The SEBI Advisory Committee on Derivatives was established to address pressing issues in the derivative markets in India, following a Securities and Exchange Board of India meeting on June 24, 2002. The committee was tasked with evaluating and providing recommendations on several issues such as physical settlement of stock options and futures contracts, the eligibility criteria for stocks permitted in derivative trading, and the rules for the use of derivatives by mutual funds. Additionally, the committee was instructed to revisit the recommendations made by the L. C. Gupta Committee in 1998, given the significant structural changes in the Indian capital markets, such as dematerialization of shares, rolling settlements, and the evolution of the equity derivatives market since 2000.

The committee’s findings revealed the need for broader market participation and improved risk management. The committee endorsed the introduction of currency and interest rate futures into a transparent exchange platform, citing the need for better price discovery and risk management. For equity derivatives, the committee supported the phased introduction of different equity derivative products. Index futures were introduced in July 2000 and index options were introduced in June 2001. Stock futures commenced trading in November 2001, and the committee provided detailed guidelines on position limits, ensuring no single market player could dominate. For instance, aggregate positions in a single stock were capped at 10 percent of the free float, while individual client positions were limited to 1 percent. The committee also emphasized the importance of upfront margin collection based on the Value at Risk method, which dynamically adjusted margins according to market volatility.

In its recommendations, the committee advocated transitioning to physical settlement of stock derivatives, acknowledging the associated risks but proposing risk-mitigation strategies to manage potential short squeezes. The committee also recommended implementing cross-margining at the client level to integrate margin computation across cash and derivative markets, thus enhancing risk management. Furthermore, the committee advised reevaluating the eligibility criteria for stocks in derivative trading, specifically suggesting that exchanges should have the flexibility to select stocks provided they meet certain liquidity and market-capitalization thresholds. The committee also proposed a shift in the inspection strategy from a blanket 100 percent inspection requirement as suggested by the L. C. Gupta Committee to a more targeted approach based on member activity levels, ensuring that resources are efficiently allocated while maintaining market integrity.

By examining the existing derivative market framework, the committee identified critical regulatory gaps and proposed key modifications including physical settlement guidelines, cross-margining strategies, and more targeted stock selection criteria for derivative trading, ultimately aimed at enhancing market participation, improving risk management, and increasing market transparency.