future and option market

8/8/2019 Future and Option Market

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BES s I NS TI TUTE OF MANAGEMENT S TUDI ES AND RES EARCH

REGULATIONS OF FUTURE AND OPTIONMARKET

Submitted To:

Prof. Mustafa Sapatwala

Submitted By:

Mr. Kunal Gajanan Malode

Roll No: 30

S.Y.M.M.S

Regul a t i ons o f F u t u r e and Opt i on Mar ke t s


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Introduction

The term futures and options (also known as derivatives) refers to contracts which are

traded in financial markets. A futures contract requires delivery of a commodity, bond,

currency, stock or index, at a specified price, on a specified future date. The physical delivery

of underlying asset may or may not happen. Instead, it may be squared off before its expiry

date. For example, if a person is long on index future i.e. who bought the contract at the

beginning of the month may sell it just two days prior to its expiry. The difference in the

value of contract will be paid to him as profit (or deducted from his account as loss) as the

case may be. Similar to trading stocks, a certain percentage of the traded value will be levied

as commission (brokerage), a service tax (to the brokerage amount) and a securities

transaction tax (STT). The brokerage may vary for different brokers. Some may charge a

fixed brokerage; some may charge based on traded value.

There are 1 month, 2 month and 3 month futures contracts available in India. The contracts

are settled on the last Thursday of every month. If this happens to be a trading holiday, the

previous day would be the expiry date.

The risk involved in trading a futures contract is equal for both buyer and seller or

symmetrical. Futures trading also come under the purview of Securities and Exchange

Board of India (SEBI).

In case of short selling equity shares (selling a share one doesnt possess) the trade needs to

be squared off on the same day; otherwise the short sold equity shares will be sold in auction.

The short seller will be penalized by the exchange for not squaring it off. But in case of

futures no such thing happens; a person can carry a short position overnight. He can

continue to do so till the expiry date. However, the minimum margin requirements need to be

maintained. Margin money is defined as the amount, based on which the broker may allow

purchase or sale of a stock or future; this margin also varies from broker to broker. In case of

equity share purchases using margin trading, the buyer needs to pay the outstanding amount

to the broker before a fixed date i.e. before he receives delivery of shares. In case of futures,

stocks in possession can be used as margin for trading in futures; however, market to market

obligations (such as losses) need to be met in cash.

Futures contract prices also have the same structure like the cash market prices. But there is

no price band for futures or options; to avoid errors in entering orders the exchange may fix

the price range. Prices in excess of the range will need to be reviewed by the exchange. In



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addition, if the open interest or the maximum number of outstanding contracts exceeds a

certain value, no fresh positions will be allowed for the particular scrip.

An option is a contract giving the buyer the right, but not the obligation, to buy or sell an

underlying asset (a stock or index) at a specific price on or before a specified date. In the case

of a stock option, its value is based on the underlying stock (equity). For an index option, its

value is based on the underlying index.

Options are traded in the same way like stocks. They can be bought and sold just like any

other security. In case of options, the buyer pays the premium amount only; not the value of

the entire contract. The commission for the Options, however, will be based on the value

(strike price) of the underlying assets.

There are two option types; Call and Put.

A Call option is an option to buy a stock or index at a specific price on or before an expiry

date. Call options usually increases in value as the value of the underlying asset increases.

The premium amount is paid by the buyer to secure the right to buy the underlying asset. In

case, if one does not want to buy the underlying asset, he will lose the option premium paid;

no other obligation exists between him and the option seller.

Put option is an option to sell a stock or index at a specific price on or before a expiry date.

Similar to the call option, a premium amount is paid by the buyer of the put option. In case if

he does not want to sell the underlying asset, as in the case of call option, he will lose the

option premium.

There are two types of expiration; European style in which options cannot be exercised until

expiry date; American style in which options can be exercised anytime before expiry. In

India all stock options are American style and index options are European style.

Option contracts should never be short sold. If the market turns the other way around, the

buyer or seller may want to exercise the option. In this case loss resulting from shorting the

option will be huge; so short selling options is very risky.

Strike Price is defined as the price at which the underlying security can be bought or sold

as specified in the option contract. Spot price refers to the market price of the underlying

security. An option writer is defined as the one who sells the option to the option holder.

Futures Contracts have symmetric risk profile for both buyers as well as sellers, whereas

options have asymmetric risk profile. In case of Options, for a buyer (or holder of the

option), the downside is limited to the premium (option price) he has paid while the profits



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may be unlimited, depending upon the spot price and whether he wants to exercise the option

or not.

In India, at the NSE, an index future trading was introduced in the year 2000. Index Options

trading was also made available in 2001. Stock futures were introduced a little later. F & O

index contracts are available in Nifty, Junior Nifty, Bank Nifty, CNX IT (IT sector index)

and CNX 100 (diversified 100 stock index accounting for 35 sectors of the economy). For

individual securities, F & O contracts are available in one hundred and eighty seven scrips,

starting from Aban Offshore to Zee Entertainment Enterprises Limited.

The contracts are traded as lots meaning a contract will have certain fixed number of

instruments. For example, the nifty shall have 50 instruments and it is called lot size. When a

buyer places an order for a contract he has to bid for 50 or multiples of 50. Stock futures are

available for most of the Nifty and Junior Nifty stocks. The stocks are chosen from amongst

the top 500 stocks in terms of average daily market capitalization and average daily traded

value in the previous six months on a rolling basis. The market wide position limit in the

stock shall not be less than Rs. 50 crore. The market wide position limit (number of shares)

shall be valued taking the closing prices of stocks in the underlying cash market on the date

of expiry of contract in the month. The market wide position limit of open position (in terms

of the number of underlying stock) on futures and option contracts on a particular underlying

stock shall be 20% of the number of shares held by non-promoters in the relevant underlying

security i.e. free-float holding.

Financial markets are, by nature, extremely volatile and hence the risk factor is an important

concern for financial agents. To reduce this risk, the concept of derivatives comes into the

picture. Derivatives are products whose values are derived from one or more basic variables

called bases. These bases can be underlying assets (for example forex, equity, etc), bases or

reference rates. For example, wheat farmers may wish to sell their harvest at a future date to

eliminate the risk of a change in prices by that date. The transaction in this case would be the

derivative, while the spot price of wheat would be the underlying asset.

Regulation in Indian derivative market

Development of exchange-traded derivatives

Derivatives have probably been around for as long as people have been trading with one

another. Forward contracting dates back at least to the 12th century, and may well have been



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around before then. Merchants entered into contracts with one another for future delivery of

specified amount of commodities at specified price. A primary motivation for pre-arranging a

buyer or seller for a stock of commodities in early forward contracts was to lessen the

possibility that large swings would inhibit marketing the commodity after a harvest.

The need for a derivatives market

The derivatives market performs a number of economic functions:

1. They help in transferring risks from risk averse people to risk oriented people

2. They help in the discovery of future as well as current prices

3. They catalyze entrepreneurial activity

4. They increase the volume traded in markets because of participation of risk averse people

in greater numbers

5. They increase savings and investment in the long run

The participants in a derivatives market

Hedgers use futures or options markets to reduce or eliminate the risk associated with price

of an asset.

Speculators use futures and options contracts to get extra leverage in betting on future

movements in the price of an asset. They can increase both the potential gains and potential

losses by usage of derivatives in a speculative venture.

Arbitrageurs are in business to take advantage of a discrepancy between prices in two

different markets. If, for example, they see the futures price of an asset getting out of line

with the cash price, they will take offsetting positions in the two markets to lock in a profit.

Types of Derivatives

Forwards: A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at todays pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a

certain time in the future at a certain price. Futures contracts are special types of forward

contracts in the sense that the former are standardized exchange-traded contracts

Options: Options are of two types - 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.



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Warrants: Options generally have lives of up to one year, the majority of options traded on

options exchanges having a maximum maturity of nine months. Longer-dated options are

called warrants and are generally traded over-the-counter.

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are

options having a maturity of up to three years.

Baskets: Basket options are options on portfolios of underlying assets. The underlying asset

is usually a moving average or a basket of assets. Equity index options are a form of basket

options.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the

future according to a prearranged formula. They can be regarded as portfolios of forward

contracts. The two commonly used swaps are:

Interest rate swaps: These entail swapping only the interest related cash flows between the

parties in the same currency.

Currency swaps: These entail swapping both principal and interest between the parties,

with the cash flows in one direction being in a different currency than those in the opposite

direction.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the

expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls

and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver

swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay

fixed and receive floating.

Factors driving the growth of financial derivatives

1. Increased volatility in asset prices in financial markets,

2. Increased integration of national financial markets with the international markets,

3. Marked improvement in communication facilities and sharp decline in their costs,

4. Development of more sophisticated risk management tools, providing economic agents a

wider choice of risk management strategies, and

5. Innovations in the derivatives markets, which optimally combine the risks and returns over

a large number of financial assets leading to higher returns, reduced risk as well as

transactions costs as compared to individual financial assets.

Development of derivatives market in India



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The first step towards introduction of derivatives trading in India was the promulgation of the

Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options

in securities. The market for derivatives, however, did not take off, as there was no

regulatory framework to govern trading of derivatives. SEBI set up a 24member committee

under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate

regulatory framework for derivatives trading in India. The committee submitted its report on

March 17, 1998 prescribing necessary preconditions for introduction of derivatives trading

in India. The committee recommended that derivatives should be declared as securities so

that regulatory framework applicable to trading of securities could also govern trading of

securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma,

to recommend measures for risk containment in derivatives market in India. The report,

which was submitted in October 1998, worked out the operational details of margining

system, methodology for charging initial margins, broker net worth, deposit requirement and

realtime monitoring requirements.

The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include

derivatives within the ambit of securities and the regulatory framework was developed for

governing derivatives trading. The act also made it clear that derivatives shall be legal and

valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC

derivatives. The government also rescinded in March 2000, the three decade old

notification, which prohibited forward trading in securities.

Derivatives trading commenced in India in June 2000 after SEBI granted the final approval

to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges,

NSE and BSE, and their clearing house/corporation to commence trading and settlement in

approved derivatives contracts. To begin with, SEBI approved trading in index futures

contracts based on S&P CNX Nifty and BSE30(Sensex) index. This was followed by

approval for trading in options based on these two indexes and options on individual

securities.

The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on

individual securities commenced in July 2001. Futures contracts on individual stocks were

launched in November 2001. The derivatives trading on NSE commenced with S&P CNX

Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4,

2001 and trading in options on individual securities commenced on July 2, 2001. Single



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stock futures were launched on November 9, 2001. The index futures and options contract on

NSE are based on S&P CNX Trading and settlement in derivative contracts is done in

accordance with the rules, byelaws, and regulations of the respective exchanges and their

clearing house/corporation duly approved by SEBI and notified in the official gazette.

Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative

products.

The following are some observations based on the trading statistics provided in the NSE

report on the futures and options (F&O):

Single-stock futures continue to account for a sizable proportion of the F&O segment. It

constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to

this phenomenon is that traders are comfortable with single-stock futures than equity options,

as the former closely resembles the erstwhile badla system.

On relative terms, a volume in the index options segment continues to remain poor.

This may be due to the low volatility of the spot index. Typically, options are considered

more valuable when the volatility of the underlying (in this case, the index) is high. A related

issue is that brokers do not earn high commissions by recommending index options to their

clients, because low volatility leads to higher waiting time for round-trips.

Put volumes in the index options and equity options segment have increased since

January 2002. The call-put volumes in index options have decreased from 2.86 in January

2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are

increasingly becoming pessimistic on the market.

Farther month futures contracts are still not actively traded. Trading in equity options on

most stocks for even the next month was non-existent.

Daily option price variations suggest that traders use the F&O segment as a less risky

alternative (read substitute) to generate profits from the stock price movements. The fact that

the option premiums tail intra-day stock prices is evidence to this. Calls on Satyam fall, while

puts rise when Satyam falls intra-day. If calls and puts are not looked as just substitutes for

spot trading, the intra-day stock price variations should not have a one-to-one impact on the

option premiums.

Commodity Derivatives

Futures contracts in pepper, turmeric, gur (jaggery), hessian (jute fabric), jute sacking, castor

seed, potato, coffee, cotton, and soybean and its derivatives are traded in 18 commodity



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exchanges located in various parts of the country. Futures trading in other edible oils,

oilseeds and oil cakes have been permitted. Trading in futures in the new commodities,

especially in edible oils, is expected to commence in the near future. The sugar industry is

exploring the merits of trading sugar futures contracts.

The policy initiatives and the modernization programme include extensive training,

structuring a reliable clearinghouse, establishment of a system of warehouse receipts, and the

thrust towards the establishment of a national commodity exchange. The Government of

India has constituted a committee to explore and evaluate issues pertinent to the

establishment and funding of the proposed national commodity exchange for the nationwide

trading of commodity futures contracts, and the other institutions and institutional processes

such as warehousing and clearinghouses. With commodity futures, delivery is best affected

using warehouse receipts (which are like dematerialized securities). Warehousing functions

have enabled viable exchanges to augment their strengths in contract design and trading. The

viability of the national commodity exchange is predicated on the reliability of the

warehousing functions. The programme for establishing a system of warehouse receipts is in

progress. The Coffee

Futures Exchange India (COFEI) has operated a system of warehouse receipts since 1998

Exchange-traded vs. OTC (Over the Counter) derivatives markets

The OTC derivatives markets have witnessed rather sharp growth over the last few years,

which have accompanied the modernization of commercial and investment banking and

globalization of financial activities. The recent developments in information technology have

contributed to a great extent to these developments. While both exchange-traded and

OTC derivative contracts offer many benefits, the former have rigid structures compared to

the latter. It has been widely discussed that the highly leveraged institutions and their OTC

derivative positions were the main cause of turbulence in financial markets in 1998. These

episodes of turbulence revealed the risks posed to market stability originating in features of

OTC derivative instruments and markets.

The OTC derivatives markets have the following features compared to exchange-traded

derivatives:

1. The management of counter-party (credit) risk is decentralized and located within

individual institutions,

2. There are no formal centralized limits on individual positions, leverage, or margining,



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3. There are no formal rules for risk and burden-sharing,

4. There are no formal rules or mechanisms for ensuring market stability and integrity, and

for safeguarding the collective interests of market participants, and

5. The OTC contracts are generally not regulated by a regulatory authority and the

exchanges self-regulatory organization, although they are affected indirectly by national

legal systems, banking supervision and market surveillance.

Accounting of Derivatives:

The Institute of Chartered Accountants of India (ICAI) has issued guidance notes on

accounting of index futures contracts from the view point of parties who enter into such

futures contracts as buyers or sellers. For other parties involved in the trading process, like

brokers, trading members, clearing members and clearing corporations, a trade in equity

index futures is similar to a trade in, say shares, and does not pose any peculiar accounting

problems

Taxation

The income-tax Act does not have any specific provision regarding taxability from

derivatives. The only provisions which have an indirect bearing on derivative transactions are

sections 73(1) and 43(5). Section 73(1) provides that any loss, computed in respect of a

speculative business carried on by the assessee, shall not be set off except against profits and

gains, if any, of speculative business. In the absence of a specific provision, it is apprehended

that the derivatives contracts, particularly the index futures which are essentially cash-settled,

may be construed as speculative transactions and therefore the losses, if any, will not be

eligible for set off against other income of the assessee and will be carried forward and set

off against speculative income only up to a maximum of eight years .As a result an investors

losses or profits out of derivatives even though they are of hedging nature in real sense, are

treated as speculative and can be set off only against speculative income.

REGULATION FOR DERIVATIVES TRADING

SEBI set up a 24- member committee under the Chairmanship of Dr. L. C.Gupta to develop

the appropriate regulatory framework for derivatives trading in India. On May 11, 1998 SEBI

accepted the recommendations of the committee and approved the phased introduction of

derivatives trading in India beginning with stock index futures. The provisions in the SC(R)A



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and the regulatory framework developed there under govern trading in securities. The

amendment of the SC(R)A to include derivatives within the ambit of securities in the

SC(R)A made trading in derivatives possible within the framework of that Act.

1. Any Exchange fulfilling the eligibility criteria as prescribed in the L. C. Gupta committee

report can apply to SEBI for grant of recognition under Section 4 of the SC(R)A, 1956 to

start trading derivatives. The derivatives exchange/segment should have a separate governing

council and representation of trading/clearing members shall be limited to maximum of 40%

of the total members of the governing council. The exchange would have to regulate the sales

practices of its members and would have to obtain prior approval of SEBI before start of

trading in any derivative contract.

2. The Exchange should have minimum 50 members.

3. The members of an existing segment of the exchange would not automatically become the

members of derivative segment. The members of the derivative segment would need to fulfill

the eligibility conditions as laid down by the L. C. Gupta committee.

4. The clearing and settlement of derivatives trades would be through a SEBI approved

clearing corporation/house. Clearing corporations/houses complying with the eligibility

conditions as laid down by the committee have to apply to SEBI for grant of approval.

5. Derivative brokers/dealers and clearing members are required to seek registration from

SEBI. This is in addition to their registration as brokers of existing stock exchanges. The

minimum net worth for clearing members of the derivatives clearing corporation/house shall

be Rs.300 Lakh. The net worth of the member shall be computed as follows:

Capital + Free reserves

Less non-allowable assets viz.,

(a) Fixed assets

(b) Pledged securities

(c) Members card

(d) Non-allowable securities (unlisted securities)

(e) Bad deliveries

(f) Doubtful debts and advances

(g) Prepaid expenses

(h) Intangible assets

(i) 30% marketable securities



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6. The minimum contract value shall not be less than Rs.2 Lakh. Exchanges have to submit

details of the futures contract they propose to introduce.

7. The initial margin requirement, exposure limits linked to capital adequacy and margin

demands related to the risk of loss on the position will be prescribed by SEBI/Exchange from

time to time.

8. The L. C. Gupta committee report requires strict enforcement of Know your customer

rule and requires that every client shall be registered with the derivatives broker. The

members of the derivatives segment are also required to make their clients aware of the risks

involved in derivatives trading by issuing to the client the Risk Disclosure Document and

obtain a copy of the same duly signed by the client.

9. The trading members are required to have qualified approved user and sales person who

have passed a certification programme approved by SEBI.

Forms of collaterals acceptable at NSCCL

Members and dealer authorized dealer have to fulfill certain requirements and provide

collateral deposits to become members of the F&O segment. All collateral deposits are

segregated into cash component and non-cash component. Cash component means cash,

bank guarantee, fixed deposit receipts, T-bills and dated government securities. Non-cash

component mean all other forms of collateral deposits like deposit of approved demat

securities.

Requirements to become F&O segment member

The eligibility criteria for membership on the F&O segment is as given in Table

1 . Table.2 gives the requirements for professional clearing membership. Anybody

interested in taking membership of F&O segment is required to take membership of

CM and F&O segment or CM, WDM and F&O segment. An existing member of

CM segment can also take membership of F&O segment. A trading member can also

be a clearing member by meeting additional requirements. There can also be only

clearing members.

Eligibility criteria for membership on F&O segment

Particulars

(all values in Rs. Lakh)

CM and F&O segment CM, WDM and F&O

segment



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Net worth 100 200

Interest free security deposit

(IFSD)

125 275

Collateral security deposit

(CSD)

25 25

Annual subscription 1 2

Requirements for professional clearing membership

Particulars

(all values in Rs. Lakh)

F&O segment CM & F&O segment

Eligibility Trading members of

NSE/SEBI registered

custodians/recognized

banks

Trading members of

NSE/SEBI

registered

custodians/recognized banks

Net worth 300 300

Interest free security

deposit (IFSD)

25 34

Collateral security deposit 25 50

Annual subscription nil 2.5

Requirements to become authorized / approved user

Trading members and participants are entitled to appoint, with the approval of the F&O

segment of the exchange authorized persons and approved users to operate the trading

workstation(s). These authorized users can be individuals, registered partnership firms or

corporate bodies. Authorized persons cannot collect any commission or any amount directly



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world learned that if the parties to both sides of the transactions are large, financially

connected with many other parties, and do not have the financial means to make good on

their promises, derivatives that are traded over the counter (OTC) and not centrally cleared

can pose dangers to entire economies. The dangers are especially great for one kind of

derivative contract on which I concentrate primarily here credit default swaps (CDS).

With CDS, non-defaulting parties (the buyers of this particular kind of insurance against loan

or bond default) are likely, especially in an economy-wide crisis, to find it more expensive to

replace their contracts with the defaulting party (the seller) than are non-defaulting parties in

other OTC swap arrangements. Indeed, mainly for this reason, unless otherwise indicated,

when I refer in this essay to derivatives I mean specifically CDS, although many of the

arguments or claims I advance refer to other OTC derivatives as well.

Fortunately, there is a growing consensus among financial regulators and academic experts

about what to do at least with respect to standardized derivatives, or those that resemble

readily traded stocks or futures contracts, and thus how to help keep financial actors who are

heavily engaged in derivatives activities and also run into financial trouble from infecting

other institutions and conceivably entire markets. I will outline this consensus shortly, which

may be enacted in some form by Congress this year as part of comprehensive financial

reform.

I have written this essay primarily to call attention to the main impediments to meaningful

reform: the private actors who now control the trading of derivatives and all key elements of

the infrastructure of derivatives trading, the major dealer banks. The importance of this

Derivatives Dealers Club cannot be overstated. All end-users who want derivatives

products, CDS in particular, must transact with dealer banks. The dealer banks, in turn,

transact heavily with each other, to hedge the risks from their customer trades and somewhat

less frequently, to trade for their own accounts.

I will argue that the major dealer banks have strong financial incentives and the ability to

delay or impede changes from the status quo - even if the legislative reforms that are now

being widely discussed are adopted - that would make the CDS and eventually other

derivatives markets safer and more transparent for all concerned. At the end of this essay, I



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will outline a number of steps that regulators and possibly the antitrust authorities may be

able to take to overcome any dealer resistance to constructive change.

Wall Street Reform and Consumer Protection Act affect the derivatives market in a variety of

areas. It provides for mandatory central clearing and exchange trading of certain swaps, real-time reporting of trades, registration and regulatory oversight for swap dealers and other

entities maintaining substantial positions in swaps (called "major swap participants"),

registration and oversight for derivative clearing organizations and swap execution facilities,

position limits and rules prohibiting manipulation of commodity markets.

"Swap" is defined to include a broad variety of derivatives products, with certain exclusions

including for physically-settled commodity forwards, commodity and securities futures and

instruments based on securities already regulated by the SEC. Over-the-counter foreign

exchange swaps and forwards are covered by the Act as "swaps," but the Secretary of the

Treasury is given the authority to exempt them from regulation under the Act.

Allocation of Jurisdiction

Generally, the Act gives the CFTC the authority to regulate swaps other than security-based

swaps, while the SEC will regulate security-based swaps. Both the CFTC and the SEC (the

"Commissions") may regulate mixed swapsderivatives that have characteristics of both

these types of swaps. The Act generally requires the Commissions to treat economically

similar products and entities in a similar manner, but it does not require the Commissions to

issue joint regulations for economically similar products and entities. Additionally, the Act

creates the framework that the Commissions will operate under to determine the

jurisdictional status of novel derivative products that may have elements of both securities

and contracts of sale of a commodity for future delivery (or options on such contracts or

options on commodities). Under the framework, each Commission must notify the other

when it receives a request to trade or list this type of novel product. From there, each

Commission may request that the other Commission determine whether the product falls

under that Commission's jurisdiction. Each Commission may also ask the other Commission

to exempt the product from its regulations. Either Commission may petition the United States

District Court for the District of Columbia if it disagrees with the other Commission's

determination as to whether the novel derivative product falls under its jurisdiction.

Clearing and Reporting



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Mandatory clearing and Trade execution. The Act generally gives the Commissions the

power to determine which swaps will be subject to mandatory central-counterparty clearing.

Generally, the Commissions will determine which swaps are subject to mandatory clearing

by considering, among other factors, the level of outstanding notional exposure, trading

liquidity, and adequate pricing data, the availability of operational clearing expertise and

infrastructure, and the likely effect that clearing will have on systemic risk and competition.

If a swap is within a category of swaps that is cleared by a clearing organization and the

applicable Commission determines that swaps in that category are subject to mandatory

clearing, then the swap must be submitted to a clearing organization. In addition, if the

Commissions do not subject a particular type of swap to mandatory clearing but a clearing

organization accepts derivative contracts of that type for clearing, an end-user may elect that

the swap be submitted to the clearing organization and cleared accordingly.

The Act, subject to grandfathering provisions, provides for extensive regulation of

derivatives clearing organizations, including registration, reporting, and minimum capital and

margining requirements. It also provides for derivatives clearing organizations to publicly

disseminate certain price and volume and other information.

Swaps that are subject to mandatory clearing generally must also be executed on a board of

trade or a "swap execution facility" if they are made available for trading on a board of trade

or swap execution facility. A "swap execution facility" is a newly defined category of swap

trading facility for which the Act prescribes registration and regulatory supervision.

End-User Exemption. Derivative contracts in which one of the counterparties is a qualified

end-user will not be subject to mandatory clearing. An entity qualifies as an end-user for

these purposes if it (1) is not a financial entity, a term that includes swap dealers, major swap

participants, commodity pools, certain private funds, employee benefit plans, and others

predominantly engaged in certain financial activities, excluding, however, certain captive

financing companies affiliated with manufacturers, (2) uses the derivative contract to hedge

or mitigate commercial risk, and (3) notifies the applicable Commission, in accordance with

prescribed procedures, how it generally meets its financial obligations associated with

entering into non-cleared swaps. This exemption may allow swap dealers and others to

continue to offer over-the-counter hedging products to commercial end-users without

running afoul of the mandatory-clearing requirements. An end-user that is a public company



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will qualify for the exemption only if an "appropriate committee" of its board of directors has

reviewed and approved its decision to enter into swaps that are subject to the exemption.

Non-"Eligible Contract Participants." The Act makes it unlawful for a person that is not an

"eligible contract participant" under the Commodity Exchange Act's definition of that term

which is made narrower by the Actto enter into a swap except on a board of trade.

Grandfathering Provisions. Swaps executed before the effectiveness of the mandatory

clearing requirements are exempted from mandatory clearing provided that they are reported

to a registered swap data repository or the applicable Commission in accordance with the

Act's transitional reporting requirements. Additionally, the Act provides that parties to a pre-

enactment swap contract may not, unless specifically provided for in their agreement, treat

the enactment of the Act as a basis for early termination of their contract.

Real-time Reporting and Public Dissemination of Transaction and Pricing Data. With the

stated goal of enhancing price discovery, the Act generally provides for the Commissions to

require "real-time public reporting"that is, making transaction and pricing data publicly

available as soon as is technologically practicable after execution of a tradefor swaps,

regardless of whether they are centrally cleared or whether the end-user exemption applies. If

data concerning a swap transaction of a particular type can be reported to a "swap data

repository"a newly created category of regulated entity to be subject to registration and

regulatory supervisionthen data regarding the swap is to be reported to such a depository

or to the applicable Commission. The new regulations will provide for time delays in

publicly disseminating data concerning "large notional swap transactions (block trades)." The

regulations will not permit public disclosure of the identity of participants to a transaction.

Swap Dealer and Major Swap Participant Registration and Regulation

A person that qualifies as a "swap dealer" or a "major swap participant," with respect to

swaps or security-based swaps, generally will be required to register with the applicable

Commission and will be subjected to requirements to be prescribed by regulations.

"Swap dealer" generally means a person that holds itself out as a dealer in swaps, makes a

market in swaps, regularly enters into swaps as an ordinary course of business for its own

account, or engages in any activity causing it to be commonly known in the trade as a dealer

or market maker in swaps. However, an insured depository institution is not a "swap dealer"

to the extent that it "offers to enter into a swap with a customer in connection with

originating a loan with that customer." In addition, entities are not "swap dealers" if they



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trade on their own account but not as part of a regular business or engage only in "de

minimis" swap dealing.

"Major swap participant" generally means a person other than a swap dealer (1) that

maintains a substantial position, excluding positions held for hedging or mitigatingcommercial risk and certain positions held by employee benefit plans, in any major category

of swaps to be specified by regulation, (2) whose outstanding swaps create substantial

counterparty risk that could have serious adverse effects on the U.S. financial system, or (3)

that is a financial entity that is highly leveraged, is not subject to regulatory capital

requirements, and maintains a substantial position in swaps in any specified major category

of swaps. Certain captive financing companies affiliated with manufacturers are excluded

from the definition of "major swap participant."

Swap dealers and major participants whose activities extend to both non-security-based and

security-based swaps may be subjected to dual registration as dealers or major participants

with both the CFTC and the SEC, in addition to any other registration requirements that may

apply to them.

The Act generally requires the Commissions to regulate swap dealers and major swap

participants with regard to the following: capital and initial/variation margin requirements

(except for financial institutions whose regulators already impose similar requirements),

reporting and record-keeping, general business conduct, business conduct with respect to

"special entity" counterparties that include federal and state agencies and certain employee

benefit plans and tax-exempt organizations, documentation standards and internal

monitoring, management, and disclosure requirements including designating a chief

compliance officer. The Act provides factors and guidelines for the Commissions to consider

in regulating swap dealers and major swap participants but gives them considerable

discretion.

In addition, by expanding the definitions of "futures commission merchant" and "introducingbroker" under the Commodity Exchange Act to cover persons soliciting and accepting orders

for swaps and other products, the Act may subject dealers or other swap participants to

registration and regulation under the Commodity Exchange Act as futures commission

merchants or introducing brokers.

Position Limits



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The Act expands the CFTC's authority to impose position limits to cover certain swaps that

"that perform or affect a significant price discovery function with respect to registered

entities." The position limits imposed by the CFTC will not apply to a bona fide hedging

transaction, a term to be defined by regulation, or to a derivative contract executed before the

relevant rule's effective date. Similarly, the SEC is given the authority to implement position

limits for security-based swaps. When establishing position limits, the SEC may require

security-based swap holders to aggregate their positions in security-based swaps with their

positions in other security-based products.

Anti-Manipulation Provisions for Commodity Markets

The Act makes it unlawful for a person to manipulate commodity markets, including through

the delivery of a false, misleading, or inaccurate report concerning crop or market

information, in contravention of rules to be promulgated by the CFTC. The Act creates a

private right of action for persons injured by such manipulation.

Authority to Prohibit Derivatives Trading by Foreign Entities

The Act gives the Commissions the authority, in consultation with the Secretary of the

Treasury, to prohibit entities domiciled outside the United States from participating in swap

or security-based swap activities, if they find that a foreign country's regulation of swaps or

security-based swaps undermines the stability of the U.S. financial system.

Extraterritorial Reach of the Act

The Act generally will not apply to activities outside the United States unless those activities

have a direct or significant connection with activities in, or effect on, commerce in the United

States or violate regulations issued to prevent evasion of the Act.

Federal Preemption

The Act contains a preemption provision to the effect that a swap, as defined in the Act, will

not be considered insurance and may not be regulated as an insurance contract under statelaw.

Timeline

The Act's provisions governing derivatives generally become effective 360 days after the

enactment of the Act, or, where implementing rule-making is required, 60 days after the



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publication of a final rule or regulation. Rules are generally required to be issued within 360

days of the Act's enactment. Certain provisions of the Act will become effective earlier,

generally under rules to be issued within shorter timeframes.

Bibliography

Web sites:

http://www.faegre.com timing 23/9/2010 4.52 p.m

http://seekingalpha.com timing 23/9/2010 5.01 p.m

http://www.brookings.edutiming 24/9/2010 8.32 p.m

http://www.derivativesindia.comtiming 25/9/2010 7.20 p.m

http://www.eurojournals.comtiming 25/9/2010 7.32 p.m

www.sebi.gov.in timing 25/9/2010 8.00 p.m

Book:

Options- pricing, hedging, and trading by A.C.Reddy page. No: 54 to 68
http://www.faegre.com/http://www.faegre.com/http://seekingalpha.com/http://www.brookings.edu/http://www.brookings.edu/http://www.derivativesindia.com/http://www.eurojournals.com/http://www.sebi.gov.in/http://seekingalpha.com/http://www.brookings.edu/http://www.derivativesindia.com/http://www.eurojournals.com/http://www.sebi.gov.in/http://www.faegre.com/

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