEBI (Stock Broker) Regulations, 2026 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

Eight separate grounds. When the exam offers three of them and an "any of the above" option, the answer is any of the above.

Position limits

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.

But note the two-tier structure. Each Clearing Member may have several Trading Members with him, and the trading limits for each such Trading Member are decided by the Clearing Members on the computerized trading system. SEBI sets the outer position limits; the clearing member sets the trading limits for the members clearing through him.

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.

In one line: new positions will not be permitted, but only squaring-off of existing positions will be permitted. You are not thrown out of the market — you are restricted to shrinking.

Membership structure for the F&O segment

Anybody interested in taking membership of the 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".

Either combination gives the member the right to execute trades and to clear and settle the trades executed by the members in these segments.

Three further facts:

• An existing member of the CM segment can also take membership of the F&O segment.
• A trading member can also be a clearing member by meeting additional requirements.
• There can also be only clearing members — entities that clear without trading at all.

Margins and liquid assets

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. These limits are set through the facility provided on the trading system up to the time specified, and once set are applicable to those trading members / custodial participants for that day, unless otherwise modified by the 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 the clearing corporation and attracts penalty from the Clearing Corporation.

The clearing corporation can also initiate other disciplinary actions: withdrawal of trading facilities and/or clearing facility, close out of outstanding positions, imposing penalties, collecting appropriate deposits, and invoking bank guarantees / fixed deposit receipts.

A clearing member is required to provide liquid assets which adequately cover various margins and liquid net worth requirements. He may deposit them as 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.

What the clearing corporation is responsible for

• 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
• Keeping a consistent record of margins at client level
• Ensuring that client margins are not appropriated against brokers' dues

That last one is the investor-protection line in the list. Your money as a client is not available to pay your broker's debts.

And the power that goes with it: 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.

What the exchange must report to SEBI

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

The Trade Guarantee Fund

Main objectives of the 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 an initial contribution towards the Trade Guarantee Fund of the Exchange.

Note the word bonafide. The fund guarantees genuine transactions — it is not a fund for underwriting misconduct.

Standard Operating Procedure on default by a 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.

The whole point of the SOP is stated plainly: 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.

And the interim measure, with a hard number in it:

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 ₹25 lakh — using the unencumbered deposits available with them. Investors with credit balances exceeding ₹25 lakh are to be paid on a pro-rata basis from the remaining funds.

Small investors get settled first and in full from unencumbered deposits. Larger balances queue behind them, pro-rata, from what is left.

Standard Operating Procedure for a stock exchange outage

Laid down by SEBI Circular SEBI/HO/MRD-TPD-1/CIR/P/2023/7 dated 9 January 2023.

The reasoning first: if 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.

The steps:

• The affected stock exchange must inform SEBI immediately on occurrence of the outage, through an email.
• 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, 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 exchange must restore normalcy at the earliest, including activating its Disaster Recovery Site.
• The exchange must inform market participants at least 15 minutes before the resumption of trading.

Note that 15 minutes appears twice, doing two different jobs: within 15 minutes to announce the outage, at least 15 minutes of notice before trading resumes.

Extension of trading hours

Two things to notice. The extension is one and a half hours, not one hour. And it applies to all stock exchanges, not only the one that had the outage — because positions and hedges span exchanges, and closing an intraday position on one may require trading on another.