UNIT – IV

TRADING, CLEARING, SETTLEMENT AND REGULATORY FRAMEWORK

TRADING
4.1.1 Trading Rules

The Derivatives Trading at BSE takes place through a fully automated screen-based trading platform
called DTSS (Derivatives Trading and Settlement System).The DTSS is designed to allow trading on a real-
time basis. In addition to generating trades by matching opposite orders, the DTSS also generates
various reports for the member participants.

4.1.2 Order Matching Rules

Order Matching takes place after order acceptance wherein the system searches for an opposite
matching order. If a match is found, a trade is generated. The order against which the trade has been
generated is removed from the system. In case the order is not exhausted further matching orders are
searched for and trades generated till the order gets exhausted or no more match-able orders are
found. If the order is not entirely exhausted, the system retains the order in the pending order book.
Matching of the orders is in the priority of price and timestamp. A unique trade-id is generated for each
trade and the entire information of the trade is sent to the relevant Members.

4.1.3 Order Conditions

The derivatives market is order driven i.e. the traders can place only orders in the system. Following are
the order types allowed for the derivative products. These order types have characteristics similar to the
ones in the cash market.
• Limit Order: An order for buying or selling at a limit price or better, if possible. Any unexecuted portion
of the order remains as a pending order till it is matched or its duration expires.
• Market Order: An order for buying or selling at the best price prevailing in the market at the time of
submission of the order. There are two types of Market Orders:
1. Partial Fill Rest Kill (PF): execute the available quantity and kill any unexecuted portion.
2. Partial Fill Rest Convert (PC): execute the available quantity and convert any unexecuted portion into
a limit order at the traded price.
• Stop Loss: An order that becomes a limit order only when the market trades at a specified price.
All orders have the following attributes:
• Order Type (Limit / Market PF/Market PC/ Stop Loss)
• Asset Code, Product Type, Maturity, Call/Put and Strike Price
• Buy/Sell Indicator
• Order Quantity
• Price
• Client Type (Proprietary / Institutional / Normal)
• Client Code
• Order Retention Type (GFD / GTD / GTC)
Good For Day (GFD) - The lifetime of the order is that trading session
Good Till Date (GTD) - The life of the order is till the number of days as specified by the Order Retention
Period.
Good Till Cancelled (GTC) - The order if not traded will remain in the system till it is cancelled or the
series expires, whichever is earlier.
• Order Retention Period (in calendar days): This field is enabled only if the value of the previous
attribute is GTD. It specifies the number of days the order is to be retained.
• Protection Points Protection Points: This is a field relevant in Market Orders and Stop Loss orders. The
value enterable will be in absolute underlying points and specifies the band from the touchline price or
the trigger price within which the market order or the stop loss order respectively can be traded.
• Risk Reducing Orders (Y/N): When a Member's collateral falls below 50 lakhs, he will be allowed to put
only risk reducing orders and will not be allowed to take any fresh positions. It is not essentially a type of
order but a mode into which the Member is put into when he violates his collateral limit. A Member
who has entered the risk-reducing mode will be allowed to put only one risk reducing order at a time.

CLEARING AND SETTLEMENT

BOI Shareholding Ltd. a joint company between BSE and Bank of India handles the operations of funds
and securities for the Exchange.

4.2 CLEARING ENTITIES

Clearing and settlement activities in the F&O segment are undertaken by BOISL with the help of the
following entities:

4.2.1 Clearing members

In the F&O segment, some members, called self clearing members, clear and settle their trades executed
by them only either on their own account or on account of their clients. Some others called trading
member-cum-clearing member, clear and settle their own trades as well as trades of their trading
members (TMs). Besides, there is a special category of members, called professional clearing members
(PCM) who clear and settle trades executed by TMs. The members clearing their own trades and trades
of the TMs, and the PCMs are required to bring in additional security deposits in respect of every TM
whose trades they undertake to clear and settle.

4.2.2 Clearing banks

Funds settlement takes place through clearing banks. For the purpose of settlement all clearing
members are required to open a separate bank account with BOISL designated clearing bank for F&O
segment. The Clearing and Settlement process comprises of the following three main activities:

1) Clearing

2) Settlement

3) Risk Management

4.3 CLEARING MECHANISM

The clearing mechanism essentially involves working out open positions and obligations of clearing (self-
clearing/trading-cum-clearing/professional clearing) members. This position is considered for exposure
and daily margin purposes. The open positions of CMs are arrived at by aggregating the open positions
of all the TMs and all custodial participants clearing through him, in contracts in which they have traded.
A TM's open position is arrived at as the summation of his proprietary open position and clients' open
positions, in the contracts in which he has traded. While entering orders on the trading system, TMs are
required to identify the orders, whether proprietary (if they are their own trades) or client (if entered on
behalf of clients) through 'Pro/Cli' indicator provided in the order entry screen. Proprietary positions are
calculated on net basis (buy - sell) for each contract. Clients' positions are arrived at by summing
together net (buy - sell) positions of each individual client. A TM's open position is the sum of
proprietary open position, client open long position and client open short position.

4.4 SETTLEMENT MECHANISM

All futures and options contracts are cash settled, i.e. through exchange of cash. The underlying for
index futures/options of the SENSEX cannot be delivered. These contracts, therefore, have to be settled
in cash. Futures and options on individual securities can be delivered as in the spot market. However, it
has been currently mandated that stock options and futures would also be cash settled. The settlement
amount for a CM is netted across all their TMs/clients, with respect to their obligations on MTM,
premium and exercise settlement.

4.4.1 Settlement of futures contracts

Futures contracts have two types of settlements, the MTM settlement which happens on a continuous
basis at the end of each day, and the final settlement which happens on the last trading day of the
futures contract.

MTM settlement:

All futures contracts for each member are mark-to-market (MTM) to the daily settlement price of the
relevant futures contract at the end of each day. The profits/losses are computed as the difference
between:

• The trade price and the day's settlement price for contracts executed during the day but not squared
up.

• The previous day's settlement price and the current day's settlement price for brought forward
contracts.

• The buy price and the sell price for contracts executed during the day and squared up.

The CMs who have a loss are required t o pay the mark-to-market (MTM) loss amount in cash which is in
turn passed on to the CMs who have made a MTM profit. This is known as daily mark-to-market
settlement. CMs are responsible to collect and settle the daily MTM profits/losses incurred by the TMs
and their clients clearing and settling through them.

Similarly, TMs are responsible to collect/pay profits/losses from/to their clients by the next day. The
pay-in and pay-out of the mark-to-market settlement are effected on the day following the trade day. In
case a futures contract is not traded on a day, or not traded during the last half hour, a 'theoretical
settlement price' is computed as per specified formula.

After completion of daily settlement computation, all the open positions are reset to the daily
settlement price. Such positions become the open positions for the next day.
Final settlement for futures

On the expiry day of the futures contracts, after the close of trading hours, BOISL marks all positions of a
CM to the final settlement price and the resulting profit/loss is settled in cash. Final settlement
loss/profit amount is debited/ credited to the relevant CM's clearing bank account on the day following
expiry day of the contract.

Settlement prices for futures

Daily settlement price on a trading day is the closing price of the respective futures contracts on such
day. The closing price for a futures contract is currently calculated as the last half an hour weighted
average price of the contract in the F&O Segment of BSE. Final settlement price is the closing price of
the relevant underlying index/security in the capital market segment of BSE, on the last trading day of
the contract. The closing price of the underlying Index/security is currently its last half an hour weighted
average value in the capital market segment of BSE.

4.4.2 Settlement of options contracts

Options contracts have three types of settlements, daily premium settlement, exercise settlement,
interim exercise settlement in the case of option contracts on securities and final settlement.

Daily premium settlement

Buyer of an option is obligated to pay the premium towards the options purchased by him. Similarly, the
seller of an option is entitled to receive the premium for the option sold by him. The premium payable
amount and the premium receivable amount are netted to compute the net premium payable or
receivable amount for each client for each option contract.

Exercise settlement

Although most option buyers and sellers close out their options positions by an offsetting closing
transaction, an understanding of exercise can help an option buyer determine whether exercise might
be more advantageous than an offsetting sale of the option. There is always a possibility of the option
seller being assigned an exercise. Once an exercise of an option has been assigned to an option seller,
the option seller is bound to fulfil his obligation (meaning, pay the cash settlement amount in the case of
a cash-settled option) even though hed may not yet have been notified of the assignment.

Interim exercise settlement

Interim exercise settlement takes place only for option contracts on securities. An investor can exercise
his in-the-money options at any time during trading hours, through his trading member. Interim exercise
settlement is effected for such options at the close of the trading hours, on the day of exercise. Valid
exercised option contracts are assigned to short positions in the option contract with the same series
(i.e. having the same underlying, same expiry date and same strike price), on a random basis, at the
client level. The CM who has exercised the option receives the exercise settlement value per unit of the
option from the CM who has been assigned the option contract.

Final exercise settlement

Final exercise settlement is effected for all open long in-the-money strike price options existing at the
close of trading hours, on the expiration day of an option contract. All such long positions are exercised
and automatically assigned to short positions in option contracts with the same series, on a random
basis. The investor who has long in-the-money options on the expiry date will receive the exercise
settlement value per unit of the option from the investor who has been assigned the option contract.

Exercise process

The period during which an option is exercisable depends on the style of the option. On BSE, index
options are European style, i.e. options are only subject to automatic exercise on the expiration day, if
they are in-the-money. As compared to this, options on securities are American style. In such cases, the
exercise is automatic on the expiration day, and voluntary prior to the expiration day of the option
contract, provided they are in-the-money.

Automatic exercise means that all in-the-money options would be exercised by BOISL on the expiration
day of the contract. The buyer of such options need not give an exercise notice in such cases. Voluntary
exercise means that the buyer of an in-the-money option can direct his TM/CM to give exercise
instructions to BOISL. In order to ensure that an option is exercised on a particular day, the buyer must
direct his TM to exercise before the cut-off time for accepting exercise instructions for that day. Usually,
the exercise orders will be accepted by the system till the close of trading hours. Different TMs may have
different cut -off times for accepting exercise instructions from customers, which may vary for different
options. An option, which expires unexercised becomes worthless. Some TMs may accept standing
instructions to exercise, or have procedures for the exercise of every option, which is in the money at
expiration. Once an exercise instruction is given by a CM to BOISL, it cannot ordinarily be revoked.
Exercise notices given by a buyer at anytime on a day are processed by BOISL after the close of trading
hours on that day. All exercise notices received by NSCCL from the NEAT F&O system are processed to
determine their validity. Some basic validation checks are carried out to check the open buy position of
the exercising client/TM and if option contract is in-the-money. Once exercised contracts are found
valid, they are assigned.

Assignment process

The exercise notices are assigned in standardized market lots to short positions in the option contract
with the same series (i.e. same underlying, expiry date and strike price) at the client level. Assignment to
the short positions is done on a random basis. BOISL determines short positions, which are eligible to be
assigned and then allocates the exercised positions to any one or more short positions. Assignments are
made at the end of the trading day on which exercise instruction is received by BOISL and notified to the
members on the same day. It is possible that an option seller may not receive notification from its TM
that an exercise has been assigned to him until the next day following the date of the assignment to the
CM by BOISL.

Exercise settlement computation

In case of index option contracts, all open long positions at in-the-money strike prices are automatically
exercised on the expiration day and assigned to short positions in option contracts with the same series
on a random basis. For options on securities, where exercise settlement may be interim or final, interim
exercise for an open long in-the-money option position can be effected on any day till the expiry of the
contract. Final exercise is automatically effected by BOISL for all open long in-the-money positions in the
expiring month option contract, on the expiry day of the option contract. The exercise settlement price
is the closing price of the underlying (index or security) on the exercise day (for interim exercise) or the
expiry day of the relevant option contract (final exercise). The exercise settlement value is the difference
between the strike price and the final settlement price of the relevant option contract. For call options,
the exercise settlement value receivable by a buyer is the difference between the final settlement price
and the strike price for each unit of the underlying conveyed by the option contract, while for put
options it is difference between the strike price and the final settlement price for each unit of the
underlying conveyed by the option contract. Settlement of exercises of options on securities is currently
by payment in cash and not by delivery of securities. It takes place for in-themoney option contracts.
The exercise settlement value for each unit of the exercised contract is computed as follows:

Call options = Closing price of the security on the day of exercise — Strike price

Put options = Strike price — Closing price of the security on the day of exercise

For final exercise the closing price of the underlying security is taken on the expiration day. The exercise
settlement value is debited / credited to the relevant CMs clearing bankaccount on T + 1 day (T =
exercise date).

Special facility for settlement of institutional deals

BOISL provides a special facility to Institutions/Foreign Institutional Investors (FIIs)/Mutual Funds etc. to
execute trades through any TM, which may be cleared and settled by their own CM. Such entities are
called custodial participants (CPs). To avail of this facility, a CP is required to register with BOISL through
his CM. A unique CP code is allotted to the CP by BOISL. All trades executed by a CP through any TM are
required to have the CP code in the relevant field on the trading system at the time of order entry. Such
trades executed on behalf of a CP are confirmed by their own CM (and not the CM of the TM through
whom the order is entered), within the time specified by BSE on the trade day though the on-line
confirmation facility. Till such time the trade is confirmed by CM of concerned CP, the same is
considered as a trade of the TM and the responsibility of settlement of such trade vests with CM of the
TM. Once confirmed by CM of concerned CP, such CM is responsible for clearing and settlement of deals
of such custodial clients.

FIIs have been permitted to trade in all the exchange traded derivative contracts subject to compliance
of the position limits prescribed for them and their subaccounts, and compliance with the prescribed
procedure for settlement and reporting. A FII/a sub-account of the FII, as the case may be, intending to
trade in the F&O segment of the exchange, is required to obtain a unique Custodial Participant (CP) code
allotted from the BOISL.

FII/sub-accounts of FIIs which have been allotted a unique CP code by BOISL are only permitted to trade
on the F&O segment. The FD/sub-account of FII ensures that all orders placed by them on the Exchange
carry the relevant CP code allotted by BOISL.

REGULATORY FRAMEWORK
The trading of derivatives is governed by the provisions contained in the SC(R) A, the SEBI Act, the rules
and regulations framed there under and the rules and bye–laws of stock exchanges.
5.1 SECURITIES CONTRACTS (REGULATION) ACT, 1956

SC(R)A aims at preventing undesirable transactions in securities by regulating the business of dealing
therein and by providing for certain other matters connected therewith. This is the principal Act, which
governs the trading of securities in India. The term “securities” has been defined in the SC(R)A. As per
Section 2(h), the ‘Securities’ include:

1. Shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like
nature in or of any incorporated company or other body corporate.

2. Derivatives

3. Units or any other instrument issued by any collective investment scheme to the investors in such
schemes.

4. Government securities

5. Such other instruments as may be declared by the Central Government to be securities.

6. Rights or interests in securities.

“Derivative” is defined to include:

1. 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.

2. A contract which derives its value from the prices, or index of prices, of underlying securities. Section
18A provides that notwithstanding anything contained in any other law for the time being in force,
contracts in derivative shall be legal and valid if such contracts are:

• Traded on a recognized stock exchange

• Settled on the clearing house of the recognized stock exchange, in accordance with the rules and bye–
laws of such stock exchanges.

5.2 SECURITIES AND EXCHANGE BOARD OF INDIA ACT, 1992

SEBI Act, 1992 provides for establishment of Securities and Exchange Board of India(SEBI) with statutory
powers for (a) protecting the interests of investors in securities (b) promoting the development of the
securities market and (c) regulating the securities market. Its regulatory jurisdiction extends over
corporates in the issuance of capital and transfer of securities, in addition to all intermediaries and
persons associated with securities market. SEBI has been obligated to perform the aforesaid functions
by such measures as it thinks fit. In particular, it has powers for:

• regulating the business in stock exchanges and any other securities markets.

• registering and regulating the working of stock brokers, sub–brokers etc.

• promoting and regulating self-regulatory organizations.

• prohibiting fraudulent and unfair trade practices.

• calling for information from, undertaking inspection, conducting inquiries and audits of the stock
exchanges, mutual funds and other persons associated with the securities market and intermediaries
and self–regulatory organizations in the securities market.

• performing such functions and exercising according to Securities Contracts (Regulation) Act, 1956, as
may be delegated to it by the Central Government.

5.3 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 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 fulfil 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 networth for clearing
members of the derivatives clearing corporation/house shall be Rs.300 Lakh. The networth of the
member shall be computed as follows:

6. Capital + Free reserves Less non-allowable assets viz.,

(a) Fixed assets

(b) Pledged securities

(c) Member’s 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

7. 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.

8. 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.

9. 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.

10. The trading members are required to have qualified approved user and sales person who have
passed a certification programme approved by SEBI.

5.4 ACCOUNTING

5.4.1 Accounting for futures

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. Hence in this section we shall largely focus on the
accounting treatment of equity index futures in the books of the client. But before we do so, a quick re-
look at some of the terms used.

• Clearing corporation/house: Clearing corporation/house means the clearing corporation/house

approved by SEBI for clearing and settlement of trades on the derivatives exchange/segment. All the
clearing and settlement for trades that happen on the BSE’s market is done through BOISL.

• Clearing member: Clearing member means a member of the clearing corporation and includes all
categories of clearing members as may be admitted as such by the clearing corporation to the
derivatives segment.

• Client: A client means a person, on whose instructions and, on whose account, the trading member
enters into any contract for the purchase or sale of any contract or does any act in relation thereto.

• Contract month: Contract month means the month in which the exchange/clearing corporation rules
require a contract to be finally settled.

• Daily settlement price: Daily settlement price is the closing price of the equity index futures contract
for the day or such other price as may be decided by the clearing house from time to time.
• Derivative exchange/segment: Derivative exchange means an exchange approved by SEBI as a
derivative exchange. Derivative segment means segment of an existing exchange approved by SEBI as
derivatives segment.

• Final settlement price: The final settlement price is the closing price of the equity index futures
contract on the last trading day of the contract or such other price as may be specified by the clearing
corporation, from time to time.

• Long position: Long position in an equity index futures contract means outstanding purchase
obligations in respect of the equity index futures contract at any point of time .

• Open position: Open position means the total number of equity index futures contracts that have not
yet been offset and closed by an opposite position.

• Settlement date: Settlement date means the date on which the settlement of outstanding obligations
in an equity index futures contract are required to be settled as provided in the Bye-Laws of the
Derivatives exchange/segment.

• Short position: Short position in an equity index futures contract means outstanding sell obligations in
respect of an equity index futures contract at any point of time.

• Trading member: Trading member means a Member of the Derivatives exchange/segment and
registered with SEBI.

Accounting at the inception of a contract

Every client is required to pay to the trading member/clearing member, the initial margindetermined by
the clearing corporation as per the byelaws/ regulations of the exchange forentering into equity index
futures contracts. Such initial margin paid/payable should bedebited to “Initial margin - Equity index
futures account”. Additional margins, if any,should also be accounted for in the same manner. It may be
mentioned that at the time when the contract is entered into for purchase/sale of equity index futures,
no entry is passed for recording the contract because no payment is made at that time except for the
initial margin. At the balance sheet date, the balance in the ‘Initial margin - Equity index futures account’
should be shown separately under the head ‘current assets’. In those cases where any amount has been
paid in excess of the initial/additional margin, the excess should be disclosed separately as a deposit
under the head ‘current assets’. In cases where instead of paying initial margin in cash, the client
provides bank guarantees or lodges securities with the member, a disclosure should be made in the
notes to the financial statements of the client.

Accounting at the time of daily settlement

This involves the accounting of payment/receipt of mark-to-market margin money. Payments made or
received on account of daily settlement by the client would be credited/debited to the bank account and
the corresponding debit or credit for the same should be made to an account titled as “Mark-to-market
margin - Equity index futures account”. Some times the client may deposit a lump sum amount with the
broker/trading member in respect of mark-to-market margin money instead of receiving/paying mark-
to market margin money on daily basis. The amount so paid is in the nature of a deposit and should be
debited to an appropriate account, say, “Deposit for mark-to-market margin account”. The amount of
“mark-to-market margin” received/paid from such account should be credited/debited to “Mark-to-
market margin - Equity index futures account” with a corresponding debit/credit to “Deposit for mark-
to-market margin account”. At the yearend, any balance in the Deposit for mark-to-market margin
account” should be shown as a deposit under the head “current assets”.

Accounting for open positions

Position left open on the balance sheet date must be accounted for. Debit/credit balance in the “mark-
to-market margin - Equity index futures account”, maintained on global basis, represents the net
amount paid/received on the basis of movement in the prices of index futures till the balance sheet
date. Keeping in view ‘prudence’ as a consideration for preparation of financial statements, provision for
anticipated loss, which may be equivalent to the net payment made to the broker (represented by the
debit balance in the “mark-to market margin - Equity index futures account”) should be created by
debiting the profit and loss account. Net amount received (represented by credit balance in the “mark-
to-market margin - Equity index futures account”) being anticipated profit should be ignored and no
credit for the same should be taken in the profit and loss account. The debit balance in the said “mark-
to-market margin - Equity index futures account”, i.e., net payment made to the broker, may be shown
under the head “current assets, loans and advances” in the balance sheet and the provision created
there against should be shown as a deduction there from. On the other hand, the credit balance in the
said account, i.e., the net amount received from the broker, should be shown as a current liability under
the head “current liabilities and provisions in the balance sheet”.

Accounting at the time of final settlement

This involves accounting at the time of final settlement or squaring-up of the This involves accounting at
the time of final settlement or squaring-up of the contract. At the expiry of a series of equity index
futures, the profit/loss, on final settlement of the contracts in the series, should be calculated as the
difference between final settlement price and contract prices of all the contracts in the series. The
profit/loss, so computed, should be recognized in the profit and loss account by corresponding
debit/credit to “mark-to-market margin - Equity index futures account”. However, where a balance
exists in the provision account created for anticipated loss, any loss arising on such settlement should be
first charged to such provision account, to the extent of the balance available in the provision account,
and the balance of loss, if any, should be charged to the profit and loss account. Same accounting
treatment should be made when a contract is squared-up by entering into a reverse contract. It appears
that, at present, it is not feasible to identify the equity index futures contracts. Accordingly, if more than
one contract in respect of the series of equity index futures contracts to which the squared-up contract
pertains is outstanding at the time of the squaring of the contract, the contract price of the contract so
squared-up should be determined using First In, First-Out (FIFO) method for calculating profit/loss on
squaring up. On the settlement of an equity index futures contract, the initial margin paid in respect of
the contract is released which should be credited to “Initial margin - Equity index futures account”, and
a corresponding debit should be given to the bank account or the deposit account (where the amount is
not received).

Accounting in case of a default

When a client defaults in making payment in respect of a daily settlement, the contract is closed out.
The amount not paid by the Client is adjusted against the initial margin. In the books of the Client, the
amount so adjusted should be debited to “mark-to-market – Equity index futures account” with a
corresponding credit to “Initial margin - Equity index futures account”. The amount of initial margin on
the contract, in excess of the amount adjusted against the mark-to-market margin not paid, will be
released. The accounting treatment in this regard will be the same as explained above. In case, the
amount to be paid on daily settlement exceeds the initial margin the excess is a liability and should be
shown as such under the head ‘current liabilities and provisions’, if it continues to exist on the balance
sheet date. The amount of profit or loss on the contract so closed out should be calculated and
recognized in the profit and loss account in the manner dealt with above.

Disclosure requirements

The amount of bank guarantee and book value as also the market value of securities lodged should be
disclosed in respect of contracts having open positions at the year end, where initial margin money has
been paid by way of bank guarantee and/or lodging of securities. Total number of contracts entered and
gross number of units of equity index futures traded (separately for buy/sell) should be disclosed in
respect of each series of equity index futures. The number of equity index futures contracts having open
position, number of units of equity index futures pertaining to those contracts and the daily settlement
price as of the balance sheet date should be disclosed separately for long and short positions, in respect
of each series of equity index futures.

5.4.2 Accounting for options

The Institute of Chartered Accountants of India issued guidance note on accounting for index options
and stock options from the view point of the parties who enter into such contracts as buyers/holder or
sellers/writers. Following are the guidelines for accounting treatment in case of cash settled index
options and stock options:

Accounting at the inception of a contract

The seller/writer of the option is required to pay initial margin for entering into the option contract.
Such initial margin paid would be debited to ‘Equity Index Option Margin Account’ or to ‘Equity Stock
Option Margin Account’, as the case may be. In the balance sheet, such account should be shown
separately under the head ‘Current Assets’. The buyer/holder of the option is not required to pay any
margin. He is required to pay the premium. In his books, such premium would be debited to ‘Equity
Index Option Premium Account’ or ‘Equity Stock Option Premium Account’, as the case may be. In the
books of the seller/writer, such premium received should be credited to ‘Equity Index Option Premium
Account’ or ‘Equity Stock Option Premium Account’ as the case may be.

Accounting at the time of payment/receipt of margin : Payments made or received by the seller/writer
for the margin should be credited/debited to the bank account and the corresponding debit/credit for
the same should also be made to ‘Equity Index Option Margin Account’ or to ‘Equity Stock Option
Margin Account’, as the case may be. Sometimes, the client deposit a lump sum amount with the
trading/clearing member in respect of the margin instead of paying/receiving margin on daily basis. In
such case, the amount of margin paid/received from/into such accounts should be debited/credited to
the ‘Deposit for Margin Account’. At the end of the year the balance in this account would be shown as
deposit under ‘Current Assets’.

Accounting for open positions as on balance sheet dates

The ‘Equity Index Option Premium Account’ and the ‘Equity Stock Option Premium Account’ should be
shown under the head ‘Current Assets’ or ‘Current Liabilities’, as the case may be. In the books of the
buyer/holder, a provision should be made for the In the books of the buyer/holder, a provision should
be made for the amount by which the premium paid for the option exceeds the premium prevailing on
the balance sheet date. The provision so created should be credited to ‘Provision for Loss on Equity
Index Option Account’ to the ‘Provision for Loss on Equity Stock Options Account’, as the case may be.
The provision made as above should be shown as deduction from ‘Equity Index Option Premium’ or
‘Equity Stock Option Premium’ which is shown under ‘Current Assets’. In the books of the seller/writer,
the provision should be made for the amount by which premium prevailing on the balance sheet date
exceeds the premium received for that option. This provision should be credited to ‘Provision for Loss on
Equity Index Option Account’ or to the ‘Provision for Loss on Equity Stock Option Account’, as the case
may be, with a corresponding debit to profit and loss account. ‘Equity Index Options Premium Account’
or ‘Equity Stock Options Premium Account’ and ‘Provision for Loss on Equity Index Options Account’ or
’Provision for Loss on Equity Stock Options Account’ should be shown under ‘Current Liabilities and
Provisions’. In case of any opening balance in the ‘Provision for Loss on Equity Stock Options Account’ or
the ‘Provision for Loss on Equity Index Options Account’, the same should be adjusted against the
provision n required in the current year and the profit and loss account be debited/credited with the
balance provision required to be made/excess provision written back.

Accounting at the time of final settlement

On exercise of the option, the buyer/holder will recognize premium as an expense and debit the profit
and loss account by crediting ‘Equity Index Option Premium Account’ or ‘Equity Stock Option Premium
Account’. Apart from the above, the buyer/holder will receive favourable difference, if any, between the
final settlement price as on the exercise/expiry date and the strike price, which will be recognized as
income. On exercise of the option, the seller/writer will recognize premium as an income and credit the
profit and loss account by debiting ‘Equity Index Option Premium Account’ or ‘Equity Stock Option
Premium Account’. Apart from the above, the seller/writer will pay the adverse difference, if any,
between the final settlement price as on the exercise/expiry date and the strike price. Such payment will
be recognized as a loss. As soon as an option gets exercised, margin paid towards such option would be
released by the exchange, which should be credited to ‘Equity Index Option Margin Account’ or to
‘Equity Stock Option Margin Account’, as the case may be, and the bank account will be debited.

Accounting at the time of squaring off an option contract

The difference between the premium paid and received on the squared off transactions should be
transferred to the profit and loss account. Following are the guidelines for accounting treatment in case
of delivery settled index options and stock options: The accounting entries at the time of inception,
payment/receipt of margin and open options at the balance sheet date will be the same as those in case
of cash settled options. At the time of final settlement, if an option expires un-exercised then the
accounting entries will be the same as those in case of cash settled options. If the option is exercised
then shares will be transferred in consideration for cash at the strike price. For a call option the
buyer/holder will receive equity shares for which the call option was entered into. The buyer/holder
should debit the relevant equity shares account and credit cash/bank. For a put option, the
buyer/holder will deliver equity shares for which the put option was entered into. The buyer/holder
should credit the relevant equity shares account and debit cash/bank. Similarly, for a call option the
seller/writer will deliver equity shares for which the call option was entered into. The seller/writer
should credit the relevant equity shares account and debit cash/bank. For a put option the seller/writer
will receive equity shares for which the put option was entered into. The seller/writer should debit the
relevant equity shares account and credit cash/bank. In addition to this entry, the premium
paid/received will be transferred to the profit and loss account, the accounting entries for which should
be the same as those in case of cash settled options.

5.5 TAXATION OF DERIVATIVE TRANSACTION IN SECURITIES

5.5.1 Taxation of Profit/Loss on derivative transaction in securities Prior to Financial Year 2005–06,
transaction in derivatives were considered as speculative transactions for the purpose of determination
of tax liability under the Income -tax Act. This is in view of section 43(5) of the Income -tax Act which
defined speculative transaction as a transaction in which a contract for purchase or sale of any
commodity, including stocks and shares, is periodically or ultimately settled otherwise than by the actual
delivery or transfer of the commodity or scrips. However, such transactions entered into by hedgers and
stock exchange members in course of jobbing or arbitrage activity were specifically excluded from the
purview of definition of speculative transaction. In view of the above provisions, most of the
transactions entered into in derivatives by investors and speculators were considered as speculative
transactions. The tax provisions provided for differential treatment with respect to set off and carry
forward of loss on such transactions. Loss on derivative transactions could be set off only against other
speculative income and the same could not be set off against any other income. This resulted in
payment of higher taxes by an assessee. Finance Act, 2005 has amended section 43(5) so as to exclude
transactions in derivatives carried out in a “recognized stock exchange” for this purpose. This implies
that income or loss on derivative transactions which are carried out in a “recognized stock exchange” is
not taxed as speculative income or loss. Thus, loss on derivative transactions can be set off against any
other income during the year. In case the same cannot be set off, it can be carried forward to
subsequent assessment year and set off against any other income of the subsequent year. Such losses
can be carried forward for a period of 8 assessment years. It may also be noted that securities
transaction tax paid on such transactions is eligible as deduction under Income-tax Act, 1961.

5.5.2 Securities transaction tax on derivative transactions

As per Chapter VII of the Finance (No. 2) Act, 2004, Securities Transaction Tax (STT) is levied on all
transactions of sale and/or purchase of equity shares and units of equity oriented fund and sale of
derivatives entered into in a recognized stock exchange. As per Finance Act 2008, the following STT rates
are applicable w.e.f. 1st June, 2008 in relation to sale of a derivative, where the transaction of such sale
in entered into in a recognized stock exchange. Sr. No. Taxable securities transaction Rate Payable by

(a) Sale of an option in securities 0.017% - Seller

(b) Sale of an option in securities, where option is exercised 0.125% - Purchaser

(c) Sale of a futures in securities 0.017% - Seller

Consider an example. Mr. A. sells a futures contract of M/s. XYZ Ltd. (Lot Size: 1000) expiring on 29-Sep-
2005 for Rs. 300. The spot price of the share is Rs. 290. The securities transaction tax thereon would be
calculated as follows:
1. Total futures contract value = 1000 x 300 = Rs. 3,00,000

2. Securities transaction tax payable thereon 0.017% = 3,00,000 x 0.017% = Rs. 51

Note: No tax on such a transaction is payable by the buyer of the futures contract.