1. Regulatory Framework

A. RBI Framework - OTC Derivatives

Master Direction - Risk Management and Inter-Bank Dealings (July 5, 2016) + Revised Circulars Oct 10-12, 2026:

1. Hedging Only, No Speculation: On a review, it has been decided that henceforth Authorised Dealers shall offer NDDCs involving INR to non-resident user only for purpose of hedging. Derivatives must be used strictly for hedging genuine exposures rather than speculative gains.
2. Underlying Exposure Mandatory: User can trade currency derivatives up to $100 million equivalent only if they can ensure existence of valid underlying contracted exposure. RBI circular 5 Jan 2024.
3. Compliance throughout lifespan: AD must ensure compliance throughout lifespan of derivative contracts, avoiding hedging same exposure with another derivative, ensuring notional amount and tenor align with exposure, adjusting hedge if exposure falls below notional.
4. Rebooking & Cancellation: Tightened rules 2026 - Unhedged position threshold cut to USD 5 Million, rebooking of cancelled contracts restricted.
5. FERR - Foreign Exchange Risk Reserve: RBI introduces 20% Foreign Exchange Risk Reserve for banks on NDDC exposures. Must distinguish between NDDCs offered to non-resident for hedging vs derivative contracts to hedge own exposures.
6. Documentation: ISDA, Suitability letter, Customer appropriateness assessment, Board resolution for corporates.

B. SEBI Framework - Exchange Traded

• SEBI (PFUTP) Regulations 2003 Reg 3(a), 4(1), 4(2)(a) - Fraudulent and unfair trade practices.
• SEBI Circular on LEI - All entities trading in exchange-traded currency, commodity, interest rate derivatives must have LEI.
• Central clearing via CCIL / NSE Clearing for standardized OTC - post 2008 reform.

C. Accounting: Ind AS 109 - Hedge accounting only if hedge effectiveness proven. Unrealised gain/loss on derivative undertaken for hedging may be offset against unrealised loss/gain on underlying hedged instrument, then net unrealised gains excluded from regulatory capital.

2. 5 Pillars of Derivative Compliance

1. Suitability: Bank must assess client understands product - e.g., KIKO (Knock-In Knock-Out), leveraged swaps cannot be sold to SME.

2. Appropriateness: Notional must match underlying. Corporate with $10 mn export cannot do $100 mn exotic.

3. Disclosure & Mark-to-Market: Daily MTM, scenario analysis, worst-case loss must be shared. RBI penalized banks in 2011 for not disclosing.

4. No Mis-selling: Fixed Income Money Market and Derivatives Association (FIMMDA) code prohibits incentive-linked sales.

5. Reporting: All OTC trades to CCIL Trade Repository within 30 mins, CERSAI for credit derivatives.

3. Detailed Case Laws - The Derivatives Mess in India

This is the most litigated part of Indian banking compliance.

A. Mis-selling Scandal 2008-2010 - The Origin

Case: Orissa High Court PIL vs RBI & Banks (2010) → FIMMDA v. Union of India - Supreme Court

• Facts: During 2007-08, banks sold complex forex derivatives (KIKO, cross-currency swaps, leveraged options) to SMEs like Rajshree Sugars, exporters, as "hedge" for ECB/exports. After Lehman crisis, INR depreciated, MTM losses Rs 30,000+ crores. SMEs alleged banks misrepresented as low-risk hedge but were speculative bets.
• Orissa HC ordered CBI probe into mis-selling of derivative products.
• FIMMDA (self-regulatory body of banks) obtained stay from Supreme Court against Orissa HC order directing thorough CBI probe. Supreme Court stayed CBI investigation on petition by FIMMDA. Last hearing 8 Nov 2010, then Rajagopalan Committee formed by RBI.
• Outcome: RBI issued comprehensive guidelines on risk management, forced banks to do appropriateness tests. No criminal liability but civil settlements - banks took 50% haircut.
• Compliance Lesson: This case created suitability doctrine in India.

B. Willful Defaulter - Derivatives Included

Kotak Mahindra Bank Ltd. v. Hindustan National Glass & Industries Ltd. & Ors. (SC, 11 Dec 2012) - Civil Appeal No. 8916 of 2012

This is THE Supreme Court authority on derivatives compliance.

• Facts: HNGIL had derivative losses of Rs 36 cr to Kotak. Bank declared it willful defaulter under RBI Master Circular on Willful Defaulters. Calcutta HC said Master Circular applies only to lender-borrower borrowing transactions, not derivative contracts.
• SC Overruled HC:
  • Definition of willful defaulter is wide enough to cover new products which come into market. Derivative transactions are expressly permitted under RBI Act 1934 and are valid so long as one party is bank/AD.
  • Supreme Court holds that RBI's Master Circular on wilful defaulters applies to non-funded transactions such as derivative contracts. Banks can invoke willful defaulter even for unfunded transactions like derivatives and guarantees.
  • Credit information of defaulter on non-funded obligations is information RBI can request.
• Three petitions decided together: Kotak Mahindra Bank vs HNGIL; Emcure Pharmaceuticals vs ICICI Bank; Finolex Industries vs RBI.
• Compliance Impact: If corporate defaults on MTM payment on derivative, it can be declared willful defaulter, CIBIL reported, barred from fresh credit. Made derivative dues equivalent to loan dues.
• Moneylife noted: "The heart of the matter—whether banks oversold, mis-sold or illegally sold derivatives to borrowers which were shown to be hedges but actually were not hedges—is yet to be resolved" - but SC at least closed the loophole that derivatives are not debt.

C. Exchange-Traded Derivatives Fraud

SEBI v. Rakhi Trading Pvt. Ltd. (2018) 13 SCC 753 - Supreme Court (Civil Appeal 1969 of 2011)

• Facts: SEBI investigation in NSE derivatives market Mar-Apr 2007 found multiple traders including Rakhi Trading executing synchronized and reverse trades in illiquid Nifty options. Buy and sell orders placed almost simultaneously at predetermined prices, then reversed within seconds, with no change in beneficial ownership, creating artificial volume.
• SC Held: Such trades are non-genuine trades that distorted price discovery mechanism, violating Regulations 3(a), 4(1) and 4(2)(a) of PFUTP Regulations. Traders engaged in fraudulent and unfair trade practice by executing synchronized and reversed trades. Price discovery system itself was affected by synchronization and rapid reverse trade, which also had impact of excluding other investors.
• Test laid: If trades are synchronized and reversed with same counterparty within time span of seconds to minutes same day, prices such that one party consistently profits other loses, no real change in ownership → fraudulent.
• Penalty upheld Rs 10.8 lakh. Now standard for all illiquid stock options cases.

SEBI v. Kanaiyalal Baldevbhai Patel (2017) 15 SCC 1

• SC held fraudulent intent can be inferred from circumstantial evidence even without direct lie. Supports Rakhi Trading.

D. Jurisdiction - Civil Court vs DRT

Rajashree Sugars & Ors. v. Axis Bank (Madras HC → SC)

• Madras HC ruled derivatives contract is valid, but bank has to approach DRT to get order for recovery.
• Supreme Court clarified: Debt Tribunal can't hear cases where derivative contract validity itself is challenged as violation of FEMA and RBI circulars. Civil Court retains jurisdiction to decide question of derivative legality.
• Compliance: If corporate alleges derivative was illegal speculative transaction violating RBI hedging guidelines, civil suit maintainable, not just DRT recovery.

E. Recent Enforcement (2026)

RBI/2026-27/293 DIR Series Circular No. 27 dated Oct 12, 2026 & Circular No. 25 dated Oct 10, 2026

• RBI tightens forex derivative rules, introduces 20% risk reserve, restricts INR derivatives to hedging. Authorized Dealers must distinguish between NDDCs offered to non-resident for permitted hedging purposes and derivative contracts undertaken to hedge own currency exposures, for which prescribed FERR requirement applies.

Violation = Penal action under FEMA + RBI Act + SEBI Act.

4. Compliance Checklist Today

Before offering derivative:

1. Valid underlying exposure proof - Invoice, LC, ECB agreement
2. Board resolution authorizing derivative + limit
3. Suitability & Appropriateness Certificate signed by CFO + Bank RM
4. ISDA + CSA + Schedule
5. Scenario analysis: What if INR depreciates 20%
6. Daily MTM email + monthly effectiveness test
7. Reporting to CCIL within T+30 min + LEI validation
8. No duplicate hedging - Check CERSAI/CCIL for same exposure
9. If corporate is SME, exotic products (KIKO, snowball) prohibited without audit committee approval

Failure = Mis-selling, willful defaulter declaration can be reversed if mis-selling proven, SEBI PFUTP penalty, FEMA contravention.