Regulatory Framework for Exchange Traded Interest Rate Derivatives

Chapter 8: Regulatory Framework for Exchange Traded Interest Rate Derivatives

NISM Series IV — Interest Rate Derivatives | ~5% weightage | ~20 questions

What this chapter is about

IRD regulation is JOINTLY RBI + SEBI — same dual structure as currency derivatives (Series I). RBI has overall authority; SEBI regulates exchange-traded products. The chapter also covers who can participate, what positions are permitted for different entity types, and FPI position limits.

Regulatory structure

RBI: Overall authority for interest rate derivatives in India (under FEMA and RBI Act). Permission required from RBI for all IR derivatives.

SEBI: Regulates exchange-traded interest rate derivatives. Position limits for exchange-traded IRDs set by SEBI.

Within SEBI regulations: Exchanges and Clearing Corporations frame their own operational procedures under their bye-laws — they can tighten but cannot dilute SEBI's rules.

Similar to: Currency derivatives in terms of dual RBI+SEBI regulation structure.

Operational procedures: Framed by EXCHANGES AND CLEARING CORPORATIONS within RBI/SEBI regulations. NOT directly by RBI or SEBI.

RBI Guideline: Rupee Interest Rate Derivatives Directions 2019

Who can participate:

• Residents (individuals, corporates, banks)
• Non-Residents
• Retail participants
• Non-retail participants

Bank participation:

• Allowed for HEDGING own interest rate risk
• Allowed for TRADING for own account
• NOT allowed to trade on behalf of clients

Insurance companies: LONG HEDGE only (cannot short sell / take short positions for speculation)

Non-residents and FPIs:

• Short positions allowed ONLY for HEDGING
• NOT for speculation (no naked short selling)

Primary Dealers:

• Can short sell (naked) but must obtain prior permission from RBI first

FPI collective limit in IRF: Net long position up to Rs 50 billion total across all FPIs.

Where IRDs can be traded (per RBI guidelines)

1. Exchanges (like NSE, BSE) 2. Over-the-Counter (OTC) market 3. Electronic Trading Platforms (ETPs) — RBI regulated

SCORES — Investor complaints system

SCORES = Securities and Exchange Board of India Complaint Redress System

All SEBI-registered entities must resolve investor complaints received via SCORES within 21 calendar days of receipt.

If unsatisfied: complaint escalated to first-level review.

SEBI (Stock Brokers) Regulations

The code of conduct for securities brokers is prescribed under Schedule II of SEBI (Stock Brokers) Regulations, 1992.

SCRA (Securities Contracts Regulation Act) 1956: Governs trading of securities. Derivatives are included in the definition of securities. NOT included in SCRA definition of securities: Unit Linked Insurance Policy (ULIP) — it is an insurance product regulated by IRDAI.

Trap Alert

Trap 1: "SEBI sets operational procedures for IRD trading" — PARTIALLY FALSE Exchanges and CCs set operational procedures within SEBI's framework.

Trap 2: "Banks can trade IRF on behalf of clients" — FALSE Banks: own account only (hedging + trading). NOT for clients.

Trap 3: "Non-residents can short sell IRFs freely" — FALSE Non-residents and FPIs: short position for HEDGING ONLY.

Trap 4: "PDs don't need prior RBI permission to short sell" — FALSE Primary Dealers need prior permission from RBI for naked short sell.

Trap 5: "ULIP is a security under SCRA" — FALSE ULIP is excluded from SCRA definition. It is regulated by IRDAI.

Trap 6: "SCORES complaint resolution = 30 days" — FALSE SCORES = 21 calendar days.

Must-remember rules

• Joint regulation: RBI (overall) + SEBI (exchange-traded)
• Position limits for exchange-traded IRD = set by SEBI
• Operational procedures = Exchanges + CCs (within SEBI framework)
• Exchanges can tighten but NOT weaken SEBI rules
• Banks: own account only (hedge + trade) | NOT for clients
• Insurance cos: long hedge only
• Non-residents/FPIs: short only for hedging | No naked short
• PDs: prior RBI permission needed for naked short
• FPI collective net long limit = Rs 50 billion in IRF
• IRDs can trade: Exchanges, OTC, ETPs
• SCORES: 21 calendar days to resolve
• SCRA covers derivatives but NOT ULIPs

Quick revision — 60 second scan

• IRD regulation: RBI (overall) + SEBI (exchange-traded)
• Banks: hedge + trade own account only, not for clients
• Insurance: long hedge only
• Non-residents/FPIs: short only for hedging
• PDs: prior RBI permission for naked short sell
• FPI net long limit: Rs 50 billion
• Trades allowed: Exchanges, OTC, ETPs
• SCORES: 21 days to respond
• SCRA: derivatives = securities | ULIPs = NOT securities