LAW OF FINANCIAL MARKETS & TRANSACTIONS IN INDIA

LAW OF FINANCIAL MARKETS & TRANSACTIONS IN INDIA Session 4 : Law of Derivatives 1012 Krishna 224 AJC Bose Road Kolkata 700017 Phone 033-22811276/ 22813742/ 22817715 Vinod Kothari Vinod Kothari & Company 601C, Neelkanth, 98, Marine Drive, Mumbai-400002 Phone: 022-22817427 www.vinodkothari.com Email: vinod@vinodkothari.com

COPYRIGHT AND DISCLAIMER The contents of the presentation are intended solely for the use of the client to whom the same is marked by us. No circulation, publication, or unauthorised use of the presentation in any form is allowed, except with our prior written permission No part of this presentation is intended to be professional advice, or solicitation of professional assignment. 2

3 Introduction To Derivative Transactions What are derivatives? Derivatives are contracts which derive its value from another contract or asset. These are basically used for hedging the risk, but they are also used to earn higher yields. The types of derivatives depends on the types of risks. Definition:- As per Securities Contract (Regulation) Act, 1956: Section 2(ac) of the act defines Derivative as: Derivatives includes- A) 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; (B) a contract which derives its value from the prices, or index of prices, of underlying securities

Introduction To Derivative Transactions (continued) 4 Definition (continued):- As per Reserve bank of India: Section 45U(a) of the Reserve Bank of India Act, 1934 defines Derivatives as: an instrument, to be settled at a future date, whose value is derived from change in interest rate, foreign exchange rate, credit rating or credit index, price of securities (also called "underlying"), or a combination of more than one of them and includes interest rate swaps, forward rate agreements, foreign currency swaps, foreign currency-rupee swaps, foreign currency options, foreign currency rupee options or such other instruments as may be specified by the Bank from time to time

Introduction To Derivative Transactions (continued) 5 Definition (continued):- As per SFAS: The word Derivative has been defined in SFAS 133 as: A derivative instrument is a financial instrument or other contract with all three of the following characteristics: a. It has (1) one or more underlying, and (2) one or more notional amounts or payment provisions or both. Those terms determine the amount of the settlement or settlements... and in some cases, whether or not a settlement is required. b. It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors. c. Its terms require or permit net settlement, it can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

Introduction To Derivative Transactions (continued) 6 Definition (continued):- As per IAS: As per IAS 39, a Derivative is a financial instrument or other contract with all three of the following characteristics: a) its value changes in response to the change in an underlying variable such as interest rate, commodity or security price; b) it requires no initial investment, or one that is smaller than would be required for a contract with similar response to changes in market factors; and c) it is settled at a future date. Recent judgments determining the definition of Derivative :- Delhi High Court in the case of CIT Delhi-IV Versus DLF Commercial Developers Limited held that trade in Derivatives, which is defined under section 2 of the Securities Contract (Regulation) Act, 1956 are excluded from the definition of speculative transactions under Income Tax Act.

Introduction To Derivative Transactions (continued) 7 Types of Derivatives:- Derivatives Forwards Options Swaptions Futures Swaps

Line of distinction between Forward based derivatives and options Forward Based Derivatives These kind of derivatives are exposed to both favorable and unfavorable situations wherein there can be unlimited gain or loss. Each party in a contract has both right and obligation. The same has been explained below: If the derivative forward contract has been entered at a pre-determined rate of INR 65 and the price of the underlying asset fluctuates to (i) INR 62 or (ii) INR 69. In both the situations the future contract will be performed. In situation (i) there is a profit of Rs. 3 and in situation (ii) there is a loss of Rs. 4. Options These kind of derivatives are exposed to unlimited gain but limits the loss. Here the right to exercise the contract is with one party and the obligation to perform is with another party. If the exercise price of the call option have been entered at INR 65 and the price of the underlying asset fluctuates to (i) INR 62 or (ii) INR 69. Now the option buyer will exercise the option only in situation (ii) and not in situation (i) as the exercise price exceeds the current market rate.

Line of distinction between Forward based derivatives and options 9 Differences between Futures and Forwards:- Futures Forwards Future are exchange traded derivatives. The counterparty in a future transaction is the exchange. The future transactions are subject to margin requirements. The futures are settled on the settlement day. The credit risk associated with futures are comparatively low. Forwards are traded over the counter. The counterparty in a forward transaction is the contracting party. Nothing as such is applicable in case of forward transactions. The forwards are settled at the end of the period mentioned in the contract. The credit risk associated with forwards are higher than that of the futures.

10 Various forms of Derivatives The various forms of derivatives depends mainly upon the various forms of risks from which such derivative arises, some of them have been listed below: Interest rate derivatives: It is a financial instrument whose value is affected by the change in interest rates. The institutional investors use these to hedge the risk of loss due to change in the interest rates. Whereas the individual investors uses these as a speculative tool. Forex derivatives: It is a financial instrument whose value is affected by the change in rates of foreign currencies. These are generally used by the foreign exchange traders or other entities who wants to hedge the risk of loss due to change in foreign currency rates. Credit derivatives: It is a financial instrument whose value is affected by the creditability of an entity. Equities derivatives: It is a financial instrument whose value is affected by the value of equities. It helps the investors to minimize the risk of loss due to the fall in the value of equity secuities.

Derivatives Forward based derivatives Options Forward Contracts Swaps Futures Contracts Foreign exchange forwards Forward rate agreements Interest Rate Swap Currency Swap Commodity Swap Equity Swap

12 Law of Derivatives Can Derivative Contracts be regarded as Wagering Contracts?? The answer to this question would NO. In a wagering contract, one party wins whereas the other one loses, on the happening of a certain uncertainty, and the only motive of the contract is to transact in money based on the happening of the uncertainty. Whereas, in a derivative transaction, the parties enter into a contract to protect the loss of one party, which cannot be regarded as wager. In order to have a wager, the motive of both the parties should be common i.e. to gain or loss money on the happening of an uncertainty.

13 Law of Derivatives (continued) General bar on derivatives: In some countries there may be omnibus bar on all futures and options, other than those that are specifically permitted i.e. only derivatives permitted by law will be allowed, others will stay banned. The bar on the operation of the derivatives differs from country to country. If a law sets a bar on a particular type of derivative, then the rest remains operative except the one which has been prohibited. For instance: Sec 19 of the Forward Contract (Regulation) Act, 1952 puts the following general bar: Prohibition of options in goods.-- (1) Notwithstanding anything contained in this Act or in any other law for the time being in force, all options in goods entered into after the date on which this section comes into force shall be illegal.

14 Laws of Derivatives in India Forward Contracts Regulation Act, 1952 The Securities Contracts Regulation Act, 1956 Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulations, 2000 Reserve Bank of India Act, 1934

15 Laws of Derivatives in India (continued) Forward Contracts Regulation Act, 1952: This act regulates in the transactions of the commodity futures in India. This act classifies the transactions into two categories: ready delivery contracts and forward contracts. Ready delivery contract are those where delivery of goods and full payment of price therefore is made within a period of eleven days. Forward contract as the contract for delivery of goods which is not a ready delivery contract. This Act very clearly prohibits options in goods. By the provisions of section 19, such agreements are prohibited. The act declares the following contracts to be illegal: Forward Contracts in the permitted commodities, i.e., commodities notified under Section 15 of the Act, which are entered into other than: (a) between the members of the recognised Association or (b) through or (c) with any such members. Forward contracts in prohibited commodities, i.e., commodities notified under section 17 of the Act. Forward Contracts in contravention of the provisions contained in the Bye-laws of the Exchange, which attract section 15 (3) of the Act. Forward Contracts in the commodities in which such contracts have been prohibited.

16 Laws of Derivatives in India (continued) The Securities Contracts Regulation Act, 1956: The futures market in stocks and securities are regulated by the Securities Contract Regulation Act, 1956. The definition of 'securities' under SCRA has been amended to include derivative contracts. (Defined earlier) Section 18A talks about the Contracts in derivatives: 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 (a) traded on a recognized stock exchange; (b) settled on the clearing house of the recognized stock exchange, in accordance with the rules and bye-laws of such stock exchange.

17 Laws of Derivatives in India (continued) Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulations, 2000: Forex derivatives are governed by FEMA as well. Regulation 2 (v) of Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulations, 2000 defined "Foreign Exchange Derivative Contract" as follows: 'Foreign exchange derivative contract' means a financial transaction or an arrangement in whatever form and by whatever name called, whose value is derived from price movement in one or more underlying assets, and includes, (a) a transaction which involves at least one foreign currency other than currency of Nepal or Bhutan, or (b) a transaction which involves at least one interest rate applicable to a foreign currency not being a currency of Nepal or Bhutan, or (c) a forward contract, but does not include foreign exchange transaction for Cash or Tom or Spot deliveries.

18 Laws of Derivatives in India (continued) Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulations, 2000 (continued): Regulation 4 of the aforesaid regulations permitted a person resident in India to enter into a foreign exchange derivative contract. Regulation 5 provides that a person resident outside India may enter into a foreign exchange derivative contract with a person resident in India.

19 Laws of Derivatives in India (continued) Reserve Bank of India Act, 1934: RBI is empowered to regulate the interest rate derivatives, foreign currency derivatives and credit derivatives. The law provides that transactions in derivatives shall be valid if at least one of the parties to the transactions is RBI, a scheduled bank or such other agency regulated by RBI. RBI issued Comprehensive guidelines on derivatives in 2007 to regulate the transactions of interest rate derivatives, foreign currency derivatives and the credit derivatives in a better way. The Comprehensive guidelines defines the parties of the transaction as User and Market maker: A user participates in the derivatives market to manage an underlying risk. A market-maker provides bid and offer prices to users and other market-makers. There has to be at least one market maker in the transaction. Permissible instruments as per the Comprehensive guidelines are: Rupee interest rate derivatives Interest Rate Swap (IRS), Forward Rate Agreement (FRA), and Interest Rate Futures (IRF). Foreign Currency derivatives Foreign Currency Forward, Currency Swap and Currency Option (Separate guidelines regarding Foreign Currency derivatives are being issued).

20 Interest Rate Derivatives Definition: It is a financial instrument whose value is affected by the change in interest rates. The institutional investors use these to hedge the risk of loss due to change in the interest rates. Whereas the individual investors uses these as a speculative tool.

21 Interest Rate Derivatives (continued) Existing Products in the market: Forward Rate Agreements Interest Rate Swaps Interest Rate Futures

22 Classification of Interest Rate Derivatives Interest Rate Derivatives Over the Counter Exchange Traded Forward Rate Agreements Interest Rate Swaps Interest Rate Futures

23 Forward Rate Agreements What are Forward Rate Agreements (FRA): A Forward Rate Agreement is a financial contract between two parties to exchange interest payments for a `notional principal amount on settlement date, for a specified period from start date to maturity date. Accordingly, on the settlement date, cash payments based on contract (fixed) and the settlement rate, are made by the parties to one another. The settlement rate is the agreed bench-mark/ reference rate prevailing on the settlement date. Buying and Selling FRA Buying a FRA means a contract to borrow a certain amount in future at predetermined interest rate. Selling a FRA means to contract to invest a certain amount in future at predetermined interest rate. Compulsorily cash settled A FRA contract is compulsorily cash settled and there is no actual borrowing or investment. Settlement of FRA on maturity takes place at the present value of the difference between the FRA rate and the actual rate.

24 Forward Rate Agreements (continued) Purpose of use Hedging: When there is an existing exposure and long or short position in the derivative is taken to eliminate that exposure. Speculation: There is no existing exposure but there is a price believe and long or short position is taken in the derivative in expectation of profiting from the price believe. Arbitrage: There is mispricing between the underlying asset and the derivative. Simultaneous long and short position is taken to make riskless profit based on this mispricing.

25 Interest Rate Swaps (IRS) What is an IRS? An Interest Rate Swap is a financial contract between two parties exchanging or swapping a stream of interest payments, indexed to two different interest rates, for a `notional principal amount on multiple occasions during a specified period. Such contracts generally involve exchange of a `fixed to floating or `floating to fixed rates of interest. Accordingly, on each payment date - that occurs during the swap period cash payments based on fixed/ floating and floating rates, are made by the parties to one another. Corporates used them for sometime as an efficient off-balance sheet method to manage interest rate exposure arising from their assets and liabilities.

Examples of Interest Rate Swaps Floating to fixed Fixed to floating LIBOR to prime Prime to LIBOR Currency A to currency B

27 Plain Vanilla Swap Fixed-Rate Payer Fixed Payments Ask Rate Floating Payments Dealer Fixed Payments Bid Rate Floating Payments Floating- Rate Payer

28 Interest Rate Futures Interest Rate Futures (IRF) Interest Rate Future is a standardized, exchange-traded contract with an actual or notional interest-bearing instrument(s) as the underlying asset. Futures used for: Speculation using futures: It can be either outright or spread trading Hedging through futures Arbitrage through futures

29 Foreign Exchange Derivatives Definition: Any financial instrument that locks in a future foreign exchange rate. Used by currency or foreign exchange traders and big corporate houses. The corporate houses use this when they expect to receive foreign currencies in future, and they want to hedge their risk of loss due to change in currency rates.

30 Foreign Exchange Derivatives FORWARD CONTRACTS TO HEDGE TRANSACTION EXPOSURE FORWARD CONTRACTS TO HEDGE ECONOMIC EXPOSURE CURRENCY FUTURES CURRENCY OPTIONS CROSS CURRENCY SWAPS EQUITY SWAP CREDIT SWAP

31 Currency Swaps A currency swap is an interest rate swap where the two legs to the swap are denominated in different currencies. The parties may agree to exchange the two currencies normally at the prevailing spot exchange rate with an agreement to reverse the exchange of currencies, at the same spot exchange rate, at a fixed date in the future, generally at the maturity of the swap.

32 Currency Options A currency option is a contract where the purchaser of the option has the right but not the obligation to either purchase (call option) or sell (put option). The seller (or writer) of the option agrees to sell (call option) or purchase (put option) an agreed amount of a specified currency- at a price agreed in advance and denominated in another currency (known as the strike price) on a specified date (European option), or by an agreed date (American option) in the future.

33 Currency Forward This a contract through which price of a currency is locked at which it can be bought or sold. Contract holders are bound to buy or sell the currency at a specified price, at a specified quantity on a specified date.

34 Currency Futures This is a contract for deliver of a curency on a future date. Unlike Currency Forwards, it is traded on the basis of a standard quantity, standard time period. It is traded on the stock exchange. It provides protection against risk of fluctuations in the spot rate.

35 REGULATIONS OF FOREIGN EXCHANGE DERIVATIVES The existing foreign exchange derivative regulations in India are as follows: Foreign Exchange Management (Foreign exchange derivative contracts) Regulations, 2000 Securities Contract (Regulation) Act Reserve Bank of India Act Comprehensive Guidelines on Foreign Exchange Derivatives and Hedging Commodity Price Risk and Freight Risk Overseas

36 REGULATIONS OF FOREIGN EXCHANGE DERIVATIVES Securities Contract (Regulation) Act: Section 18A of the Securities Contracts Act legalizes derivatives traded in recognized exchanges. It says- 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 (a) traded on a recognised stock exchange; (b) settled on the clearing house of the recognised stock exchange, in accordance with the rules and bye-laws of such stock exchange.

37 REGULATIONS OF FOREIGN EXCHANGE DERIVATIVES Reserve Bank of India Act: Sec 45V of the RBI Act provides that Derivatives contracts are valid only if at least one of the parties to the derivative is a bank or an entity falling under the regulatory purview of the Reserve Bank of India. The section also provides legality to all derivatives permitted by the RBI. The RBI Act provisions are pertinent to derivatives in general, and are not specifically directed to forex derivatives.

38 Master Circular on Risk Management and Inter-Bank Dealings Product-wise, the transactions have been classified broadly into three categories: Contracted Exposures Probable Exposure Special Dispensation

39 Master Circular on Risk Management and Inter-Bank Dealings (continued) Contracted Exposure Forward Foreign Exchange Contracts Cross Currency options Foreign Currency INR Options Foreign Currency INR Swaps Cost Reduction Structures Hedging of borrowings in foreign exchange

Master Circular on Risk Management and Inter-Bank Dealings (continued) Contracted Exposure Products Market Maker User Sub Products 40 Forward Foreign Exchange Contracts AD Category I Bank Persons Resident in India Cross Currency Options (not involving INR) Foreign Currency-INR Options AD Category I Banks as approved by RBI for this purpose AD Category I Banks as approved by RBI for this purpose Persons Resident in India Persons Resident in India Foreign Currency-INR Swaps AD Category I Bank Residents having foreign currency liabilities Incorporated bodies having foreign currency liabilities Cost Reduction Structures AD Category I Banks Listed companies along with their associates having a net worth together of Rs. 200 crore Hedging of borrowings in foreign exchange AD Category I Bank Offshore banking unit in SEZ Branch outside India of an authorized bank Residents in India who have borrowed in foreign currency. Interest Rate Swap, Cross Currency Swap, Cross currency Options, Interest rate cap or collar, Forward Rate Agreement

41 Master Circular on Risk Management and Inter-Bank Dealings (continued) Probable Exposure Market Maker AD Category I Banks in India User Corporates who are importers and exporters having a Net Worth of at least Rs. 200 Crores and an annual turnover of Import and Export of Rs. 1000 crores. Products Forward foreign exchange contracts Cross currency options (not involving the rupee) Foreign currency- INR options Cost reduction structures

42 Master Circular on Risk Management and Inter-Bank Dealings (continued) Special Dispensation Category Market Maker Products Small and Medium Enterprises Resident Individuals AD Category I AD Category I Forward Foreign Exchange Contracts Forward Foreign Exchange Contracts

43 Comprehensive Guidelines on Derivatives by RBI Broad Principles for Derivative Transactions: Market makers may undertake a transaction in a derivative structured product as long as it is a combination of two or more generic instruments permitted by RBI and does not contain any derivative instrument in underlying. Market-makers should be in a position to arrive at the fair value of all derivative instruments, including structured products on the basis of the following approach : (a) Marking the product to market, if a liquid market in the product exists. (b) In the case of structured products, marking the constituent generic instruments to market. (c) If (a) and (b) are not feasible, marking the product to model, provided: All the model inputs are observable market variables. Full particulars of the model, including the quantitative algorithm should be documented. It may be ensured that structured products do not contain any derivative, which is not allowed on a stand alone basis.

44 Comprehensive Guidelines on Derivatives by RBI (continued) All permitted derivative transactions, including roll over, restructuring and novation shall be contracted only at prevailing market rates. All risks arising from derivatives exposures should be analyzed and documented, both at transaction level and portfolio level. The management of derivatives activities should be an integral part of the overall risk management policy and mechanism. It is desirable that the board of directors and senior management understand the risks inherent in the derivatives activities being undertaken. Market-makers should have a Suitability and Appropriateness Policy visà-vis users in respect of the products offered, on the lines indicated in these guidelines. Market-makers may, where they consider necessary, maintain cash margin/liquid collateral in respect of derivative transactions undertaken by users on mark-to-market basis.

45 Comprehensive Guidelines on Derivatives by RBI (continued) Documentation: ISDA master agreement, however necessary adjustments can be made. Specific confirmation for each transaction which should contain the details of various terms of contract like gross amount, rate, value date, etc.. Participants must ensure that the counterparties are competent to enter into contract, power and authority to enter into contract. Participants must obtain documentation regarding customer suitability, appropriateness etc.

Comprehensive Guidelines on Derivatives by RBI (continued) 46 Prudential Limit on Derivatives: PV 01 of all non-option rupee derivative contracts (including rupee foreign currency contracts) should be within 0.25% of the Net Worth of the bank as on the date of last Balance Sheet. Prudential Norms on derivatives issued by RBI from time to time will have to be complied by the participants.

47 Documentation of Derivatives Though the parties to a derivative transaction are free to choose their documentation template, however ISDA from time to time comes up with drafts of various standard common documentation templates for the parties to use. Generally, a derivative transaction is backed by the following documents: Master Agreement: The master agreement generally covers all OTC derivative transactions. Schedule to the master agreement: This contains certain items to be filled in. Confirmation of trade: Once the parties to the transaction agrees to carry out a particular trade, they have to sign a confirmation, which is a legal memo for the transaction. This document does not bring the transaction into effect, it simply records the confirmation of the parties. Each confirmation is backed by definitions, there are definitions for different kinds of derivatives, like for Credit Derivatives, the 2003 credit Derivative Definitions are relevant.

48 ISDA Master Agreement The common master agreement in use is 1992 Master Agreement, which is also known as multi-currency, cross-border master agreement. In 2002 ISDA came out with a revised master agreement. The principal features of the master agreement have been discuss below: Netting: It is one of the most significant clause, as it provides for the details of netting. The netting clause provides for the following things: It says that netting is possible in case of all sums payable in a particular currency. It also says that netting is applicable to all the sums payable in a particular day. By default, cross currency netting is applicable to all derivative transactions covered by the master agreement.

49 ISDA Master Agreement (continued) Grossing up for withholding taxes: It talks about grossing up of withholding taxes. It says all indemnifiable tax will be grossed up. Indemnifiable tax refers to the taxes arising out due to the reasons of residence, tax residence or permanent establishment of the tax payer. Representations and warranties of both the parties: The representations and warranties have been put very succinctly. There are some basic representations such as authority to enter into the transaction, consents, and so on. Apart from these, the other representations made by the parties are listed below: No events of default, or potential evens of default, have either occurred or would occur as a result of the agreement or any credit support document. There is no litigation pending or threatened that may affect the legality, validity, or enforceability of the agreement or credit support documentation. All information is true, accurate and complete.

50 ISDA Master Agreement (continued) Mutual covenants on compliances: As per this clause the parties shall adhere to reasonable demands for the information by the counterparties. The parties shall ensure that the agreements continue to remain authorized and applicable laws are complied with at all times. Events of Default: This clause is important as it sets out the events of defaults and termination events. The events of default are listed below: Failure to pay any sum payable under the agreement constitutes an event of default. Breach of agreement, any breach of any other covenant of the agreement remaining un remedied for 30 days of notice of the breach being given by the other party will be taken as an event of default. Credit support default, this clause covers several breaches of credit support agreements.

51 ISDA Master Agreement (continued) Misrepresentation includes incorrect and misleading representations in any material respect. Default under specified transaction and cross default, deals with cross defaults under other transactions and specified entities are filled up in the schedule. Bankruptcy Merger without assumption, refers to the when a counterparty merges into some other entity, and the merged entity does not takeover the obligations of the merging entity under the derivatives contract. Termination Events: This includes those events, which does not constitute an event of default, rather gives a right of termination. Termination event includes the following: Illegality, if any illegality arises that makes the transaction or the contract illegal, then the event is treated as illegal. Some of the events are- Adoption or change in law, Change in interpretation of law etc.

52 ISDA Master Agreement (continued) Tax event and tax event upon merger Credit event upon merger Consequences of events of defaults: The happening of an event of default gives rise to two possibilities- Termination upon notice Automatic termination (incase of Bankruptcy, only if the parties agrees to do so) Consequences of termination events: Termination events gives rise to early termination. If a termination happens due to one single party then such party may transfer the contract to any other affiliated party to avoid illegality or tax event.

53 ISDA Master Agreement (continued) Early Termination: This clause talks about the early termination of a contract. Early Termination of Payments: This talks about computation of early termination payments: Loss and market quotation, the Loss has been replaced by Replacement value in 2002 s draft. Choice of jurisdiction: This shows the jurisdiction under which the parties will settle their disputes.

54 Applicability of SARFAESI Act while recovering debt arising from Derivative Transactions To make a move under SARFAESI Act, 2002 there must be a- Secured Creditor Secured Loan Security Interest Loan classified as Non Performing Asset. Borrower The Security interest must not fall under section 31 In a derivative transaction- The bank and the counterparty are two parties to a contract of purchase and sell There is no financial assistance in a derivative transaction. In a derivative transaction the capacity of the Bank is of a derivative dealer. So ideally, Derivative Transactions are not covered by the SARFAESI Act.

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