banks i. e. the rbi provides the requisite synergy. the major elements of the regulatory framework for otc derivatives include a broad specification of products to be permitted, nature of participants in the markets, distinct responsibilities for market makers and users for all otc derivatives, effective reporting systems for capturing systemic information, governance and oversight and focus on developing market infrastructure for post - trade clearing and settlement. the underlying rationale for key stipulations is explained below. ( i ) there is a requirement that for an otc derivative transaction to be legally valid, one of the parties to the transaction has to be a rbi regulated entity. this is to ensure that the entire otc derivative market is within the regulatory perimeter. prudential prescriptions for each class of participants may be decided by the respective regulator within the broad policy framework but it makes systemic monitoring possible. risky pv01 represents the value change ( present value impact ) of the cds when the spread moves by 1 basis point. ( ii ) there is a clear distinction between the roles of market makers and users for all otc derivatives. it is the market makers which function as risk transferors in the system. it is extremely important that these entities function in a totally transparent and regulated manner. only banks and primary dealers in case of certain interest rate derivatives are permitted to act as market makers since extending this facility to all agents can result in risks building up on the balance sheets of such entities. box 1 rbi amendment act, 2006 in 1999, by the securities laws ( amendment ) act, 1999, section 18a was inserted in securities contracts ( regulation ) act, 1956 ( scra ) which reads as under : “ 18a. contracts in derivative – 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 ( a ) traded on a recognised stock exchange ; ( b ) settled on the clearing house of the recognised stock exchange, ( c ) in accordance with the rules and bye - laws of such stock exchange. ” in view of the said section 18a of scra, a doubt was raised about the legality of otc derivatives such as forward rate agreements and interest rate swaps permitted under rbi guidelines issued in july 1999. it was felt that these otc derivatives could be deemed as wagering contracts and as such, void under section 30 of the indian contract act, 1872 and not legally valid under section 18a of scra. recognising

that otc derivatives play a crucial role in reallocating and mitigating the risks of corporates, banks and financial institutions and that the ambiguity regarding the legal validity of otc derivatives inhibits the growth and stability of the market for such derivatives, suitable amendments, effective january 9, 2007, were carried out to the reserve bank of india act, 1934 ( rbi act ). section 45v of rbi act, 1934 ( inserted by reserve bank of india ( amendment ) act, 2006 ) lays down that notwithstanding anything contained in scra or any other law for the time being in force, transactions in such derivatives, as may be specified by rbi from time to time, shall be valid, if at least one of the parties to the transaction is rbi, a scheduled bank, or such other agency falling under the regulatory purview of rbi under the rbi act, the banking regulation act, 1949, the foreign exchange management act, 1999, or any other act or instrument having the force of law, as may be specified by rbi from time to time. it also provides that transactions in such derivatives, as had been specified by rbi from time to time, shall be deemed always to have been valid. the act further gives powers to the reserve bank under section 45w to “... determine the policy relating to interest rates or interest rate products and give directions in that behalf to all agencies or any of them, dealing in securities, money market instruments, foreign exchange, derivatives, or other instruments of like nature as the bank may specify from time to time. ” however, the directions shall not relate to “ the procedure for execution or settlement of the trades ” in respect of transactions on exchanges. ( iii ) the users, including financial entities, are permitted to transact in derivatives essentially to hedge an exposure to risk or a homogeneous group of assets and liabilities or transform an existing risk exposure. this stipulation is essentially to restrict speculative trading in derivatives by the real sector, whose primary economic interest in undertaking derivative transactions should be to hedge their exposures. ( iv ) derivative structured products ( i. e. combination of cash and generic derivative instruments ) are permitted as long as they are a combination of two or more of the generic instruments permitted by rbi and do not contain any derivative as underlying. structured products entail packaging of complex, exotic derivatives into structures that may lead to increased build - up of risks in the system. some of these structures may simply be unsuitable for a large section of