What’s the Work of Market Regulator ( SEC or SEBI )– SEBI Indian Exchange Market Regulator Explained Indepth.( Must Read ).
India has made great efforts to create an investment environment that
is comparable with the safest markets in the world. To develop the markets, India (1)
created a world-class regulator, the Securities and Exchange Board of India; and (2) implemented state-of-the-art
market surveillance and safeguard mechanisms to ensure the safety and integrity
of the markets.
The fact that India’s
capital markets are well-regulated and tightly controlled from a safety
standpoint is due both to the implementation of several important government
reforms made in the 1990s that created an effective body of regulations, and to
innovative market professionals who designed exceptionally sophisticated
exchange systems to ensure market safety and integrity.
The reforms and systems that made India’s financial markets strong and
safe include:
_ Regulation and enforcement: Strict rules and regulations along with reasonable enforcement
have been implemented to maintain the integrity of the system.
_ Disclosure and transparency:
More stringent disclosure
requirements and stricter “know-your-customer” rules contribute to a more
transparent investing environment.
_ Settlement and trading: The entire trading and settlement process is fully electronic and
has been streamlined to be extremely robust and efficient.
_ Risk mechanisms: Risk control mechanisms have been built into the exchange trading
systems, which are online and real time to provide fast responses to problems
as they develop.
The Securities and Exchange Board of India, the internationally
recognized regulator of India’s
capital markets, is discussed along with the risk management policies they implement.
Next, the risk management systems and policies of the two primary stock
exchanges, the Bombay Stock Exchange and the National Stock Exchange, are discussed, including continuous and online
price and position monitoring, member capital adequacy monitoring, daily price movement
controls for both the market and individual securities, and the very
sophisticated, individual security-specific, multiple margin system that has
proven to be extremely effective in ensuring timely settlement and few defaults.
Derivative-specific controls and risk management are addressed, followed by a
discussion of the underappreciated but immensely important
and valuable guarantee funds maintained by the exchanges that further ensure settlement on a
timely basis.
THE SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI)
India’s financial markets are regulated by the Securities and Exchange Board of India (SEBI). SEBI is the regulatory authority established under Section 3 of
the Securities and Exchange Board of
India
Act in 1992 to:
_ Protect the interests of
investors in securities.
_ Promote the development of India’s
securities markets.
_ Regulate the securities markets.
Besides the act that created SEBI, several other government acts,
including two enacted before the creation of SEBI, help SEBI meet its
objectives and exercise its powers. These include the:
_ Securities Contracts
(Regulations) Act 1956
_ Depositories Act 1996
_ Companies Act 1956
SEBI regulates securities market activities through four
departments:
1. Market Intermediaries
Registration and Supervision Department (MIRSD): The MIRSD oversees the registration, supervision, compliance monitoring,
and inspection of all market intermediaries for all
segments of the market, including equity, derivatives, and debt.
2. Market
Regulation Department (MRD): The MRD
is responsible for formulating new policies and supervising the operation of
securities exchanges, their subsidiaries, and market institutions such as
clearing and settlement organizations and depositories for all instruments
except derivatives.
3. Derivatives
and New Products Departments (DNPD): The
DNPD approves the creation and introduction of new derivative products and supervises
trading for derivative operations of the stock exchanges.
4. Integrated
Surveillance Department: The
Integrated Surveillance Department monitors the activities of the cash, and
futures and options markets and generates detailed reports at the end of each
day concerning
such issues as the identity of the most active scrips, clients,
and brokers. The department monitors market movements, analyzes abnormal trading
patterns, and, if suspecting that something is amiss, initiates
appropriate action.
Rigorous risk management methodology is used by the stock
exchanges and SEBI’s four departments to regulate securities market activities.
Market
Surveillance
The stock exchanges are the first and primary regulator for
detection of market manipulation, price rigging, and other regulatory breaches regarding
capital market functions. Unusual deviations from normal
behavior are reported to the SEBI. In addition, SEBI, through the
Integrated Surveillance Department, also initiates surveillance cases based on references
received from other regulatory agencies, and from investors and corporations.
SEBI
Risk Management
In its quest to enhance investor protection and encourage market
development, SEBI regularly reviews and updates its policies and systems to anticipate,
monitor, and address market risk, operational risk, and systemic risk in the
financial market. The risk management procedures used by SEBI include:
_ Imposing varying margin
requirements based on liquidity and volatility of securities, and then
categorizing securities into these groups for the imposition of margins.
_ Specifying mark-to-market
margins.a
_ Specifying intraday trading
limits and gross exposure limits.
_ Real-time monitoring of intraday
trading limits and gross exposure limits by the stock exchanges.
_ Specifying time limits for the
payment of margins.
_ Collecting margins on a T+1 basis.
_ Using index-based marketwide
circuit breakers.
_ Automatically deactivating
trading terminals in case of breach of exposure limits.
_ Using a VaR-based margin systemb that addresses 99 percent of the statistical
risks in the market.
_ Specifying extreme loss margins
to address on-balance 1 percent risks.
Enforcement
SEBI is a highly regarded regulator throughout the global
investment world with policies and practices that are more than adequate to
address the safety needs of the market. However, the enforcement of policies is
still considered by some market participants to require greater vigilance with
a more financially
astute enforcement team. While the enforcement division was
initially aMark-to-market
margin refers to margins determined by the daily fluctuation in the price of a
financial instrument and is used both pre- and post-settlement..
MARKET SAFETY AND SAFEGUARDS
The safety and integrity of the financial market is important for
SEBI and the government to maintain a well-functioning, highly regarded
financial market.
Investor protection in India’s markets is safeguarded and
addressed through preventive measures, instantaneous automatic response
mechanisms to ongoing situations, and remedial relief for problems. Preventive measures
include:
_ Strict know-your-customer requirements
and comprehensive initial margin requirements.
_ Systems to monitor, detect, and
react to unusual, potentially illegal market activity.
_ Systems to anticipate and
mitigate potentially destabilizing market movements. Safeguards designed to
address the consequences of problems that have already occurred include
settlement and investor protection
funds.
DISCLOSURE AND TRANSPARENCY RULES
Preventive market safeguards include greater disclosure and transparency
by requiring market participants to be readily identifiable across brokers and accounts,
and the ability to monitor the activity of every market participant.
The measures begin with account opening procedures for all
clients. Strict know-your-customer requirements have been enforced to provide a
mechanism whereby illegal, unusual, or manipulative market activity can be
traced across firms and account names directly to the party involved.
All brokerage account forms require a permanent account number (PAN),
which is a unique 10-digit alphanumeric number issued by the Income Tax
Department (similar to a Social Security number in the United States). All orders entered
into exchange trading systems must include a client’s PAN before being accepted
by the system. Surveillance systems have the ability to monitor unusual trading
activity and marketwide positions across brokerage firms and brokerage accounts
by looking at individual and entity-specific PANs.
EXCHANGE SURVEILLANCE
The markets are monitored by surveillance systems built into the
trading systems of each exchange. The stock exchanges created independent
surveillance departments under a 1995 SEBI directive. Surveillance activity is
divided broadly into three major segments:
1. Price
monitoring: Price movements and volumes of
individual stocks are monitored for abnormal activity that is not consistent
with normal trading patterns. Trading in newly listed scrips is watched closely.
2. Position
monitoring: Member-brokers’ positions and
exposures, as well as underlying client exposures, are monitored on a daily
basis to ensure that overextension beyond financial settlement capacity does
not occur. Also, default risk is managed by taking timely action.
3. Investigations:
Snap investigations, examinations,
and detailed investigations are conducted where manipulation or aberrations are
suspected.
Detecting
and Responding to Market Abuse
Markets are monitored to first understand normal behavior in the
market and then, based on deviations from this observed norm to detect market abuses
such as abnormal price and volume movements, artificial transactions (i.e.,
wash sales), and insider trading. When market surveillance departments suspect
abnormal behavior, preliminary investigations are conducted. SEBI can also
request an investigation in cases where it has concerns. Should such investigations
determine that something is awry and find market abuses or suspect behavior, the exchanges have numerous tools at their
disposal to address the situation. These include:
_ Imposition of special margins on
specific stock issues
_ Narrowing of price movement
circuit filters
_ Imposition of trade-to-trade
settlement
_ Suspensions
_ Deactivation of trading terminals
The surveillance departments maintain an active monitoring program
to assess market risk. This program includes extensive and sophisticated price and
position monitoring.
Price
Monitoring
Price monitoring to detect abnormal price fluctuations is carried
out in several ways, through:
_ Online surveillance
_ Offline surveillance
_ Derivative market surveillance
_ Surveillance action
_ Rumor verification
_ Proactive measures
Online
Surveillance The main objective of online surveillance is to detect potential
market abuse at an early stage with the goal of quickly addressing such abuse
and minimizing its impact on the market. An alert is generated when a
particular metric behaves significantly differently from its benchmark, or
normal behavior. Alerts are generated online, in real time, based on preset
parameters such as:
_ Like-price and volume variations
in shares; this is a sign of potential wash sales.
_ Members taking large positions
that are not commensurate with their financial positions; this is an indication
of possible insider trading, as well as a potential settlement risk.
_ Members having large concentrated
positions in one or a few scrips; this is another indication of both insider
trading and settlement risk.
Offline
Surveillance Offline surveillance systems consist of preparing and analyzing
reports based on different parameters, such as:
_ Percentage changes in prices over
a week, fortnight, and month
_ Most actively traded stocks
_ Activity in infrequently traded
scrips
_ Stocks hitting new highs and lows
_ Shares identified as the subject
of rumors
_ Shares identified in investor
complaints
Derivative
Market Surveillance The derivative markets are scrutinized with an additional set of
criteria that look at the relative movements between the prices of the
derivatives versus their underlying shares and include monitoring trading activity at the close, where great
potential exists for price manipulation.
Surveillance
Action Once the surveillance systems identify or suspect unusual trading
in a particular issue, there are a number of different responses that may be
initiated, including:
_ Special margins: Special margins may be imposed on specific stocks that have
demonstrated abnormal price or volume movements. Margins of 25 or 50 percent of
a client’s net outstanding purchase or sale position or both can be imposed.
_ Trade-to-trade: The surveillance departments can impose a trade-totrade settlement
basis versus the standard settlement basis on specific stocks to control
excessive volatility or abnormal trading volume. If a stock is shifted to a trade-to trade settlement basis, the
selling and buying of shares in that stock would require giving or taking
delivery of shares at the gross level with no intraday settlement netting-off capability permitted.
_ Suspension of trading: Shares can be suspended by the surveillance departments in
exceptional cases pending investigation or if a stock is suspended by another
stock exchange for surveillance action.
_ Warning to members: The surveillance departments may issue verbal and written warnings
to members suspected of market manipulation.
_ Imposition of a penalty,
suspension, and deactivation of terminals: The surveillance departments may impose penalties, deactivate
trading terminals to deny trading access, or suspend members who are involved in
market manipulation. Habitual offenders are taken to a Disciplinary Action
Committee.
_ Rumor verification: If a stock is the subject of market rumors leading to unusual
trading activity, the surveillance departments must investigate to verify or refute
the rumors.
Proactive
Measures The surveillance departments perform proactive measures to detect
and minimize problems before they impact the market. Some of these measures
include:
_ Compiling and disseminating a
list of companies that have changed their names to mislead investors as to
their actual business. Changes to suggest that business interests are in the
software industry are prime examples.
_ Compiling and disseminating a
list of non-banking financial companies that had their registration
applications rejected by the Reserve Bank of India.
_ Issuing notices advising members
not to deal on behalf of debarred clients and to exercise due diligence when
registering a new client.
Position
Monitoring
The surveillance departments monitor the outstanding exposures of
members on a daily basis to avoid settlement defaults as well as to track
irregular and possibly illegal market activity. Reports are generated and evaluated
for excessive purchase or sale positions compared with the normal business of
that member to determine: (1) whether there have been abnormally concentrated
purchases or sales, (2) whether the purchases have been made by inactive or
financially weak members, and (3) whether the quality of the positions held
suggests inordinate exposure risk. Based on an analysis of these factors, the
margins already paid, and the capital deposited by a member-broker, early
settlement calls can be required and members can be advised to reduce their
outstanding exposure in the market. Trading restrictions can be placed on
financially weak members.
The reports generated include the following:
_ Reports detailing the top
100 purchasers and sellers: Reports
detailing the largest 100 net purchasers and 100 net sellers in the A, B1, B2,
and Z groups of scrips (see Appendix G: BSE and NSE Equity classifications) are
prepared and evaluated daily. This enables the surveillance departments to
monitor the exposure of members, ascertain the quality of exposure, measure the
risk vis- ` a-vis the cover available by way of margins and capital, and
initiate action such as calling for early settlement or imposing trading
restrictions on members. A detailed report on the net outstanding positions of
top purchasers and top sellers with exposure to individual scrips above certain
limits and margin cover available is prepared daily.
_ Concentrated purchases and
sales: The concentration of purchases
and sales by a member in one or a limited number of scrips is monitored.
The fundamentals of the scrips, their daily turnover, and the
nature of the transactions are evaluated and, if deemed warranted, appropriate surveillance
action is taken.
_ Purchases and sales of
scrips with thin trading: Purchases
and sales of illiquid stocks are closely scrutinized. Details of trades in such
stocks are requested from members to assess the market risk involved.
_ Settlement liabilities of
members above a threshold limit: The
liability of members with respect to settlement funds that are due is monitored
when the funds exceed a certain threshold limit with respect to the member’s
current liability, the member’s capital, and the margin cover available to the
exchange against the member’s settlement liability. In cases of inadequate
margin cover, the reasons for the excessive liability are ascertained. If
warranted, an advance margin can be called to ensure that settlement is
completed smoothly.
In addition to the reports generated, position monitoring also
entails the following proactive monitoring:
_ Verification of
institutional trade: Unduly large
institutional trades executed by member-brokers may be subject to scrutiny.
_ Scrutiny: The surveillance departments conduct preliminary investigations of
particular transactions to ascertain irregularities. If deemed appropriate, the
transactions can be referred for a more detailed investigation to the
Disciplinary Action Committee of an exchange and to the Scrutiny Committee of
an exchange to reassess the financial soundness of the member.
_ Bulk deal disclosure and
monitoring: Member-brokers are required to disclose
by 5 P.M. daily all transactions in a
stock for a client where the total quantity bought or sold is more than 0.5
percent of the company’s outstanding listed equity shares. “All transactions”
is clarified as:
_ Single trades: Member-brokers must immediately report the execution of an order
where the traded quantity is more than 0.5 percent of the listed shares.
_ Cumulative trades for the
day: Member-brokers must report within
one hour from the close of trading where the cumulative quantity traded under
any single client code on that day either purchased or
sold is more than 0.5 percent of the listed shares.
Investigations
If the surveillance departments conclude that some monitored
activity or market situation requires further scrutiny, it will conduct the
following types of analysis and, if necessary, take appropriate and timely
action:
_ Snap investigations: A preliminary analysis of the trading pattern and corporate
developments in a security is performed and a determination is made as to
whether the price or volume variation represents possible manipulation.
_ Examinations: A more detailed analysis of the trading pattern and various
company developments is prepared upon receiving a request from SEBI, any
department of the exchange, or an investor.
_ Investigations: If an examination suggests further review, a complete analysis is
conducted to resolve whether the suspected manipulation occurred. Considerable
resources are used for such an investigation.
STOCK EXCHANGE RISK SYSTEMS
Bombay Online Surveillance System (BOSS)
The Bombay Stock Exchange (BSE) developed the Bombay Online Surveillance System (BOSS) to generate online alerts in real time. When an order is entered
into the exchange trading system, it simultaneously goes to BOSS.
In BOSS, the order, security name, and client are evaluated for
anything abnormal, such as circular trading (wash trades), manipulation, and
excessive trade sizes. If the system detects anything abnormal, it generates an
immediate alert to the BOSS staff and exchange, who then evaluate whether
further action is necessary.
BSE
Online Trading (BOLT) Risk Management
Trading on the BSE takes place in the BSE Online Trading (BOLT) System.Numerous
risk management alerts, indicating a breach of any particular monitored risk
characteristic, are built into the BOLT system to permit the exchanges to
monitor and control their member-brokers and the memberbrokers to closely
monitor and control their employee-traders’ activities.
Risk management features in this system include:
_ Order-size controls:
_ If a single order exceeds a
certain value, a warning is issued to the trader who entered the order. This
feature prevents data-entry errors.
_ No single order greater than 2.5
percent of a member’s liquid capital is accepted by the system.
_ Capital adequacy checks:
_ If a member exceeds liquid
capital limits, the system will flash a message on BOLT terminals saying
“capital adequacy limit violated,” and all of the BOLT terminals will be
deactivated (as discussed later,
there are numerous warnings prior to deactivation to give the
member an opportunity to increase its liquid capital).
_ Gross exposure limit norms for
members:
_ Members are allowed to set
trading limits for traders. Members can selectively grant these trading rights.
The following types of limits are available:
_ Grant or remove trader access to
the BOLT trading system, and thus trading.
_ Maximum gross buy and maximum
gross sell limits (in rupees lakhs).
_ Net value limits (in rupees
lakhs).
_ Maximum order quantity and value
(in rupees lakhs).
_ Scrip limits on selected stocks.
_ Default buying and selling limits
for scrips on which an explicit limit has not been set.
_ Scrip control.
_ Group control:
_ Members can specify buy-side and
sell-side value limits on trading for groups such as the A, B1, B2, Z, and F
groups. Traders are not allowed to trade in those groups once the value is
exceeded. If the buy value is exceeded, the trader will not be allowed to buy, and
when the sell value is exceeded, the trader will not be allowed to sell.
National
Stock Exchange (NSE) Risk Management
The National Securities Clearing
Corporation Ltd. (NSCCL), the clearing and
settlement subsidiary of the National Stock Exchange (NSE), also maintains a
comprehensive risk management system that seeks to ensure that trading members
have adequate capital to meet their obligations. These risk-containment
measures include:
_ Stringent margin requirements.
_ Position limits based on capital.
_ Online monitoring of member
positions.
_ Automatic disablement from
trading when limits are breached.
_ Capital adequacy requirements for
members.
_ Monitoring of member performance
and track record.
MARKET-EMBEDDED SAFEGUARDS TO CONTROL ABNORMAL STOCK AND MARKET
BEHAVIOR
Market safety mechanisms built into the trading and settlement
systems instantaneously and automatically respond to abnormal trading events as
they are happening. These mechanisms are triggered automatically when predetermined
safety levels are breached. In addition, SEBI, the NSE, and BSE, acting
together, have the ability to tighten the safety levels of different embedded
mechanisms if they deem it prudent to do so, given the circumstances.
These mechanisms act to reduce volatility as well as to reduce any
chance of settlement default. The primary safety mechanisms built into the trading
and settlement systems are:
_ Individual stock circuit filters
_ Market circuit filters
_ Real-time monitoring of exchange
members’ available capital
_ Margin adjustment controls:
_ VaR margin
_ Mark-to-market margin
_ Extreme loss margin
Price
Movement Controls and Market Circuit Breakers
The exchanges have built two types of price movement controls into
their trading systems: (1) individual stock daily movement limits, and (2)
market index daily movement limits. Both are designed to reduce stock and
market volatility and enhance investor safety.
Individual Stock Movement Limits The exchanges have the ability to control the daily price
volatility of individual stocks. These controls take the form of price bands
above and below the previous day’s closing price within which executions may
occur and orders may be accepted by the trading system. The trading systems
will reject all orders with buy limits below the bottom range of the band and
sell orders with limits above the top range of the band. In addition, the
system will not execute any trades outside the band.
Typically, the individual stock price movement limit is set at ?20 percent
from the previous trading day’s closing price, implying that a stock price is
permitted to fall a maximum of 20 percent below the previous closing price and
is permitted to rise a maximum of 20 percent above the previous day’s closing
price. A stock trading to its limit is not suspended from trading, but only
halted from trading outside the ?20 percent band. At any time during
the trading day, executions may occur at or within the band.
Individual Circuit Limit Bands If
a stock closes at 100 on the previous day, its price movement is limited to a
trading band of 80 to 120. In the extreme case if the stock falls to 80, then
orders to buy or sell at a price below 80 will be rejected by the system, limit
orders to buy or sell at 80 will be accepted by the system, and market sell
orders will also be accepted. However, no executions will occur below 80,
despite the existence of an unfilled market order. The stock will not trade
again the rest of the day unless a buyer who is prepared to pay 80 or above enters an order into the
system. Thus, price movements of individual stocks can be controlled without
suspending trading in that stock for the day
Tightening Circuit Filter Bands As
noted above, the typical stock has a price band of ?20
percent. However, this level can be reset either for the market as a whole or
for specific individual stocks. The circuit filters can be reduced to 10
percent, 5 percent, or 2 percent based on the prevailing circumstances. A reset
of the band, and thus a reduction in a security’s potential daily volatility, may
be applied for illiquid scrips or related to abnormal trading behavior,
speculation, fear of manipulation, or any number of other reasons. However, the
exchanges must agree and act in unison to change a circuit filter trading band
and may not do so unilaterally. This rule is significant given that the large
bulk of companies listed on the BSE and NSE exchanges, the nation’s two principal stock exchanges, are
dually listed. If both exchanges do not agree, then the active limit remains in
effect with no change on either exchange.
Circuit filters do not apply to all securities trading on the
exchanges. Futures and options do not have circuit filters and can trade freely
without limits. In addition, scrips on which derivative products are available and
scrips that are included in indexes on which derivative products are available
(i.e., the 30 constituent stocks of the Sensex, for which an index future
exists) have no circuit filters. However, the exchanges have imposed dummy
circuit filters on these scrips to avoid input errors such as keypunch errors.
There are also other methods that can be used by SEBI and the
exchanges to reduce volatility:
_ Applying extra margins to
individual securities
_ Applying extra limits to
individual brokers
_ Imposing limits on individual
client exposure
Marketwide
Circuit Breakers SEBI created a set of market circuit filters in an effort to
control excessive market movements and their indexes due to potential panic
among market participants. This ability is similar to market circuit breakers
on international exchanges. These circuit breakers will result in a coordinated trading halt on both the equity and derivative
markets with the express purpose of providing a cooling-off period for market
participants to digest the market’s behavior and rationally react to the cause
of excessive market movements.
SEBI has mandated that the marketwide circuit breakers trigger at
10 percent, 15 percent, and 20 percent movements on either the BSE Sensex or the
NSE Nifty, the key market index barometers for these two exchanges.The circuit
breakers would go into effect on both exchanges simultaneously regardless of
which index band is breached first.
Market Circuit Breaker Trigger Points The percentage movements for which these circuit breaker limits
become effective are calculated and set quarterly based on the closing index
value of the last trading session of the previous quarter. They are not
calculated based on the previous session’s closing value. The percentage
movement triggers of 10 percent, 15 percent, and 20 percent are translated into
absolute points of index variation (rounded off to the nearest 25 points for
the Sensex). The calculation using the quarter-end index close then applies for
the entire following quarter until a new level is set at the end of that
quarter, applicable to the subsequent quarter.
Marketwide
Circuit Breakers
Time of Circuit Breaker Breach
Size of Movement Before 1 p.m. 1 p.m.–2:30 p.m. After 2:30 p.m.
10% 1 hour 1/2 hour None
15% 2 hour 1 hour Remainder of the day
20% Trading halted the remainder of the day
Source: The Bombay Stock Exchange.
Application of Market Circuit Breakers A greater understanding of the application of market circuit
breakers can be gained from real-value examples of how they have been used. For
example, the December 2005 Sensex closed at 9397.93, of which 10 percent of
that level is 939. This is then rounded to the nearest 25 points, or 950. Thus,
the marketwide circuit breakers applicable for the entire next quarter, January
to March 2006, are as follows:
Circuit Filter Absolute Index Points
10% 950
15% 1,425
20% 1,900
In the quarter January to March 2006, if the index had moved 950 points
on a single day, regardless of the then-level of the index, it would trigger
the 10 percent marketwide circuit breaker and lead to a trading halt
on the nation’s stock exchanges.
On March 31, 2006, the Sensex closed at 11,279.96, of which 10
percent of that level is 1,128. Rounding off to the nearest 25 points leads to
a circuit breaker absolute number of 1,125. A new calculation of the circuit
breakers was then performed with new absolute index points being set as the
circuit filter levels. These levels, applicable for the entire quarter of April
to June 2006, were set at:
Circuit Filter Absolute Index Points
10% 1,125
15% 1,687
20% 2,250
On July 1, new levels were set for the July-to-September quarter
based on the closing index levels on June 30. These would be applicable until October
1, when the September 30 close determines the new break levels, and so on.
Broker
Capital Account Monitoring
The central factor upon which the exchanges manage intraday risk
revolves around the availability of members’ capital to meet their actual or
potential settlement liabilities. All stock exchange members are required to
maintain adequate liquid capital balances to retain their trading privileges
and have access to the exchanges’ trading systems. These balances are
continually monitored by the exchanges and updated on a real-time basis. If a
broker has insufficient available capital at any point of the trading day, he
is unable to enter orders into the exchange trading systems.
When an order is entered into the exchange trading terminal, the
system calculates the required initial margin for that particular trade and
then immediately debits the broker’s capital account by the calculated margin amount
before placing the order into the trading system order book. There are three
possibilities:
1. The broker has more than
sufficient capital to cover the debited margin, and the order is then accepted
by the trading system and placed into the exchange trading book.
2. The broker does not have
sufficient capital with the exchange to cover the required margin for this
particular trade, and the trade is rejected.
3. The broker has used up his
available capital. The moment this occurs, the broker’s trading terminals will
be deactivated in order to make them incapable of accepting or entering new
orders.
The system generates a number of warnings to the broker regarding
the real-time balances of available liquid capital. Warnings are generated by
the system when 70 percent, 80 percent, and 90 percent of the available liquid capital
has been utilized. At 100 percent, the terminals are deactivated until the
liquid capital is increased. Deactivation of terminals due to insufficient liquid
assets results in the imposition of fines and penalties, increasing with the
frequency of such occurrences.
The exchanges provide a facility for member-brokers to increase
liquid capital intraday online to respond to the warnings and avoid
deactivation and the imposition of fines.
The result of this safety mechanism is that the trading system
accepts orders only from members that have sufficient capital on hand to
provide the TABLE 4.2 Eligible Forms of Capital to Meet Margin Requirements
Form of Capital Percent Applicable Against Requirements
1 Cash 100% (i.e., no haircut)
2 Fixed Deposit Receipts from Banks 100%
3 Government Securities 100%
4 Bank Guarantees 100%
5 Mutual Fund Units NAV minus 10%
6 Group 1 Shares∗ 100%
minus margin requirement
∗Highly liquid shares, as defined
by the exchanges.required up-front margins for
every entered trade. This minimizes the chance of settlement default and the
ability of brokers to overextend themselves.
Brokers’ capital can be categorized as base minimum capital and
liquid capital. Base minimum capital for every broker is equal to Rs10 lakh (US$23,000) and must be on deposit
with the exchange at all times. Very importantly, this base minimum capital is
not applicable to meet margin requirements. Margin requirements must be funded
by additional capital over and above the base minimum capital. This additional
capital may be held in various forms. Each form is subject to its own haircutc with regard to the percentage that is used to meet capital requirements. Table shows the different forms in which the capital can be held and the haircut
applied to each form.
There are two additional stipulations about member capital. At all
times, 50 percent of a member’s capital must be in the most liquid forms, which
are forms 1 through 4 in Table 4.2. In addition, 5 percent of
total aggregate member capital with the exchange cannot be greater
than 5 percent for a single bank, with regard to bank guarantees and deposits. This
avoids the eventuality of a single bank’s insolvency impacting more than 5
percent of the aggregate exchange-members’ capital.
MARGIN CONTROLS
The Indian capital markets have built into their trading and
settlement systems a very sophisticated set of margin requirements. These cA “haircut” with regard to
capital refers to the percent of the asset used for capital purposes that does not apply to the liquid capital computation. An
asset subject to a 10 percent haircut means that only 90 percent of the asset
value can be applied to the capital computation. requirements,
in combination with the real-time monitoring of broker capital accounts
discussed above, are extremely effective in (1) reducing volatility and
speculation in stocks, (2) ensuring that brokers and investors do not overextend
themselves by taking on additional exposure without adequate capital, and (3)
minimizing any possibility of settlement default on presettled trades.Every trade executed on the Bombay Stock Exchange and National Stock
Exchange is subject to a combination of different types of margins, including:
_ VaR margin
_ Mark-to-market margin
_ Extreme loss margin
_ Special margins
Derivatives trades are additionally subject to:
_ Premium margin
_ Assignment margin
The margins required for any particular trade can vary and are
associated very specifically with the particular security and instrument
traded, with the trading characteristics of the particular security used to
determine the required margins for that trade. Furthermore, the regulator and
exchanges acting together have the ability to tighten beyond the standard
requirement certain of these margins for the market as a whole, or for
individual securities if they deem it necessary or beneficial to the proper
functioning of the market. In addition, the exchanges have the ability to selectively
impose a gross exposure margin in cases where they are concerned about too much
exposure by a particular broker or client or in too concentrated a set of positions.
This stock-specific determination of applicable margins yields
margin rates that can range from a low of as little as 7.5 percent for large,
extremely liquid, blue-chip companies to as much as 100 percent for the smaller, illiquid, less financially sound companies. The result
and benefits include the fact that in the instance of a severe market
correction or the default of a member-broker, settlement risk will have been
effectively minimized for a large majority of executed but pre-settled trades
that either will be settled with already-deposited funds or will involve easily
liquidated securities.
This section discusses these different requirements, how and why
they are applied, and the contribution they make to the safety and integrity of
the Indian capital markets.
Margins
for Equities
There are some differences in the margin requirements for equities
versus derivatives. In this section, those requirements pertaining to equities
are discussed.
VaR
Margin As mandated by the SEBI, the stock exchanges apply a valueat- risk (VaR) margin system to all outstanding, pre-settled trades. The VaR margin is intended
to cover the largest loss that could be expected for a given share with a 99
percent probability (99% VaR). Because VaR margin calculations are based on
each individual stock’s trading history, each
individual stock has its own margin requirement. The most liquid stocks have VaR margins below 10 percent, and many
illiquid stocks are subject to 100 percent VaR margins. Specific stock VaR margins are regularly
recalculated and can be found on the Web sites of both primary exchanges on a
daily basis. They can be found on the BSE Web site at
www.bseindia.com/mktlive/market summ/margin.asp and on the NSE Web site at
www.nse-india.com/content/nsccl/nsccl eqvarrates.htm.
There are three categories of shares with regard to VaR margin
calculations, each with its own formula for determining a particular stock’s margin
requirement: Group 1, Group 2, and Group 3 stocks, with Group 1 stocks considered the most liquid. The categories are
distinguished by the different liquidity and market impact characteristics of
their traded shares.
As noted above, the VaR margin is intended to cover with 99
percent probability a negative price movement. For the most liquid stocks, the
margin covers a one-day loss, whereas for illiquid stocks, it covers a
three-day loss (to allow the exchange three days to liquidate an illiquid
position). This three-day requirement leads to a scaling factor of the square root
of three for illiquid stocks. For liquid stocks, the VaR margins are based only
on the volatility of the stock itself, whereas for illiquid stocks the formula
also includes the volatility of the market index in the calculations. Details
of the formulas can be found on the BSE and NSE Web sites.
Defining Liquidity Groups Stocks
are deemed liquid if they have traded on 80 percent of the trading days over an
18-month period, and they are deemed illiquid
if they have traded fewer than 80 percent of the days
over the last 18 months. Illiquid stocks are defined as Group 3 stocks. Liquid stocks
are further characterized and divided based on the market impact they exhibit
during trading. Specifically, the market impact is measured by impact cost, a measure of how
much a stock price is moved by a market order of Rs500,000 (∼US$11,000) coming into the market.
∗The impact cost is a measure of
how much a stock price is moved by a market order of 500,000 shares coming into
the market.
This is evaluated by examining four randomly chosen snapshots of
the order book depth every day over the trailing six months. Stocks exhibiting an
impact cost consistently less than 1 percent are deemed the most liquid, the Group 1 stocks. Those exhibiting an impact cost
greater than 1 percent, but still trading for more than 80 percent of the days
for the trailing 18 months, are deemed Group 2 stocks.
A key feature of the VaR margin is that it is an upfront margin, calculated immediately
upon the broker entering an order on a trading terminal and instantaneously
collected from the member-broker’s liquid capital account before the order is accepted for
execution. For example, in the case of a Group 3 stock with 100 percent VaR
margin, the entire cost of a purchase order is collected by the exchange from
the broker before the order is even executed, meaning that there is a 100
percent chance of the trade settling or, put another way, zero chance of the
settlement failing. As noted above in the discussion of broker capital
monitoring, this upfront feature prevents brokers from overextending themselves
beyond their available liquid capital.
Mark-to-Market
Margins Mark-to-market margins in
reference to stock trading refer to margin requirements post-execution but
pre-settlement, and they apply on trade date, T, as well as T+1. For
mark-to-market margins, investors are required to put up additional margin
equal to the paper loss resulting from the difference between the execution
price and the closing price (on T), and the closing price on T+1 versus
the closing price on T. On settlement day T+2, the trade is settled. No
credit is issued for net paper profits on T or T+1. For example, if a stock
purchase is executed at 100 in the morning and the stock closes on that trade
day at 95, the investor must post an additional mark-to-market margin of 5,
representing the mark-to-market loss. If the stock price falls to 91 on T+1, the
investor must post an additional 4 mark-to-market margin to cover the
additional mark-to-market difference from T. If on T the stock closes at 103,
no credit is given for the markto- market profit. Similarly, if the stock
closes on T at 95, requiring the 5 mark-to-market margin, and then at a price
above 95 (whether 96 or 106), there is no return of the previous day’s margin
payment and no credit is generated.
On an intraday basis, individual clients are permitted to net out
their various mark-to-market losses against mark-to-market profits across all
their securities, either to partially reduce their mark-to-market margin
requirement or to completely offset any mark-to-market payment. Again, no
credit is generated from net mark-to-market gains. Clients cannot net across
days, using T gains to offset T+1 mark-to-market losses.
On the broker level, there is no netting of one client versus
another.
From a broker point of view, all netted client positions are
grossed up, and payments are debited from the member’s capital the following
morning.
Extreme
Loss Margins Extreme loss margins are
imposed to cover unusual instances where losses fall outside the VaR-addressed
99 percent probability of loss. The extreme loss margin for each stock is the
greater of 5 percent of the price and 1.5 times the standard deviation of daily
logarithmic returns of the stock price over the previous six months. (Specific extreme
loss margins applicable to any specific stock can be found on the above noted
BSE and NSE Web sites.)
Special
Margins Exchanges have the ability to impose an additional special margin
on particular stocks to contain volatility, speculation, or other abnormal
trading activity. An additional margin may be imposed on a specific member-broker
or specific investor if there is too much exposure in general or in too
concentrated a set of positions.
Margin
Obligations for Equities
In all instances, the member-broker’s capital is debited the upfront
margin before an order is accepted by the exchange trading system. However, in the
equity market, the broker has the discretion as to when the client has to put
up the margin. If the broker does not require the client to fund the margin,
the broker funds it with his own liquid capital on behalf of the client.
While brokers have the discretion to sell out client positions in
the case of nonpayment, it is important to note that there is no required
forced selling of client positions. This loophole in the regulations is one of
the few in an otherwise very tight system of control that could, in a
worst-case scenario, cause the default of a broker who has chosen to extend
payment dates and excessive credit to a client who subsequently fails to cover
his own margin requirements. In such an instance, numerous clients of the
broker could be
affected.
Margins
in the Futures and Options Segment of the Exchanges
The risk management mechanisms for the futures and options
segments of the markets also use online position monitoring and sophisticated
online, real-time systems. The futures and options margin requirements differ somewhat
from the cash segment rules. In the futures and options segment of the market, clients are required to pay upfront margins. Thus, the
loophole in equities discussed above, whereby a broker may elect to extend
excessive credit to a client, is closed in the case of derivatives.
There are three types of futures and options margins:
1. Exposure
margin: This is an initial, upfront
margin, equal to 10 percent of the contract size.
2. VaR-based
99 percent margin: In the case of
futures contracts, this VaR margin may be computed for a two-day period.
3. Mark-to-market
margin: This continues for the life of
the position.Risk management for the futures and options segments of the BSE
and NSE stock exchanges entails online, intraday position monitoring and a sophisticated margin system. There are different margin
calculations and position limits for the market’s aggregate outstanding
derivative position for any particular underlying security for (1) individual
member-brokers, and (2) different types of end-clients. These calculations and
limits may be adjusted by regulators to tighten market security.
Initial
Exposure Margin An initial exposure margin is collected upfront for all of the
open positions of a clearing member based on the internationally accepted Standard
Portfolio Analysis of Risk (SPAN1) methodology. The objective of SPAN is to
identify overall risk in a portfolio of futures and options contracts for each
investor. The system treats futures and options contracts uniformly, while at
the same time recognizing the unique exposure associated with options
portfolios such as extremely deep out-of-the-money short positions, intermonth
risk, and intercommodity risk. A more detailed explanation of the SPAN margin
can be found on the Web site of the NSE at www.nse-india.com/content/nsccl/nsccl
fospan.htm.
dIt is the opinion of the author
that this is a serious loophole that should be addressed, and closed, by the
regulatory authorities.
SPAN evaluates scenarios of probable changes in underlying prices
and volatilities in order to identify the largest loss, with a 99 percent
probability, that a portfolio might suffer, and then it sets the margin
requirement at a level sufficient to cover this one-day loss.
While initial margin requirements are based on 99 percent VaR over
a one-day time horizon, in the case of futures contracts (on index or
individual securities) the initial margin may be computed over a two-day time
horizon.
The methodology for the computation of VaR is determined by the
SEBI.
Minimum Initial Margins Minimum
initial margins in the derivative market vary depending upon the product. For
all of the products, the following apply:
_ A derivative product upfront
initial margin is required to be collected from end-clients. This differs from
the cash segment, where the broker must provide the upfront margin, but has the
discretion of collecting it, or not, from the end-client.
_ For initial margin requirements,
netting is permitted at the level of individual client, but grossed across all
clients, at the trading/clearingmember level. Trading/clearing members may net
their own proprietary positions, but not net against client positions.
_ The exchanges and SEBI have the
discretion to impose stricter requirements for tighter risk management in
instances where they deem it appropriate and beneficial to the smooth
functioning of the markets. This might occur in times of excessive volatility or excessive
speculation, in an effort to reduce such activity.
Product-specific initial margins are as follows:
Stock Futures There is a minimum
initial margin equal to 7.5 percent of the notional value of the contract based
on the last available price of the futures contract. This minimum initial
margin is further scaled up by the square root of three for stocks that have a
mean value of impact cost of more than 1 percent.
Calendar spread margins are calculated to give credit for the
hedged nature of the position. However, a calendar spread is treated as a naked
position in the far-month contract as the near-month contract approaches expiry.
The calendar-spread margin is charged in addition to the VaR margin.
Stock Options A minimum margin on
short option positions is equal to 7.5 percent of the notional value of all
short stock options if the sum of the VaR margin and the calendar-spread margin
is lower than the short option minimum margin. A net option value is calculated
for each member as the net current market value of options in the portfolio. A
member’s liquid capital is then either debited (for net short positions) or
credited the amount of the net option value.
For unsettled option positions, the value of the premium is
deducted from the member’s liquid capital on a real-time basis until the buyer
settles (pays for) the trade.
Index Futures The minimum initial
margin is 5 percent of the notional value of the contract. This value is
monitored real time, and the margin is calculated and applied against a
member’s capital on an intraday basis.Index derivatives are also subject to a
spread charge of 0.5 percent per month for the difference between the two sides
of the spread, subject to a minimum of 1 percent and maximum of 3 percent.
Index Options A short option
minimum margin is 3 percent of the notional value of all short index options
held. This is applicable if the VaR margin plus the calendar spread margin is
less than 3 percent. The net option value (the value of long options minus
short options) is calculated and added to the member’s liquid capital. Negative
values are deducted against capital.
Premium
Margin In addition to an initial margin, a premium margin is charged
to members and must be paid by the buyer until the premium settlement is
complete.
Assignment
Margin An assignment margin is levied on a member in addition to the SPAN margin and premium
margin. This is required to be paid on assigned positions of members toward
interim and final exercise settlement obligations for option contracts on
individual securities, until such obligations are fulfilled.
Daily
Mark-to-Market Margin Clients are assessed mark-to-market margins on a daily basis.
These can be netted out on a member level.
ADDITIONAL RISK CONTROLS FOR DERIVATIVES
Exposure
Limits on Capital
In addition to the various margin requirements imposed by the
exchanges to limit the risk of settlement default that might roil the markets,
additional controls have been instituted to further safeguard the markets.
Among these are exposure limits on positions taken by exchange members for
individual stock and index futures and options. These safeguards are as
follows:
Individual
Stock Futures and Options The notional value of gross open positions carried by a firm may
not be greater that 20 times the available net worth of the member. The
member’s liquid capital will be debited on a real-time basis by an amount of 5
percent or 1.5 standard deviations of notional value of gross open positions in
single stock derivatives (futures and options), whichever is higher. This debit
will be over and above the margin collected for the SPAN margin.
Index
Futures and Index Options The notional value of gross open positions may not exceed 331/3 times the available liquid net worth of a member. For index
futures contracts and gross short open index option positions, 3 percent of the
notional value of gross open positions is collected from a member’s capital on
a real-time basis. This is in addition to the SPAN margin.
These exposure limits on capital may be tightened by the exchanges
for risk-management purposes.
Position
Limits
Another mechanism employed by the exchanges to minimize risk in
the markets is to limit the size of positions taken by exchange members for individual
stock and index futures and options. The position limits are as follows:
Individual
Stock Futures and Individual Stock Options Position limits are imposed: (1)
on the number of marketwide outstanding positions that may exist, (2) on the
maximum positions that a member-broker may hold, and (3) on the maximum
positions that individual investors may hold.
Marketwide Limits Marketwide
limits on open positions on stock options and futures contracts are based on
the number of shares of underlying stock and are the lower of: (1) 30 times the
average daily volume of the underlying stock during the previous month, or (2)
20 percent of the free-float of shares (i.e., non-insider shares) trading in
the market.
Broker Limits Broker limits are
calculated on a gross basis for all of a broker’s clients. They are related to
the marketwide position limits and vary depending on whether the marketwide
position limit is less than or greater than Rs250 crore (US$56 million). The limits are: (1)
20 percent of the marketwide limit for stocks with marketwide position limits
less than or equal to Rs250 crore, or (2) Rs50 crore (US$11 million) for stocks with a position
limit greater than Rs250 crore.
Once brokers reach the position limit, they are permitted only to
execute offsetting positions that lower their gross open positions.
Client Limits An individual client
is subject to a position limit with respect to the underlying shares of all
derivative positions that are the greater
of: (1) 1 percent of the free-float number of shares,
or (2) 5 percent of the open interest in the underlying stock.
Index
Derivative Limits Position limits for index derivatives are:
Broker Limits The position limit
for a broker is based on the gross positions of all of its clients and the
aggregate of all open interest positions in all index derivatives contracts,
futures, and options existing in the market for that particular index. The
limit is the higher of: (1) 15 percent of the aggregate open positions, or (2) Rs250
crore (US$56
million).
Client Limits One entity or a group
of entities acting in concert are not subject to a maximum holding, but are
required to report in a timely manner any holding exceeding 15 percent of the
open interest in any particular index.
There are different limits that apply to foreign-based investors,
Option
Exercise Limits
There are currently no limits on the number of individual stock or
index option contracts that can be exercised. However, the exchanges do have
the ability to set limits in the interest of risk management.
STOCK EXCHANGE CENTRAL COUNTERPARTY ROLE
The stock exchanges in India play a central counterparty role on
all transactions executed on their trading systems. Thus, the buyer and seller
of a particular transaction have no direct contractual relationship with each other,
but rather, each separately has as its counterparty to the transaction only the
stock exchange (or one of its subsidiaries). The significance of this system is
that each member no longer is subject to the counterparty risk and settlement
risk associated with the various other trading members of the exchange. Each
member-broker has as its counterparty only the exchange and thus is concerned
only with the ability of the exchange to settle the transaction. As is
explained in the next section about guarantee funds,the exchanges have taken the final step of removing any settlement
risk on their own part. As a consequence, credit risk no longer poses any
threat in the Indian marketplace. The market has full confidence that
settlement will occur on time and will be completed irrespective of defaults by
isolated trading members.
The central counterparty dealing with a settlement default with
one of the members has several tools at its disposal to mitigate the impact of
that default. First, the margin system, discussed earlier in this Section, ensured that the defaulting member had already deposited with the
exchange significant funds to cover settlement, ranging up to 100 percent of
the settlement requirement for illiquid securities. Second, tight monitoring of
the cash position of the member minimizes the number of transactions for which
settlement is at risk. Third, the exchanges maintain settlement guarantee
funds, discussed below, to cover shortages in the event of such a default
occurring.And finally, the exchanges are in a strong position with significant
leverage over the defaulting member to press for a speedy resolution to any
default.
The exchanges as counterparties provide an additional valuable
feature:
Because the exchanges are the counterparty to every transaction, a
member knows only the exchange as the other side of his trade, not the member who
entered the contra-order. Thus, all trades on the exchanges are done anonymously
to all other parties.
In summary, the exchanges acting as a central counterparty, in
conjunction with automatic margin collection and settlement guarantee funds, significantly
reduce, if not eliminate, settlement counterparty risk in the Indian capital
markets.
GUARANTEE FUNDS
A little known and underappreciated, yet extremely valuable
feature of India’s
markets is the existence of guarantee funds. There are three types of guarantee
funds:
_ The Trade Guarantee Fund of the BSE and the Settlement
Guarantee Fund of the NSE insure/guarantee the
settlement of all trades executed on these two exchanges.
_ The Broker Contingency Fund of the BSE makes temporary cash advances to member-brokers who are
facing short-term financial difficulties.
_ The Investor Protection
Funds of the BSE and NSE insure
investors against losses due to the default of their broker (similar to the
Securities Investor Protection Corporation (SIPC) in the United States).
As noted in the section above discussing the central counterparty
role of the exchanges in India’s
capital markets, each member-broker has as its counterparty to every
transaction the exchange on which the trade was executed and thus is concerned
only with the ability of the exchange to settle the transaction. This has
limited the counterparty risk of trading on the NSE and BSE exchanges to the
exchanges themselves. The settlement guarantee takes the final step of removing
any settlement risk associated with the exchanges.
The trade and settlement guarantee funds effectively guarantee
settlements and eliminate all counterparty risk for securities transactions
executed on the NSE and the BSE. The creation of these funds can be traced to
1997, when the SEBI stipulated that the exchanges should introduce a system to
guarantee settlement of bona fide transactions by members to ensure that market
equilibrium is not disturbed in the case of payment default by members.
Both the NSE and the BSE have reported that there has never been a
year since the trade guarantee funds were established when the balance of the
funds was not higher than the previous year. Furthermore, there has never been
a case where any money from the guarantee funds used to settle transactions was
not replaced with assets of the defaulting broker.
The guarantee funds are regularly tapped to complete settlements
on behalf of brokers who miss the T+2 pay-in settlement deadline.
While these funds are usually replaced the same or next day, the commonly
accepted reason given for payment delays is an inefficient national banking
system, particularly outside of major cities.
BSE
Trade Guarantee Funds
The BSE trade guarantee funds were implemented in 1997 with the
following objectives:
_ To guarantee the settlement of
bona fide transactions between members of the exchange that form part of the
stock exchange settlement system and to ensure timely settlements of
executions, thereby protecting the
interests of investors and members of the exchange.
_ To instill confidence in
secondary market participants and global investors in order to attract more
players into the capital markets.
_ To protect the interests of
investors and to promote the development of and regulation of the secondary
market.
The balance of the trade guarantee funds (TGF) as of November 30, 2006
was Rs2,643.76 crore (∼US$590 million), which represents 57
percent of the November 2006 average daily equity turnover on the exchange.
Since India
trades in a T+2 environment, at any one time there are two days of unsettled
trades outstanding; thus the coverage ratio is approximately 28.5 percent of
the total value of all unsettled trades outstanding. In other words, brokerage
firms representing 28.5 percent of all trades executed over a two-day period
could default, and the total value of all of the trades would be covered and
settled. Since many of the S, T, and Z-classified shares are subject to 100
percent margin collected by the exchange prior to execution (thus are fully paid for), virtually no settlement risk exists in
those sharese.
Since these trades constitute approximately only 4.5 percent of
all trades, the TGF then represents in excess of 30 percent of the total
aggregated average A, B1, and B2 share two-day turnover. Since these shares are
also subject to pretrade margin, including VaR-based margin and extreme loss
margin, the outstanding funds due are substantially less than the total value
of the trades, thus raising the coverage ratio of the TGF even higher. Since
the value at risk for a defaulted settlement is not 100 percent of the value of
the shares but rather considerably less (in all likelihood less than 15
percent), the practical ability of the trade guarantee funds to settle all
unsettled balances of pre-settled executed trades would represent significantly
more than the 30 percent of unsettled trades, and probably many multiples of
average daily turnover. Thus, the TGF provides a valuable and important cushion
of safety to the market.
The balances in the BSE trade guarantee funds come from the
following sources:
_ The exchange contributed an
initial sum of approximately Rs170 crore (US$38.5 million).
_ All active members are required
to make an initial contribution of Rs10,000 (US$225)
in cash to the fund.
_ All active members also
contribute Rs0.25 for every Rs1 lakh (US$2,300) of gross turnover in all of the groups of scrips through continuous
contributions that are debited to their settlement accounts in each settlement.
_ Active members are required to
maintain a base minimum capital of Rs10 lakh (US$23,000) with the exchange. This contribution is transferred to the
fund and treated as a refundable contribution of members.
_ Each member is required to
provide the fund with a bank guarantee of Rs10 lakh (US$23,000) from a scheduled
commercial or cooperative bank as an additional contribution to the fund.
The trade guarantee funds totaled Rs2643.76 crore (∼US$590 million) as of November 30, 2006.
NSE
Settlement Guarantee Funds
Settlement guarantee funds of the National Securities Clearing
Corporation Ltd. (NSCCL) assume the counterparty risk for trades executed on
the NSE.The total value of the settlement guarantee fund as of March 31, 2006,
wasRs4,055.18 crore (∼US$905 million). This represents
58.4 percent of the FY06 average daily turnover for the NSE, implying that
member-brokers representing more than 29 percent of all trades over a two-day
period could default and the fund could fully settle every trade in its
entirety.
Further,as noted above when discussing the BSE TGF, given the
margin collected by the exchanges prior to execution, and the fact that many
securities carry an upfront 100 percent margin, the funds available in the
settlement guarantee fund would represent significantly more than 58 percent of
the daily outstanding balances.
A separate settlement guarantee fund is maintained for the futures
and options segment. The total value of the futures and options settlement
guarantee fund was US$2.606
billion as of March 31, 2006.
Brokers’
Contingency Fund
The brokers’ contingency fund was established in 1997 to:
_ Make temporary refundable
advances to members facing temporary financial shortfalls.
_ Protect the interests of
investors dealing through members of the exchange by ensuring timely completion
of settlement.
_ Instill confidence in investors
regarding the safety of exchange transactions.
The balance for the brokers’ contingency fund comes from the following:
_ The exchange contributed an
initial sum of Rs9.51 crore (US$2.2 million).
_ Active members are required to
make an initial nonrefundable contribution of Rs1,000,000 (∼US$23,000).
_ Active members contribute Rs0.125
(US$0.0027) for every Rs1
lakh (US$2,300)
of gross turnover through continuous contributions that are debited to their
settlement accounts for each settlement.
The fund totaled Rs50.69 crore (US$11.3 million) as of November 30, 2006.
Members are eligible to get advances from the fund for up to a
maximum of Rs25 lakh (US$57,000)
at a rate of 21 percent per annum.
The fund ensures that settlement cycles at the exchange are not
affected due to temporary financial problems faced by members. This helps to
contribute to the credibility of the stock exchange settlement system.
Investor
and Customer Protection Funds
As mandated by the Ministry of Finance, the BSE and NSE
established investor protection funds to meet the claims of investors against
defaulting members. Funds come from:
_ Members contribute Rs0.15 per
Rs100,000 (US$2,200)
of gross turnover.
_ The stock exchange contributes
2.5 percent of the listing fees that it collects on a quarterly basis.
_ Total interest earned by the
exchange from 1 percent security deposits made by companies making public and
rights issues is credited to the fund.
_ Auction proceeds from instances
of price manipulation or rigging are impounded and transferred to the fund.
_ The surplus in accounts of
defaulters after meeting their liabilities on the exchange is released to them
after transferring 5 percent of the surplus amount to the fund.
The BSE fund totaled Rs269.92 crore (US$60.1 million) as of November 30,
2006, and the NSE fund was about Rs173.7 crore (∼US$43
million) as of April 30, 2007.
In the event of default by a member, the maximum amount payable to
an investor from the investor protection funds of the BSE and NSE is Rs10 lakh
(US$23,000).
INSPECTION OF BROKERS’ BOOKS
As stipulated by the Ministry of Finance, the stock exchanges are
required to inspect accounts of at least 10 percent of their active members
during each financial year. The number of inspections carried out by the
exchanges every year tends to far exceed the requirements. The purpose of these
inspections is to verify that members have maintained the required books of
accounts as per the Securities Contracts
(Regulation) Rule 1957 and that members have
adhered to the rules, regulations, and bylaws of the exchange and SEBI.
The findings of the inspections are reported to the examined
members, and follow-up action is taken based on the responses and
clarifications provided by members. If the violations are serious, the matter
is referred to the Disciplinary Action Committee of the exchange. Members are
required to have their annual accounts audited by a chartered accountant and to
submit an audit certificate as well as profit-and-loss and balance sheet
statements to the exchange. Members are also required to submit net-worth
certificates at the end of every March and September. The filing of these
documents by members is monitored by the Inspection Department.
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