Derivative trading in India and Taxing Effects

Dr. Ajay Kumar

Vivek Dubey




The global economic order that emerged after World War II was a system where many less developed countries administered prices and centrally allocated resources. Even the developed economies operated under the Bretton Woods system of fixed exchange rates. Gradually, this system of fixed prices came under immense stress. High inflation and unemployment rates made interest rates more volatile. Ultimately, the Bretton Woods system was dismantled in 1971, freeing exchange rates to fluctuate.

Price fluctuations, more often than not, make it extremely strenuous for businesses to estimate their future production costs and revenues. This has created various kinds of risks. In fact risks are inherent in all kinds of markets. Financial markets are no exception to the above and are systemically volatile. Therefore, it is the prime concern of all the financial agents to balance or hedge the related risk factors. This has induced the market participants to search for ways to manage risk. Derivatives are one of such risk management tools which are getting increased popularity in the current market dynamics. This paper shall discuss at length the legal and financial intricacies of derivatives trading in the Indian regulatory framework.

Derivatives are considered to be extremely versatile financial instruments, as they help to manage risks, lower funding costs, enhance yields and diversify portfolios. The contributions made by derivatives have been so great, that they have been credited with having ‘changed the face of finance’ in the world.   Surprisingly, less than three decades ago, the global markets for derivatives barely even existed. However, today, the derivatives market has multiplied several times of its initial size and stands witness to its own rapid growth. Derivatives markets are an integral part of capital markets in developed as well as in emerging market economies. These instruments assist business growth by disseminating effective price signals concerning exchange rates, indices and reference rates or other assets, thereby, rendering both cash and derivatives markets more efficient. These instruments also offer protection from possible adverse market movements and can be used to manage or offset exposures by hedging or shifting risks particularly during periods of volatility thereby reducing costs. By allowing for the transfer of unwanted risk, derivatives can, also, promote more efficient allocation of capital across the economy, thereby, increasing productivity.

Despite derivatives activity scaling new heights every year, it appears that the world market still has a further unaccounted potential for expansion. In many of the lesser-developed financial markets, derivatives usage is still a limited phenomenon owing to various factors. These markets have a tremendous scope for growth which needs to be efficiently tapped.


Despite extensive press coverage, ‘derivatives’ continue to remain one of the most widely misused and misunderstood financial term. This is, in part due, to the wide range of financial instruments included under the rubric of ‘derivatives’ and also, to the complex nature of these instruments. There is an unfortunate perception among many that a derivative is anything, which causes loss to an investor. Ironically, derivatives have often been described as ‘esoteric’, ‘arcane’, and a subject capable of being understood only by ‘rocket scientists’.  This research paper makes an attempt to clarify that even though derivatives are complex instruments, they are not conceptually inscrutable. However, quantifying the market risks of derivatives or understanding how they are priced requires an advanced knowledge of mathematics.

The derivatives are not formally defined under any Act in India, except for a brief reference in Section 2(aa) of Securities Contract (Regulation) Act of India. It states that “Derivatives include: (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, and (b) a contract which derives its value from the prices or index of prices or underlying securities.” The Act also clarifies that, notwithstanding anything contained in any other law for the time being in force, contracts in derivatives shall be legal and valid only if such contacts are traded on a recognized stock exchange and settled on a clearing entity of the recognised stock exchange in accordance with the rules and bye-laws of such stock exchange, thus precluding ‘OTC derivatives’.

In almost all common law jurisdictions, the term ‘derivatives has no precise legal meaning ascribed to it. Different industry and regulatory groups have developed their own working definitions of ‘derivatives’, which provide useful insight into the range of financial instruments covered. CASAC, for example, has defined a ‘derivatives instrument’ as:

“A financial instrument whose value is derived from some other thing, such as:

          A physical commodity (for instance wool, cattle, oil or gold.)

          a financial asset for instance, shares or bonds)

          an index (for instance, a share price Index)

          an interest rate

          a currency

          Another derivative.”

The global Study Derivatives Group has adopted a similar definition that has often been quoted: “A Derivative is a bilateral contract or payments exchange agreement whose value derives, as its name implies, from the value of an underlying asset or underlying reference rate or index.” Although the International Swaps and Derivatives Association’s definition is not much different from either of the above definitions. It is narrower in scope since it confines the term to instruments to manage risks: “Derivatives are bilateral contracts involving the exchange of cash flows and designed to shift risk between parties. When transactions mature, the amounts owed by each party are determined by the prices of underlying commodities, securities or indices.”

In general, the term ‘derivative’ itself indicates that it has no independent value. The value of a derivative is entirely derived from the value of a cash asset. A derivative contract, product, instrument or simply ‘derivative’ is to be sharply distinguished from the underlying cash asset, which is an asset bought or sold in the cash market on normal delivery terms. A simple derivative instrument hedges the risk component of an underlying asset. For example, rice farmers may wish to sell their harvest at a price which they consider is ‘safe’ at a future date to eliminate the risk of a change in prices by that date. To hedge their risks, farmers can enter into a forward contract and any loss caused by fall in the cash price of rice will then be offset by profits on the forward contract.

The primary purpose behind investing in derivative instruments is to enable individual or corporate investors to either increase their exposure to certain specified risks in the hope that they will earn returns more than adequate to compensate them for bearing these added risks, known as speculation, or reduce their exposure to specific financial risks by transferring these risks to other parties who are willing to bear them at lower cost, known as hedging.


At present the Indian market trades in both exchange-traded and over the counter derivatives on various assets including securities, both equity and debt commodities, currencies, etc. the various types of derivatives being traded in India are discussed below:



Today, Indian and International financial markets trade innumerable derivative products on all kinds of underlying assets, both tangible and intangible. Before proceeding with the regulatory issues of derivatives trading, it is important to have a detailed understanding of the four generic derivative products in detail.



A forward contract is defined as an agreement, which ‘obligates one counterparty to buy, and the other counterparty to sell, a specific underlying at a specific price, amount and date in the future.

It is more clearly a one-to-one, bipartite/tripartite contract, which is to be performed mutually by the contracting parties, in future, at the term decided upon, on the contract date. In other words, a forward contract is an agreement to buy or sell an asset on a specified future date for a specified price. One of the parties to the contract assumes a long position, i.e. agrees to buy the underlying asset while the other assumes a short position, i.e. agrees to sell the asset. As this contract is traded off the exchange and settled mutually by the contracting parties, it is called an Over-the-counter product. It can be better understood with the help of an illustration.

Assume that there are two parties, Mr. A (buyer) and Mr. B (seller), who enter into a contract to buy and sell 500 units of asset X at Rs 100 per unit, at a predetermined time of two months from the date of contract. In this case, the product(asset X), the quantity (500 unites), the product price (Rs 100 per unit) and the time of delivery (2 months from the date of contract) have been determined and well understood, in advance, by both the contracting parties. Delivery and payment (settlement of transaction) will take place as per the terms of the contract on the designated date and place.

It is pertinent to note that forward contracts are negotiated by the contracting parties on a one-to-one basis and hence offer tremendous flexibility in terms of determining contract terms such as price, quantity, quality(in place of commodities), delivery time and place.

Like other OTC products, forward contracts offer tremendous flexibility to the contracting parties. However, as they are customized, they suffer from poor liquidity. Furthermore, as thee contracts are mutually settled and generally not guaranteed by any third party, the counter party risk/default risk/credit risk is considerable in such contracts.



A futures contract is similar to a forward contract, in that it is an agreement to buy or sell a specified commodity or instrument, at a specified price, at a date in the future. Illiquidity and counter party risk were the two issues concerning forward contracts that offered the exchanges a tremendous business opportunity and they started trading these forward contracts, but with a difference. In order to differentiate between the exchange-traded forwards and the OTC forward, the market renamed the exchange-traded forwards as Futures Contract. Hence, future contracts are essentially standardized forward contracts, which are traded on the exchanges and settled through the clearing agency of the exchanges. The clearing agency also guarantees the settlement of these trades.

Reasons for using futures contracts can be diversified and complicated. First, they attract lower transaction costs. They are normally only a fraction of the costs of trading in the underlying commodity or instrument. Second, counterparty risk is minimal as it is unlikely that the clearinghouse would collapse, as it is usually well-backed financially. In addition, if a participant defaults, the rules of a typical clearinghouse will provide for the allocation of the losses to the surviving participants according to a predetermined formula. Third, futures contracts permit anonymity of participants as most brokers act for undisclosed principals. Fourth, there is no requirement for large capital outlays as initial deposits range between five to fifteen percent only. Fifth, futures markets are more liquid, and therefore, it is easier for the participants to ‘close-out’ or settle their contracts. However, a major disadvantage of using futures contracts is their inflexibility. Any investor using futures contracts for hedging would be exposed to basis risk. ‘Basis risk’ refers to the risk where the futures contract and the instrument that is being hedged may not be perfectly matched.



Swaps like forward contracts, are customized over-the-counter transactions. A swap has been described as ‘an agreement between two parties to pay each other a series of cash flows, based on fixed or floating interest rates in the same or different currencies.’

Swap transactions are broadly classified into interest rate, currency, commodity or equity swaps. It is possible to use swaps for a variety of purposes including the reduction of borrowing costs; asset and liability management; and yield enhancement.  The principle of comparative advantage, a concept central to international trade, plays an important role in swap transactions. Each counterparty borrows in the market where it enjoys a comparative advantage, and through the use of swap obtains financing at a more favorable rate than it would otherwise be able to do so. Swap cash flows can be decomposed into equivalent cash flows from a bundle of simple forward contracts. This has implications for the hedging of swap risks. Swaps are now hedged with a variety of derivative products, and no longer only by matching two identical but opposing swaps.

A swap derivative is nothing but barter or an exchange but it plays a critical role in international finance. Currency Swaps help eliminate barriers caused by international capital markets. Interest rate Swaps help eliminate barriers caused by regulatory structure. While Currency rate swaps result in exchange of one currency with another, interst rate swaps help exchange a fixed rate of interest with a variable rate. Swaps are private agreements between two parties and are not traded on exchanges but they do have an informal market and are traded among dealers. Swaptions is an option on swap that gives the party the right, but not the obligation to enter into a swap at a later date.



An option is the ‘right to buy or sell a specific price on or before a specific date in the future’. It is a right that the option seller gives to the option buyer to buy or sell an underlying asset at a predetermined price, within or at the end of a specified period. The party taking a long position, i.e. buying the option is called the buyer/holder of the option and the party taking a short position, i.e. selling the option is called the seller/writer of the option.

The option buyer who is also called long option, or long premium or holder of option, has the right and no obligation with regard to buying or selling the underlying asset while the option seller/ writer who is also called short on option or short on premium, has the obligation but no right, in the contract. In other words, the option buyer may or may not exercise his option but if he decides to exercise it the option seller/writer is legally bound to honor the contract.

The right to buy an asset is a ‘call option’, while the right to sell an asset is a ‘put option’. An option which gives the buyer a right to buy the underlying asset, is called a call option and the option, which gives the buyer a right to sell the underlying asset is called put option.

An American option is one which can be exercise any time until maturity, while a European option is one which can be exercised on maturity date. The buyer of an option is usually called the ‘option holder’, and the seller of the option, the ‘option writer’. The option holder must pay the option writer a price known as the ‘premium’ in order to acquire the rights under the option. Options are available on a wide range of assets including commodities, foreign currencies, shares, bonds and even other derivatives.



India joined the league of exchange-traded equity derivatives in June 2000, when futures contracts were introduced at its two major exchanges, viz. the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). The BSE sensitive index, popularly known as the SENSEX (compromising 30 scrips), and S&P CNX Nifty Index (compromising 50 scrips), commenced trade in futures on June 9, 2000 and June 12, 2000 respectively. Index options and individual stock options on 31 selected stocks were subsequently added to the derivatives basket, in 2001. November 2001 witnessed the introduction of single stock futures in the Indian market. This list of stocks was selected, based on a predefined eligibility criteria linked to the market capitalization of stocks, floating stock, liquidity, etc.



The Forward Contract Regulation Act (FCRA) governs commodity derivatives in India. The FCRA specifically prohibits OTC commodity derivatives. Accordingly, at this point in time, we have only exchange-traded commodity derivatives. Furthermore, FCRA does not even allow options on commodities. Therefore, at present, India trades only exchange-traded commodity futures.

Though commodity derivatives in the country have existed for a long time, trading has been regionally concentrated due to the regional nature of the commodity exchanges. Recently however, India began trading in commodity derivatives through two nation-wide, online commodity Exchanges- the National Commodities and Derivatives Exchange (NCDEX) and the Multi Commodity Exchange (MCX). They started functioning in the last quarter of 2003 with the introduction of futures contracts on various assets such as gold, silver, rubber, steel, mustard seed, etc.

It is important to note that both these exchanges have been recording a very high rate of growth. But it is interesting to note that the growth in volume of commodity derivatives has been achieved without institutional participation in the market. At present, banks, financial institutions, mutual funds, pension funds, insurance companies and Foreign Institutional investors are not allowed to participate in the commodities market.



India has been trading forward contracts in currency, for the last several years. Recently, the RBI has allowed options in the OTC market. The OTC currency market in the country is considerably large and well-developed. However, the business is concentrated with a limited number of market participants.



An Interest Rate Derivative is a derivative where the underlying asset is the right to pay or receive a (usually notional) amount of money at a given interest rate. There has also been significant progress in interest rate derivatives in the Indian OTC market. The NSE introduced trading in cash settled interest rate futures in the year 2003.



Derivatives markets fall in two broad categories: exchange-traded derivatives markets and over-the counter (OTC) derivatives markets.



A derivatives exchange may simply be described as an organized market for the trading of derivatives contracts. The derivatives exchanges are a vital component of the global market for exchange-traded derivatives.

In a typical transaction, the client’s order is routed to a floor member for execution. After the trade is executed, the contract between the two contracting floor members is then sent to the clearing house for registration. Once the contract between two clearing members is registered, the legal nexus between the original buyer and seller is broken. The clearinghouse interposes itself between the buyer and seller and two new contracts come into existence. In one contract, the clearinghouse acts as buyer to the original seller, and in the other contract, the clearinghouse interposes itself between the buyer and seller. The clearinghouse does not guarantee the performance of the open contracts. Rather it assumes the responsibility for performance by acting as the counterparty in both the contracts.

The various exchange traded derivatives market in India are the National Stock Exchange(NSE), the Bombay Stock Exchange(BSE), the National Commodities and Derivatives Exchange(NCDEX) and the Multi Commodity Exchange(MCX).

Some of the international exchanges where such derivatives are traded are The Sydney Futures Exchange, the New Zealand Futures And Options Exchange, Singapore Exchange Derivatives Trading Limited, Commodity and Monetary Exchange of Malaysia, Kuala Lumpur Options and Financial Futures Exchange, Hong Kong Futures Exchange.



The over-the-counter (OTC) derivatives markets are principal-to-principal dealer markets. Products/contracts that are traded outside the exchanges are called OTC derivatives. They are contracts those which are privately traded between two parties and involve no exchange or intermediary. Swaps, Options and Forward Contracts are traded in Over the Counter Derivatives Market or OTC market. The main participants of OTC market are the Investment Banks, Commercial Banks, Govt. Sponsored Enterprises and Hedge Funds. The investment banks markets the derivatives through traders to the clients like hedge funds and the rest.

The OTC derivatives markets are much larger than the exchange-traded derivatives markets. The OTC derivatives markets are predominantly institutional markets and individual transactions tend to be fairly large in size, while the exchange traded derivatives markets, on the other hand, have a significant retail component and their average transaction size tend to be much smaller. Unlike the exchange traded derivatives, the OTC derivatives markets are usually unregulated and operate on a caveat emptor basis. The OTC derivatives markets do not have a formal trading place, are less transparent, have no margining mechanisms, and generally suffer from reduced liquidity.

OTC contracts, such as forwards and swaps, are bilaterally negotiated between two parties. The terms of an OTC contract are flexible, and are often customized to fit the specific requirements of the user. However, OTC Contracts have substantial credit risk; which is the risk that the counterparty that owes money may defaults on the payment. In India, OTC derivatives are generally prohibited with some exceptions: those that are specifically allowed by the Reserve bank of India (RBI) or, in the case of commodities (which are regulated by the forward markets commission), those that trade informally in ‘havala’ or forward markets.



The enactment of Securities Laws (Amendment) Act 1999 and repeal of 1969 notification provided a legal framework for securities based derivatives trading on stock exchanges in India, which is co-terminus with framework of trading of other “securities” allowed under the SCRA. The trading of stock index futures started in June 2000 and later on, other products, such as, stock index options and stock options and single stock futures were also allowed.

The regulation has been designed to achieve specific well-defined goals. Therefore it is inclined towards positive regulation designed to encourage healthy activity and behavior. It has been guided by the following factors:



To improve investor confidence and facilitate a larger flow of investments, regulatory attention has been given to certain aspects like fairness & transparency, safeguarding clients’ money, competent & honest service and market integrity. SEBI as a regulatory body and watchdog further ensures investor protection.

The International Organisation of Securities Commissions (IOSCO) has been providing international best practices and perspectives on derivatives markets. In 1990, the IOSCO published the Principles for Oversight of Screen Based Trading Systems for Derivatives Products. It was suggested that all the jurisdictions adopt (SEBI, being a member organization, has adopted these principles,) the 10 non-exclusive general principles for the oversight of screen based trading systems for derivatives products which identify areas of common regulatory concern.

These principles basically relate to compliance by system sponsor with the regulatory requirements relating to legal standards, regulatory policies, risk management mechanisms and adequate disclosures of attendant risks. This shows that the international principles also value investor protection, which has been adequately adopted by the Indian regulatory framework.




RBI vide circular A.P.(DIR Series) Circular no. 13, dated September 1, 2003 has specified that Foreign Institutional Investors(FIIs) may trade in all exchange traded derivative contracts approved by SEBI from time to time subject to the limits prescribed by SEBI. The existing FII position limits in equity index derivative contracts were reviewed by the Advisory Committee on Derivatives and Market Risk Management. The recommendations of this committee were considered and approved by the SEBI Board.



The position limits for FII and their sub-accounts shall are as under:

        AT THE LEVEL OF THE FII:  In the case of index-related derivative products, there is a position limit of 15 per cent of open interest in all futures and options contracts on a particular underlying index on the Exchange, or Rs 100 crore, whichever is higher. For securities in which the market-wide position limit is less than or equal to Rs 250 crore, the FII position limit in such stock is 20 per cent of the market-wide limit. For securities in which the market-wide position limit is greater than Rs 250 crore, the FII position limit in such stock is Rs 50 crore.

        AT THE LEVEL OF THE SUB-ACCOUNT:  any person or persons acting in concert who together own 15 per cent or more of the open interest of all futures and options contracts on a particular underlying index on the Exchange are required to make disclosure.. The gross open position across all futures and options contracts on a particular underlying security, of a sub-account of an FII, should not exceed the higher of 1 per cent of the free float market capitalization (in terms of number of shares) or 5 per cent of the open interest in the derivative contracts on a particular underlying stock (in terms of number of contracts). These position limits are applicable on the combined position in all futures and options contracts on an underlying security on the Exchange.



The Clearing Corporation monitors the FII position limits at the end of each trading day. For this purpose, the following procedure is prescribed:

          FIIs intending to trade in the F&O segment of the Exchange shall be required to notify the following details of the Clearing Member/s, who shall clear and settle their trades in the F&O segment, to Clearing Corporation. The details to be provided are i) Name of FII ii) SEBI Registration Number iii) Name of sub-account/s of FII (if any) iv) Name of the Clearing Member/s.

          A unique code will be allotted by Clearing Corporation to each such FII prior to commencement of trading by them. This will be utilized by Clearing Corporation for the purpose of monitoring position limits at the level of the FII.

          Each FII/ sub-account of the FII, as the case may be, intending to trade in the Futures & Options segment of the Exchange, shall further be required to obtain a unique Custodial Participant  code allotted from the Clearing Corporation, through their Clearing Member.

          Clearing Member/s of the FII are required to submit the details of all the trades confirmed by FII to Clearing Corporation, by the end of each trading day, as per the mechanism specified.

          Clearing Corporation are required to  monitor the open positions of the FII/ sub-account of the FII for each underlying security and index on which futures and option contracts are traded on the Exchange, against the position limits specified at the level of FII/ sub-accounts of FII respectively, at the end of each trading day.

          In the event of an FII breaching the position limits on any underlying, Clearing Corporation will advise the Exchange to withdraw the facility granted to such FII to take any fresh positions in any derivative contracts. Such FII will be required to reduce their open position in such underlying, in accordance with the mechanism provided by Clearing Corporation from time to time. The facility withdrawn may be reinstated upon due compliance of the position limits.



The position limits would be computed on a gross basis at the level of a FII and on a net basis at the level of sub-accounts and proprietary positions. The open position for all derivative contracts would be valued as the open interest multiplied with the closing price of the respective underlying in the cash market.




To prevent every stock from trading in derivatives products, it has been provided that the stock being in the top 200 lists in terms of market capitalization can only be traded. ‘Quarter sigma order size’, a new measure has been introduced to determine the eligibility of scrips to have single stock derivative products. The mechanism for discontinuance of single stock derivatives contracts in cases where scrip fails to satisfy the eligibility criteria has also been envisaged. A stock index would normally be eligible for derivatives trading if most of the weight age in the index (some 90%) is accounted for by constituent stocks that are themselves eligible for derivatives trading.



Keeping in view the swift movement of funds and the technical complexities involved in derivatives transactions, a need was felt to protect particularly the small investors by preventing them from venturing in to options and futures market, who may be lured by the sheer speculative gains. Therefore, threshold limits of the transactions have been pegged at Rs. Two Hundred Thousand, which means the minimum contract size for any investor to participate in the derivatives market, is Rs. Two Hundred Thousand.



Following the recommendations of the Secondary Market Advisory Committee, the SEBI decided to permit the Mutual funds to participate in the Derivatives market at par with Foreign Institutional Investors (FII). Accordingly the Mutual funds are treated at par with registered FII in respect of positions limits in Index futures, Index options, Stock options and Stock futures contracts. The Mutual funds are considered as trading members like registered FIIs and the schemes of Mutual funds is treated as clients like sub-accounts of FIIs.

They are also required to follow strict disclosure and accounting norms. Each mutual fund is required to disclose the maximum net derivatives exposure in terms of percentage of portfolio value, the limits of derivatives exposure per scrip/instrument and derivatives positions and limits in the offer documents/addendum of the respective schemes to the investors. The data of actual exposures has to be disclosed in the half yearly portfolio statements.



Although, India has been able to provide for a reasonably strong regulatory framework for derivatives trading, still there are many issues left to be addressed.



While the Indian regulatory framework for derivatives is mostly consistent with the international practices, some elements of financial infrastructure need to be strengthened. There is a need for Bankruptcy and insolvency laws to explain clearly the rights of securities holders on winding up of or on insolvency of intermediaries.  In order to bring in transparency and create stability in the financial markets, public disclosure of trading and derivatives activities of the banks and security firms were required to be made mandatory.



Another problem faced in the derivatives market especially by retail investors is the minimum contract size, which has been fixed at Rs.Two Hundred Thousand. The idea behind this decision was to curb too much speculation from small investors who had little knowledge about derivatives. However, it is being felt that the minimum contract value of Rs. Two Hundred Thousand has been too high and acts as a deterrent for retail investors who are otherwise willing to transact in the derivatives market.




The Income Tax Act, 1961 of India did not have any specific provision regarding taxability of derivatives income. The tax authorities are still undecided on this issue, and in the absence of any provision, derivatives transaction are held at par with transactions of speculative nature, particularly, the index futures/options which were essentially cash settled, are treated this way. Therefore, the loss, if any, arising from derivatives transactions, was treated as a speculative loss and was eligible to be set off only against speculative income up to a maximum period of eight years. It is suggested that derivatives instruments are essentially used by investors to hedge risks, and therefore they should not be considered as speculative transactions. They should be taxed as short-term capital gains or losses on securities. The problem of lack of clarity on taxation needs to be addressed urgently.



Allowing cross margining between spot and derivatives market is an issue which has to be addressed.  Cross margining resulted in a far more efficient use of a member’s capital for trading in related products and in more than one market. A clearing corporation could easily compute and levy a single net margin amount based upon offsetting positions in different products/markets/exchanges. Cross margining could include adjustment of margins in case of opposite positions in the cash and derivatives market. It is suggested that cross margining between positions in trades of the underlying and derivatives in a stock, cross margining between different indices, stocks, etc. be allowed.



The Basel Committee on Banking Supervision and IOSCO Technical Committee have presented recommendations for public disclosure of trading and derivatives activities of banks and securities firms which could also be used by such non-financial companies that make material use of complex financial products. These recommendations emphasize the importance of transparency in promoting financial stability. It is observed that transparency based on meaningful public disclosure plays an important role in reinforcing the efforts of supervisory authorities in encouraging the sound risk management practices and promoting financial market stability.

Accounting and valuation and reporting requirements for forward rate agreements and interest rates swaps have been prescribed in the RBI guidelines (for regulatory reporting), to all scheduled commercial banks, primary dealers and All India Financial Institutions by RBI in July 1999. However, what is being suggested is that the IOSCO principles would need to be suitably incorporated (through a statutory mandate) in the public disclosure of trading and derivatives activities of banks and securities firms.

The disclosure should be on the major risks associated with their trading and derivatives activities including credit risk, market risk, liquidity risk, operational risk, legal risk and reputational risk. Further, institutions should also disclose about their performance in managing these risks.


Many people have the perception that derivatives are very risky. Such perceptions are systematically induced by well publicized debacles such as the Barings episode.

In 1995, financial markets the world over were shocked when the 233 year-old Barings Investment Bank was left with a loss of $ 1.3 billion by Nicholas William Lesson, a man who had established a great track record of being a savvy trader in the derivatives market. It all started when Lesson was sent to Singapore in1992. Though he had permission for intra day trading activities, he exceeded his authority by taking huge overnight positions. He traded simultaneously in Tokyo stock exchange-Nikkei 225 and Singapore Stock Exchange along with Osaka Stock exchange, Japan. His strategy amounted to a bet that the Japanese stock market would neither fall not go up substantially.

The Japanese stock market started falling on the news of a violent earthquake in Kobe, Japan. Barings took a self destructive step when it allowed Lesson to act both as front office trader and back office settlements manager. Lesson used this to his full advantage and opened an account ‘88888’ which he used to hide losses that he was making on derivative trading activities. Thereafter, he scaled up his trading activities in futures and options, and by December 1994 had accumulated losses of $208 million on that account. All through this, he always represented to the top management that he had been making profits in trading activities. This was concealed by not divulging the details of account ‘88888’ to Barings in London, giving false reports, misrepresenting the profitability of trading activities and a number of false trading transactions and accounting entries.

Lesson expected Tokyo’s NIKKEI stock index to rise substantially at the beginning of 1995 and took huge positions, which he lost heavily on when the index did not rise. He bought 20000 futures contract over a period of three months in a futile attempt to move the market.  The result is well known. A single trader could not direct the market as desired and consequently the market fell drastically. As a result, Barings registered colossal losses on Lesson’s positions. The Bank was unable to sustain these losses and one trader collapsed one of the most oldest and prestigious banks in England.


Till Assessment Year 2005-06, the Income Tax Act, 1961 did not have any special provisions dealing with taxation of derivatives transactions in general, and dealing with futures and options in particular, though derivatives contracts have been traded on Indian stock exchanges since 2000. The Finance Act 2005 has amended the proviso to section 43(5), with effect from Assessment Year 2006-07, to provide that derivatives trading transactions would not be regarded as speculative transactions, subject to the fulfilment of certain conditions.

For the most part, therefore one needs to look at the normal provisions of the Income Tax Act and understand their applicability to derivatives transactions. Various issues do arise for consideration, more so, since there is also no case law on the subject, as futures and options transactions are of recent origin.

To understand the taxation, one also needs to understand the accounting treatment. The ICAI Guidance Note on Accounting for Equity Index and Equity Stock Futures and Options provides guidance as to how such transactions are to be accounted for.

In substance, the Guidance Note provides that the profit or loss on the transactions is to be recognised only on expiry of the future or option or on squaring up of the position (unless there is an intervening balance sheet). Till such time of expiry or squaring up, the initial margin, premium paid and mark-to-market margin is to be accumulated and shown as a current asset.  If a balance sheet is prepared during the intervening period before expiry of the future or option, a provision is to be made for the notional loss, if any, as on that date on a mark-to-market basis, but no profit is to be recognised on such basis.


a) Whether Always Taxable as Business Income:  

The most common issue that arises in taxation of derivatives transactions is that of whether derivatives transactions are always to be regarded as business transactions.

It is true that in most cases, derivatives transactions would be regarded as business transactions on account of the following factors:

1.   The purpose behind entering into most derivatives transactions is to profit from short-term fluctuations in market prices.

2.    The period of any derivatives transaction cannot exceed 3 months, and such transactions are invariably short-term transactions.

3.     Often, the sheer volume of trades in derivatives transactions entered into by a person on an ongoing basis indicates that it amounts to a business.

4.     Many people who trade in derivatives may be associated with the stock market in some way or the other – they may be stock brokers or their employees, or regular day traders. For such people, derivatives trading is an extension of their normal business activities.


However, the issue of whether an activity amounts to a business or not depends upon various factors, and is not decided just because of the existence or absence of any one circumstance. There can be situations where derivatives transactions may not amount to a business. For instance, derivatives transactions may be carried on by an investor to hedge his investment portfolio. In such a case, the mere fact that the investor had to square up his derivatives position every 3 months and take up a fresh position, or pay mark-to-market on a daily basis, would not detract from the fact that the prime purpose of such transactions was to preserve the value of the investment portfolio.

Another common practice in the stock markets is arbitrage between the cash market and the futures market. It is a well known fact that the difference in prices between the futures market and the cash market is primarily dictated by the short-term interest rates, and such difference is normally equivalent to the interest that one would earn on short term lending. Therefore, a person having surplus funds may buy shares in the cash market, while simultaneously selling an equal amount of futures of the same share in the futures market. He would take delivery of the shares bought in the cash market.  On maturity of the futures, the shares bought in the cash market would be sold in the cash market. Since the futures would be squared off at the cash market price, the profit on the transaction would normally consist mainly of the difference between the initial purchase price in the cash market and the initial sale price in the futures market, with small adjustments for expenses such as brokerage, securities transaction tax, service tax and the market spread between the buying and selling quotes in the cash market.

Are such arbitrage transactions business transactions, or are they really in the nature of interest seeking transactions? If one looks at the substance of these transactions, they are not motivated by a desire to earn profits, but just to avail of the benefit of the short term interest rates. There just two legs of the transaction – the purchase and futures sale, and the expiry of futures and cash sale. The income element in the transactions is determined right at the outset, and does not fluctuate to any material extent, even if there is substantial volatility in the market.  Going by the principle of the substance of the transaction, a view is possible, as was being taken in the past in the case of vyaj badla transactions that such transactions are in the nature of earning of interest, though they take the form of arbitrage transactions.

It may be however noted that other factors, such as frequency of transactions, nature of other business carried on, etc., would also determine whether such transactions are business transactions or not.


b) If not Business Income, under which Head Taxable:  

The question arises that in a situation where derivatives transactions are not business transactions, under which head of income should such transactions be considered? 

The answer to this question would partly depend upon the substance of the transactions. If the transactions are in the nature of interest-seeking transactions, then going by the substance of the transactions, the income from such transactions may be considered as interest.

But if the transactions are in the nature of hedging of investments, how would they be taxed? A derivative, being a security and a right under a contract, is certainly a valuable right, which is capable of being assigned. The right under the derivatives contract can therefore certainly be regarded as property, and therefore as a capital asset.

The issue which arises is – is there a transfer of the capital asset? When the transaction is squared up by an opposite corresponding transaction, there is certainly a transfer. But in cases where the squaring up is on expiry of the contract, can a transfer be said to have taken place? Considering the definition of “transfer” in section 2(47), the expiry of such a contract can possibly be regarded as an extinguishment of the rights in the asset. As held by the Supreme Court in the case of CIT vs. Grace Collis , the definition of “transfer” in section 2(47) clearly contemplates the extinguishment of the rights in a capital asset distinct and independent of such extinguishment consequent upon the transfer itself. A view is therefore possible that on expiry of the derivatives, there is a transfer of the capital asset. The gains or losses arising from such derivatives would accordingly be taxable under the head “Capital Gains”.

Though such income would be taxable under the head “Capital Gains”, and the derivatives transactions would be subject to Securities Transaction tax, such gains would not be entitled to the concessional tax treatment for short-term capital gains under section 111A, since the benefit of that section is available only to equity shares in a company or a unit of an equity oriented mutual fund.


c) Determination of Turnover:


If derivatives transactions are business transactions, the question then arises as to what constitutes the turnover in derivatives transactions for the purposes of section 44AB or for other purposes? In the case of futures, the purchases of futures is not recorded as a purchase in the books of account, nor is the sale of futures recognized as a sale. Only the initial margin and mark-to-market margins are recorded as and when paid, and the profit or loss on the futures transaction is recorded as an income/expense on squaring up of the transaction or on expiry of the futures contract.  

The margin paid is certainly not the turnover, and neither can the futures sale be regarded as a sale in the light of such accounting treatment. At best, only the difference (profit or loss on the futures transaction) can be regarded as turnover.

The question then is – should one net off the profits and losses and is only the net profit or loss to be regarded as the turnover? This does not appear to be proper, as the net profit or loss would not reflect a measure of the actual volume of transactions. It should be the gross differences which would constitute turnover, and not the net differences. The scrip wise gross differences for each maturity should be determined, the negative signs of the losses within a scrip of each maturity ignored and such losses grossed up with the gains to compute the turnover. 

In the case of options, only the premium and margins paid is reflected in the books of account at the inception of and during the currency of the option. The strike prices of the margins do not get reflected in the books of account, except for the limited purpose of identifying different sets of options. On the squaring up or expiry of the options, the value of the option on sale or maturity is received or paid, and the profit/loss on the options accounted for. There is a view that such value of the options on squaring up/maturity would constitute the turnover in case of options, though the better view seems to be that it would be the gross differences (taking the losses also as a positive figure) as in the case of futures that would constitute the turnover.


Exclusion of Derivatives from definition of Speculative Transaction:

A new clause (d) has been added to the proviso to section 43(5), excluding certain derivatives trading transactions from the definition of “speculative transaction”.  Such exclusion of derivatives transactions is however subject to certain conditions.

These conditions are:

                      the transaction should have been carried out electronically on a screen-based system. This condition does not pose any difficulty, as all derivatives transactions on the National Stock Exchange or the Bombay Stock Exchange (which today are the only stock exchanges in India offering derivatives transactions) are electronic screen-based transactions.

                      The transaction should have been carried out through a stock broker or sub-broker or other intermediary registered under section 12 of the SEBI Act, 1992 in accordance with the Securities Contracts (Regulation) Act, 1956, the SEBI Act, 1992 or the Depositories Act, 1996 and the rules, regulations or bye-laws made or directions issued under those Acts, or by banks or mutual funds. Since all derivatives transactions on NSE or BSE have to be routed through stock brokers, this condition also does not pose any difficulty. 

                        c.       The transaction has to be carried out on a recognised stock exchange. Unfortunately, the definition of “recognised stock exchange” for the purposes of this provision is not the same as under the Securities Contracts (Regulation) Act, 1956, and requires certain further conditions to be fulfilled. A recognised stock exchange is defined as a stock exchange recognized under section 2(f) of SCRA, and which fulfils the prescribed conditions and which is notified by the Central Gov Acternment for this purpose. The prescribed conditions have been laid down vide rule 6DDA    notified on 1st July 2005 [276 ITR (St.) 69]. These are: 

                        the stock exchange shall have the approval of the Securities and Exchange Board of India established under the Securities and Exchange Board of India Act, 1992 (15 of 1992) in respect of trading in derivatives and shall function in accordance with the guidelines or conditions laid down by the Securities and Exchange Board of India ;

                        the stock exchange shall ensure that the particulars of the client (including unique client identity number and PAN) are duly recorded and stored in its databases ;

                        the stock exchange shall maintain a complete audit trail of all transactions (in respect of cash and derivative market) for a period of seven years on its system ;

                        the stock exchange shall ensure that transactions once registered in the system cannot be erased or modified.

                        The procedure for notification of a recognised stock exchange has been laid down in rule 6DDB. Since no stock exchange has been notified so far as a recognised stock exchange, the question arises as to the position of derivatives transactions entered into till date. Rule 6DDB does not clarify whether a notification can be issued with retrospective effect, but merely clarifies that the notification will be valid until cancelled. One will therefore have to await the notification of stock exchanges as recognised stock exchanges.

                      The transaction has to be supported by a time-stamped contract note issued by such stock broker, sub-broker or other intermediary. This also poses no difficulty, as all contract notes now issued by NSE or BSE bear the time-stamp.

                      The contract note has to indicate the unique client identity number allotted under SCRA, SEBI Act or Depositories Act and the permanent account number of the client. The system of unique identification number (UIN) under the MAPIN system introduced by SEBI was to be made mandatory for all non-corporate investors for all transactions exceeding Rs.1 lakh after 31st March 2005. Because of objections raised by investors, this date was postponed, and a committee was set up by SEBI to take a relook at the system.  After considering the committee report, SEBI has now made such unique identity number mandatory for all investors for transactions exceeding Rs.5 lakhs. It is therefore quite possible that many investors entering into derivatives transactions during financial year 2005-06 may not have obtained such UIN.

If such UIN is not mentioned in the contract note, as it has not been obtained, can the benefit of derivatives transactions not being regarded as speculative transactions be denied? If the UIN has ultimately been obtained before the end of the year, it may be possible to contend that the main requirement of obtaining the UIN has been complied with, and the mere fact of non-mention of such number in the contract note cannot result in denial of the benefit. Such an argument may not be tenable in a case where the UIN has not been obtained at all, though one can certainly contend that since the date for obtaining UIN has been extended by SEBI, non-mention of UIN in contract notes for the financial year 2005-06 in cases of non-corporates should not result in denial of the benefit. 

There may be cases where the value of the transactions is below Rs.5 lakhs, where UIN is not made mandatory by SEBI. In such a case, can the benefit of treatment of derivatives transactions as non-speculative be denied to such a person, on the ground that he has not obtained UIN? The purpose of mention of UIN and PAN is to ensure that such transactions of one person are not recorded as the transactions of another. If, through PAN identification on the contract notes, such purpose is served, an assessee should not be denied the benefit for not complying with a requirement that is not otherwise mandatory for him. 

It needs to be understood that the classification of derivatives transactions as non-speculative is not always beneficial. Take for instance, a day trader who trades in shares and also trades in derivatives. If he has incurred a loss in his share day trading activities, and earned a profit on his derivatives transactions of an equal amount, only the day trading loss will be regarded as a speculation loss, and the derivatives profit will be taxable as normal business income. If the derivatives transactions had also been regarded as speculative transactions, the speculation profit or loss would have been the net result of both his day trading as well as derivatives trading activities, whereby in effect the day trading loss would have been set off against his derivatives trading profit. So, can the exclusion granted by clause (d) be regarded as clarificatory, and therefore applicable even to past transactions? Since the exclusion is subject to various conditions, it may be difficult, in most cases, to claim the benefit for earlier years.  Besides, the Explanatory Memorandum clarifies that the amendment is being carried out due to the fact that recent systemic and technological changes introduced by stock exchanges have resulted in sufficient transparency to prevent generating fictitious losses through artificial transactions or shifting of incidence of loss from one person to another. In such a situation, the argument that the amendment is clarificatory may be difficult to sustain, if one looks only at the amendment.

The question that is then often asked and will continue to be relevant in the future will be – are derivatives transactions speculative transactions, even in the absence of applicability of clause (d) of the proviso to section 43(5) of the Income Tax Act?  Can it be argued that index futures or index options are certainly not stocks and shares, and that the definition of speculation transaction, which requires the contract to be for the purchase or sale of any commodity, including stocks and shares, therefore does not apply? Even otherwise, can a transaction for purchase or sale of an equity stock future or an equity stock option be regarded as a transaction for purchase or sale of shares?

It is fairly clear that derivatives are securities which are distinct from the underlying securities. The definition of securities under SCRA very clearly shows that shares and derivatives are two distinct types of securities. Therefore, purchase and sale of derivatives cannot be equated with purchase and sale of stocks and shares.

Now the question is can derivatives be regarded as commodities?  Also, can the decisions of various courts in the cases of Imperial Tobacco Co. (of Great Britain & Ireland) Ltd. vs. Kelly (H.M. Inspector of Taxes), ANZ Grindlays Bank vs. Dy. Commissioner, Income Tax. and Comfund Financial Services (I) Ltd. vs. Dy. Commissioner, Income Tax. be relied upon to treat derivatives as commodities? In these decisions, foreign currency, government securities and units of UTI and mutual funds were held to be commodities, on the footing that they satisfied the dictionary meaning of “any article of trade or commerce”.

 If one examines the definition in Black’s Law Dictionary, after defining “commodity” as an article of trade or commerce”, it goes on to clarify that the term embraces only tangible goods, such as products or merchandise, as distinguished from services. An alternative definition is “an economic good, especially a raw material or an agricultural product. The very term “article” also indicates physical goods.

 From this, it is clear that a commodity has to be in the nature of tangible goods, and not something which has no existence of its own, but is a mere contractual right, such as a derivative. The better view therefore seems to be that transactions in derivatives would even otherwise not have been covered by the definition of “speculative transaction” in section 43(5) of the Income Tax Act.

Another aspect is that transactions in derivatives, particular derivatives based on indices such as index options and index futures, are by their very nature incapable of being delivered. From inception in 2000 till today, equity stock options and equity stock futures cannot be settled by delivery, but can only be cash settled. Can a person be penalised by law for not doing the impossible? This supports the view that even de hors clause (d) of the proviso to section 43(5), a derivatives transaction could not have been regarded as a speculative transaction, and that clause (d) therefore merely clarifies the position as it always has been.




a) Whether explanation to s.73 attracted? 

The explanation to section 73 deems the business of a company consisting of purchases and sale of shares as speculation business.  This explanation applies to a company, notwithstanding the fact that the transactions may otherwise not have been regarded as speculative transactions by applying the provisions of section 43(5).  

Can purchase and sale of equity stock future/option be regarded as purchase/ sale of shares of other companies? As discussed above, derivatives are distinct securities, separate from shares. Transactions of purchase and sale of derivatives therefore cannot be regarded as transactions in shares, and the provisions of explanation to section 73 would therefore not apply to a derivatives trading business.


b) Deductibility of Provision for loss on outstanding net position on Balance Sheet Date

In accounting for derivatives, the ICAI Guidance Note requires provision to be made for any diminution in value of derivatives outstanding on the Balance Sheet date.  Is such provision for possible loss arising on the derivatives outstanding transactions allowable as a deduction in computing the taxable income.

If the derivatives transactions constitute a business, is such a provision a provision for a contingent loss, or can one contend that it is a method of stock valuation? Considering the fact that derivatives are not accounted for as purchases and therefore not accounted for as stock in trade, it may be difficult to claim that the loss provided for on the Balance Sheet date is really a method of stock valuation. It is more in the nature of a provision for a loss, which is estimated on the Balance Sheet date.

So now the question is can one draw upon the real income theory to claim that such loss is an allowable deduction? The Supreme Court, in the case of Godhra Electricity Co. Ltd. vs. CIT, has reiterated the concept of taxability of “real income”, which was enunciated by it earlier in the cases of CIT v. Shoorji Vallabhdas and Co., CIT v. Birla Gwalior (P.) Ltd., Poona Electric Supply Co. Ltd. v. CIT, and R. B. Jodha Mal Kuthiala v. CIT   and by the Bombay High Court in the case of H. M. Kashiparekh and Co. Ltd. v. CIT  In all these cases, the Courts have held that tax can be imposed only if there is real income and income-tax cannot be imposed on hypothetical income. The real income theory would dictate that business income can be computed only after taking into account losses up to the end of the year.

This view is also supported by the decision of the Special bench of the Income Tax Appellate Tribunal where it has been held that foreign exchange loss in respect of outstanding transactions on the balance sheet date is not a contingent loss, but a fait accompli, and is an allowable deduction.

Further, section 145 of the Income Tax Act requires that accounting standards prescribed by the CBDT are to be followed in computing the business income. Accounting Standard 1 prescribed by the CBDT vide notification no. SO 69(E) dated 25th January 1996 provides that accounting policies adopted by an assessee should be such so as to represent a true and fair view of the state of affairs of the business in the financial statements prepared and presented on the basis of such accounting policies. It further provides that for this purpose, the major considerations governing the selection and application of accounting policies are prudence, substance over form and materiality.  As per this standard, under consideration of prudence, provisions should be made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only a best estimate in the light of available information. On this criteria, provision for such loss is in accordance with such standard. Therefore, the better view seems to be that such loss is an allowable deduction.

Would such loss be an allowable deduction in computing book profits for the purposes of section 115JB? The explanation to Section 115JB provides that amounts set aside to provisions made for meeting liabilities, other than ascertained liabilities, is to be added to the amount of net profit to compute the book profits. Going by the logic of the decision in ONGC’s case, such a provision is for an ascertained liability, and is therefore not required to be added to the net profit to compute book profits.


Recent Developments

RBI in order to regulate the currency market volatility has allowed the trading in currency future and forward on April 20,2007. And as there was difficulty in managing the currency future along depending on FOREX with other derivatives traded in Security exchange market depending on SENSEX, Therefore the RBI and SEBI came together and jointly formed an standing committee to analyze the trade in currency forward and future market around the world and thus laying down the guideline to introduce and manage the exchange traded currency future market in India. The committee has submitted the report on May 29,2008 . RBI and SEBI is now cooperating and working together manage this segment of future and option trading in India . this segment has mostly benefited importer and exporter to manage their future risk  by hedging there fund in currency future were they could lock there future currency exchange rate so that they could manage there risk in fluctuating Indian currency in international market. Various currency derivatives have been introduced by NSE and MCX  to make Indian Securities market  globally competitive and larger.




The entire concept of taxation of derivatives is at crossroads, the dilemma is that if the derivatives transactions are regarded as taxable under the head “Capital Gains”, there is no provision for deduction of such provision, particularly as the gains would be computed and taxable only on the date of transfer, i.e. the date of squaring up or expiry of the derivatives, and not on any interim date. Further, in computing capital gains, only the cost of acquisition, cost of improvement and expenses in connection with the transfer are deductible. Such provision would therefore not be deductible if the derivatives transaction income is taxable as capital gains.

 If the derivatives transactions are taxable as “Income from Other Sources”, the real income theory would again require the deduction of such provision for loss in determining the taxable income.

The taxation of derivative transactions is not specifically dealt with under the Indian Income-tax Act (Act). There could be two possible interpretations viz. derivatives transactions are pure business transactions and hence, the income/loss thereon should be assessed as normal business income / loss. The other view is that derivatives are covered under the definition of speculative transaction under section 43(5) of the Act in absence of delivery of the underlying security or commodity.

Under the Act, speculative profits/losses are allowed to be setoff only against speculative losses/profits respectively. The unabsorbed speculative losses are allowed to be carried forward for 8 immediately succeeding assessment years. However, setoff of such carried forward speculative losses is allowed to be setoff only against speculation profits.

In view of the aforesaid, there is a risk of such derivative transactions being treated as speculative transactions under the Act. Therefore, one is advised to seriously consider the tax implications of entering into derivative transactions.

A high level panel consisting of a special three-member committee had been set up by the Department of Revenue to examine the definition of `Speculative Transactions' with respect to trading in financial derivatives. The committee is of the view that the definition of speculative transaction in Section 43(5) of the Income Tax Act is fairly obsolete when viewed against the latest developments in the capital markets. Therefore, to my understanding, it is likely that the derivative transactions will be put outside the ambit of speculative transactions based on the recommendations of the Committee and looking at the Government's commitment to deepen and modernize capital markets, as government is keen to make Indian securities market globally competitive by introducing innovative derivatives to play globally and fulfill the global market demand of Derivatives from Indian prospering Securities Market  .

From the above discussion it is evident that derivative trading has left an indelible mark on the face of the global financial markets. This conclusion is supported by the fact that derivatives have grown at explosive rates, and at times trading in derivatives has even surpassed trading in their underlying instruments. However, derivatives are more risky than other traditional financial products because they are highly leveraged, more complex and less transparent. Being relatively newer instruments, there is a general lack of understanding of how they operate or how they should be managed.

However, a closer scrutiny of the losses suffered by end-users reveals that in many cases, the underlying causes were the improper use of derivatives, greed, and ignorance. Losses from derivatives trading could have been reduced if there was proper disclosure of the risks involved, It is firmly suggested that with the help of a comprehensive regulatory framework and the concurrent acceptance of the recommendations made above, derivatives trading could prove to be not only safe but highly lucrative. The following words of Arthur Levitt, Chairman of the United States Securities and Exchange Commission (when testifying before the Senate in January, 1995) very aptly summarise the nature of derivatives:

 “Derivatives are not inherently bad or good. They are a bit like electricity, dangerous if mishandled, but bearing the potential to do tremendous good.”