It can be understood from the word ‘derivative’ itself, that it carries no value of its own, rather any attributed value is ‘derived’ from that of an underlying asset
“It is a contract for the exchange of cash or delivery flows between two parties, each of which is taken into consideration equal to the other at the start of the agreement”.
In other words, derivative means a contract of pre-decided fixed duration, linked for contract fulfillment to the value of a given real or monetary asset or to an index of securities. Such contracts are frequently used as a tool for hedging and reducing risk in transactions.
Since the Securities Laws (Second Amendment) Act, 1999, ‘Derivative transactions’ have been included in the definition of Securities.
The earliest derivative transactions started off as producers of commodities protecting themselves against future price fluctuations of the commodity they produce. This was a derivative contract in its most rudimentary form. An illustration is provided below to understand this problem.
Every year an Apple farmer produces 10,000 kilos of apples. But he’s got a problem, every year the apple price jumps around a bunch sometimes it sells after the harvest for over 30 rupees and this guy makes a ton of money per pound and then sometimes it drops down to 10 rupees per pound and this guy can’t even cover his cost. On the other side of the equation is a certain Bakery which specializes in making apple pies. So when the price of Apple’s goes super-high the Bakery can’t cover their costs and they start running at a loss but when the price goes really low they have a bonanza.
But neither party here likes this scenario, the unpredictability of one year having a feast and then one year having a famine. So what they do is agree ahead of time regardless of what the actual market price of pies ends up being after the harvest, to transact at a specified price. A contract is set up where the chain the chain agrees to buy 10,000 kilos at a specified date for 20 rupees a kilo 20 rupees a kilo. This works out well for the chain because they can ensure regardless of what the market price ends up being and make a decent. It works out for the farmer because he knows that at 20 rupees a kilo he can cover his costs and pay his rent and pay his employees and feed his family and it also takes out the unpredictability the volatility for him.
In India, this kind of trading was regulated through an RBI notification in 2007. It allows trading in derivatives only when there is a genuine underlying exposure to risk. The forms of Derivatives and their validity will be discussed in the next section.
In the recent past, there are questions raised regarding the legality of derivative transactions, especially, hedging contracts in relation to forex rates. One view has been that such agreements are wagering contracts and, hence, invalid as under the provisions of section 30 of the Indian Contract Act, 1872.
Despite the above provision affirming wagering contracts as void, there has been a practice of drafting derivative contracts in the financial market. Such contracts are in particular resorted to dealings with forex resulting from fluctuations in the exchange rates.”
During import-export of goods and services, the payments payable and receivable are to be obtained or paid in foreign currency respectively. Herein the parties involving in such transactions might incur heavy losses due to constant fluctuations in the rates of exchange. Hence to insulate one against the harms of such fluctuations derivative contracts may be entered into but strictly for hedging purposes.
In India as per the exchange control laws, a citizen is permitted to be a party to a foreign derivative contract in order to protect himself against foreign exchange risks. The RBI mandates that these hedging contracts must be centered on only ‘forex payable and receivable’ and never on ‘speculative purposes’.
In the case of capital markets, it was initially governed under the Securities Contracts (law) Act, 1956. It later underwent an amendment to become the Securities Laws (Amendment) Act, 1999. The amendment was made to allow for trading in derivatives. Henceforth any individual was permitted to be a party to a derivative contract based on shares, loans, debt instruments, etc.
Despite the number of instances pointing out the need for a uniform legislation pertaining/regulating derivative contract in India, the Indian Contract Act to a great extent remains silent barring s.30 which talks about the illegality of wagering contracts. Nevertheless, the question of the legality of derivative contracts remains elusive at large.
The RBI Act of 1934 recently underwent an amendment in 2006, and the corresponding amended provisions came into effect in the January of 2007. An important result of this amendment was that it allowed RBI to participate in derivative transactions.
The law provides for that transaction in derivatives will be valid if at the least one of the parties to the transactions is RBI, a scheduled bank or such other organization regulated by RBI. The RBI amendment Act declares various kinds of derivative contracts as valid and, thereby, carves out an exception to the Contract Act provisions.”
The question whether each individual contract is in compliance with relevant law such as FEMA or SCRA is a question of fact to be decided in each case and hence, derivative contracts specified in the Amendment Act will have to be treated as valid as far as Section 30 of the Contract Act is concerned.
In effect, the RBI Amendment Act validates all past transactions in derivatives, in which one of the parties to the transaction is a scheduled bank. While such validating provision will provide relief to the banks who have been entering into derivative transactions in the past instead of such piecemeal legislation, it is necessary to carve out an exception to the principle laid down in Section 30, regarding wagering contracts and amend the provisions of the Contract Act to facilitate derivative transactions in the financial market.
The norms for such derivative transactions as a matter of general policy can be prescribed with the exception to be created under Section 30 of the Contract Act.
click here Some Authorities on the Legality of Derivatives (Common Law)
The court held that wagering contracts included contracts for differences.
The contract for differences has been defined by Halsbury as: “Agreements between those who are only ostensible buyers and sellers of stock and shares where the common interest of the parties is to pay or receive the differences between their prices on one day and their prices on another day.”
The court declared that contracts akin to cash-settled derivatives were ‘contracts for differences.
Reading this judgment in light of the first case it can be derived that cash-settled derivatives are wagering contracts and therefore unenforceable.
Under Indian Exchange control laws, an Indian corporate, being a person resident in India, can enter into a foreign currency derivative contract only to hedge an exposure to foreign exchange risk and not for speculating and yielding profits.
Since March 2008, Axis Bank and Rajshree Sugars have been fighting a legal battle over the foreign exchange derivatives contract. The court evolved a threefold test to determine whether the contract is a wager”.
As explained the Contract Act, 1872 views agreements by way of the wager as void and also doesn’t define what constitutes a wager and what doesn’t. “It only mentions that such agreements will be void and unenforceable and no action can lie to either recover anything that is due under a wager or for the performance of a contract that is in the nature of a wager.
Therefore, the Contract Act should provide an express definition that would clarify as to what constitutes a wager, thereby removing any ambiguity with regard to the legality of derivative contractswhich are in the nature of wagering agreements.
Hence Section 30 should be amended to define the word wager. In other words, the scope of section 30 needs to be widened”.
- D. Bandopadhyay; “Formulation of new Economic Offences Code for India’ – West Bengal National University of Juridical Sciences campus”
The former Revenue Secretary of India said, “The intertwining of corporations, accounting & law firms, and banking institutions on the stock exchanges would constitute a vast and complex subset of the universe of economic offenses, and this would be a very difficult area to legislate upon and implement.”
- Varma Committee
“The problem with derivatives is that they control an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets. Hence the committee was set up by SEBI to examine the reduction of risks in such derivative transactions”.
- Malimath Committee
The committee has proposed a definition for economic offenses. They held that “it should be an illegal act, committed through misrepresentation or outright deception, by an individual or group, with specialized skills whether professional or technical, with a view to achieving illegal financial gain, individually or collectively.”
Trading in derivatives is allowed only when there is a genuine underlying exposure to risk. One can enter into derivative contracts only with Authorised Dealers (AD) under the FEMA, 1999 and only in transactions that it permits.
Thus the recommendations of the report have often been used in case laws to ascertain the legality of Derivatives along with the Contract Act.
- SEBI Circular SEBI/ IMD/CIR No. 4/2627/ 2004 – STOCKS
The circular with regards to stocks lay down “The guiding principle while initiating any derivatives position shall clearly be ‘hedging’ or ‘portfolio balancing’. At no point in time, the derivative position shall result, even for a few moments on an intra-day basis, in actual or potential leverage or short sale / short position on an underlying security.” Hence this addresses the point that rose earlier regarding banks being able to draw out derivative contracts. It creates an obligation on the Banks to disclose the position to the investors.
As mentioned in the aforesaid SEBI circular an obligation on the banks is created to disclose the position to the investors. The violation of this will lead to criminal charges as per the recently amended Securities Contract Regulation Act, 1956 which holds that ‘only those derivative contracts are valid which are traded in accordance with the rules of the stock exchange’. It provides that any contravention of this section is an offense punishable by up to 1-year imprisonment, or fine or both. These offenses are cognizable under the Criminal Procedure Code per Section 25 of the SCRA, 1956.
In India, speculative practices have always been viewed with skepticism. Section 30 of the Indian Contract Act makes all agreements which are in the form of a wager illegal. Derivatives transactions, though they are meant to be contracts of insurance, often assume a purely speculative nature. An example would be traders who engage in short selling activities. SEBI regulations strictly prohibit these activities as the transferor here is engaging in a purely speculative transaction. ‘He does not own the shares himself and therefore is exposed to no risk of falling market prices for those shares. He only bets that the market price will fall in the future. He has no insurable interest in the whole deal and therefore his activities constitute an offense under the SEBI regulations’.
All regulations from the SEBI and the RBI are majorly centered on ensuring that derivatives contracts remain insurance contracts and do not become merely speculative transactions. Most of the regulations place a high importance on ensuring that there is an underlying exposure to risk or insurable interest, which the derivatives contract will hedge against. If no underlying exposure to risk can be shown, then the promisor will be faced with criminal penalties.
Without an insurable interest or in the case of derivatives contracts, an underlying exposure to risk, contracts will be hit by section 30 of the Indian Contract Act and will become unenforceable, causing parties involved in the transaction great losses.
To ensure that parties do not engage in such risky activities, the SEBI and RBI have gone ahead and imposed criminal penalties over the civil liability to act as an extra deterrent.
Derivatives Transactions are meant to hedge against risks, instead, they have been the downfall of many a mighty financial institution or corporation. So where are we going wrong? The problem is that the concept of insurable interest seems to be disappearing from derivatives transactions, which renders these transactions purely speculative. “Derivatives transactions can cause huge losses and gains in very little time, a feature that makes it both very attractive to investors and also fatal to the economy”.
The Indian legal system seems to have understood this problem and therefore has made the requirement of insurable interest crucial to these transactions. Banks are responsible to see that an underlying exposure to risk exist, and must document this exposure for verification by authorities. According to the researcher, violations constitute an economic offense and attract penalties of imprisonment and fine.
Hence as discussed throughout the derivative contracts pose an important risk of ‘unreasonable speculation’ because of higher leveraging power, especially considering that the regulations (specifically the Contract Act) remain silent to that matter of fact. Without appropriate knowledge, one may make huge losses easily. This would simply mean to release a devil at large that would consume ignorant masses in its contracts.