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
Rigorous risk management methodology is used by the stock exchanges and SEBI’s four departments to regulate securities market activities.
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.
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
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.
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
_ 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 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.
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.
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
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
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.
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
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.
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.
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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