Risk and the Regulation of
Capital Markets in
P.H. Parekh & Co.,
Risk is something to avoid in a capital market, unless of
course its assumption pays for itself with returns higher than the risk
assumed. In an ungoverned capital market, certain risks can be avoided by
governing the market and its players effectively. Reducing such risk for which
no real return is obvious is the role of the regulator and Self Regulating Organisations like stock exchanges. This paper discusses
the types of systemic risks which fall into the above category.
Though easily identified post hoc, defined with some
difficulty and nearly impossible to enumerate its types, the concept of risk
has been broken into several component parts for better understanding and for
making regulations possible. This paper explores risk management in the Indian
capital markets from several angles.
Common sense dictates that there exists a trade-off between
risk and return in the securities markets. You can either eat well or you can
sleep well. The more risk you are willing to assume, the higher the expected
pay-off. Though the concept is sound at times, the concept of risk has
undergone a dramatic change since the 1970s. Risk is no longer measured by the
volatility of an individual asset but by the portfolio in which it sits. It is
possible for two securities which are individually highly risky, to be
practically risk free if bought simultaneously. The modern portfolio theory has
brought its authors 1
the Nobel Prize. This paper does not deal with the portfolio risk of an
investor but rather goes into the systems in place which reduce system-wide
risk which has no real return – but may have some costs attached.
II. Structure of the Indian Capital Markets
The introduction of screen based trading in 1995 by the
then newly developed National Stock Exchange of India was responsible for a
similar development by other stock exchanges in the country. The capital market
in the country is essentially comprised of the Bombay Stock Exchange 2
(the “BSE”, the oldest stock exchange in
Over the last few years, more and more stocks have been put
on the compulsorily “dematerialised” list (over 99
percent of all shares traded today are in paperless form). A sea change in the
stock markets has seen dematerialised stocks, faster
settlements, increased transparency, reduced fraud and competitive costs.
Introduction of exchange-traded derivatives in June 2000 was preceded by over
five years of consultation, involving a lot of serious deliberations for
introducing the best practices in risk management from around the world. The
regulations and structure have developed quite well to date but significant
concerns about efficient pricing in the derivatives markets remain. 4
April 2003 will see the movement in the cash segment
towards a T+2 clearance and settlement with daily net settlement (i.e.,
a buy and a sell order of the same person, made on the same day can be set off
and settled net rather than gross). Reduction of fraud, easing of costs, easing
of complications and the virtual elimination of mistakes in clearing and
settlement of securities have made the Indian capital markets amongst the best
in terms of efficiency, technology and costs. Unfortunately, with the recent
downturn in the economy, liquidity has lost its retail character and exchanges
are facing larger volatility in stocks.
III. The Regulatory Regime
The relevant Acts and statutory provisions are contained in
the Securities Contract (Regulations) Act, 1957, Securities and Exchange Board
of India (“SEBI”) 1992 (the “SEBI Act”) and rules and regulations passed under
them. SEBI has passed guidelines from time to time regulating the role of
market intermediaries and Self Regulating Organisations
(“SRO”s). These regulations provide the regulatory
framework for securities regulations by SEBI. The regulations at the level of
the stock exchanges are the most detailed. The rules, regulations and bye-laws
provide in great detail risk management techniques founded in global practice
to reduce systemic risk. These rules and regulations of the SROs
have been held to bypass certain statutory provisions like insolvency laws and
the arbitration statutes because to do otherwise would be to affect the risk
structure of the market. 5
IV. Derivatives Regulatory Regime
The extant regulations which regulate securities 6
automatically apply to derivatives because of the definitional change in the
term securities. Thus, for instance, SEBI (Stock Brokers and Sub-Brokers)
Regulations, 1992 would automatically apply to all trading members of the
derivatives segment. What is added to the existing structure is the SRO level
regulations which are incorporated in the Derivatives Segment/F&O segment
Rules, Regulations and Bye-laws.
For the purposes of this paper, the regulatory regime is analysed by reference to the component parts of the
regulatory framework, namely:
• Member Regulation;
• System Regulation;
• Default Regulation.
V. Member Regulation
A. Segregation of Client Accounts
Each client has a client ID assigned so that that client’s
assets are segregated from those of the member. Not only are the monies of a
client not permitted to be pooled with that of a member, but the monies of one
client are not permitted to be pooled with that of other clients. A similar
segregation is ordered in the books of the members who must maintain separate
accounts for proprietary trades from those of its clients.
B. Audit Trails and Internal Review
An audit is mandated to be carried out every year by each
member and the audit report is to be submitted to the exchange. The exchange
also has the right to inspect the books of any member without notice and visit
the place of record-keeping of such member.
The member is required to enquire into the client’s
background and must ensure that clients read a Risk Disclosure Document, which
explains briefly the risks involved in trading in derivatives. There is
considerable market scepticism over the value of such
Risk documents but institutions must be seen to have explained the risk
potential to clients.
Few topics have been as hotly debated since the 1987 market
crash 7
in the
Margins in the derivatives segment are collected with only
one purposes in mind – as a collateral for due settlement of trades, keeping in
mind a worst case scenario. They also contribute to the amount of leverage a
person can use. Thus, lower margins would increase leverage and therefore
increase the risk of a person defaulting. 8
However, higher margins would suck away liquidity from the market. To determine
a safe margin which would balance with the costs associated with higher margin,
statisticians calculate the worst case scenario loss – and provide for a
reasonable degree of safety.
The computation of Worst Scenario Loss has two components.
The first is the valuation of the portfolio under sixteen scenarios to give a
range of “Scenario Contract Values”. At the second stage, these Scenario
Contract Values are applied to the actual portfolio positions to compute the
portfolio values and the initial margin (Worst Scenario Loss). For
computational ease, exchanges are permitted to update the Scenario Contract
Values only at discrete time points in each day and the latest available
Scenario Contract Values are applied to member/client portfolios on a real time
basis.
Normally, a 3 sigma standard is used in futures contracts
so that margin levels would cover approximately 99 percent of scenarios, so
that in case of default, the margin would be sufficient to meet with the
shortfall. Options attract a higher standard since only one person, the
writer/short, takes up more risk.
E. Cross Margining with Cash Segment
Portfolio based margining approach takes an integrated view
of the risk involved in the portfolio of each individual client comprising of
positions in all derivatives contracts i.e. index futures, index options, stock
options and single stock futures. Cross margining reduces members’ combined
daily margin requirements and, accordingly, reduces the potential for a
financial cul-de-sac, especially during volatile markets when clearing organisations may demand additional clearing margins from
their members. Similarly, cross-guarantees reduce systemic risk posed by a
common member's default because that member may have positions spread across
markets such that its asset position at one clearing agency is positive even
though its asset position at another clearing agency is negative.
The cash segment and derivatives segment exposures in India
are not allowed to be treated as a single portfolio and exposure in one does
not reduce the liability in another on the basis of a unified portfolio. This
author strongly recommends cross margining be allowed between the two segments.
Doing so will allow easy arbitrage and a more efficient market in both the cash
and the derivatives segment. The principle of cross margining has been accepted
by SEBI and its implementation is now a matter of bureaucratic implementation.
One source of concern in the markets is whether thinly capitalised entities would be able to survive a severe
market decline. A person (individual or corporate) must satisfy all capital and
other entry requirements for membership to trade in the market. The person must
further satisfy the net worth requirement and pay in a base capital and other
amounts which are called its liquid net worth to be used as security not merely
for its own default, but partly also that of other members. 9
The member is also be obliged to pay on a continuous
basis a capital contribution. The initial contribution to capital, the member’s
continuous contribution and the contribution of the exchange to the corpus of
the Trade Guarantee Fund form the basis of “General Access Funds” which can be utilised towards the default of any member of the exchange.
The member may also be required to pay additional capital contribution if so required
by the exchange. 10
Specific Access Funds are those funds which may be used only for the default of
the defaulting member and on account of no other person.
Further, each member has exposure limits circumscribed by
its capital/security deposited. If for reasons of adverse price change, a
member exceeds its exposure limits beyond that afforded by its deposits, its
trading terminal will not permit any further trades which will increase its
exposure. The member may be permitted to enter trades which will reduce the
exposure limit – since on a portfolio basis adding further exposure can reduce
overall exposure obligations. The member is also obliged to immediately furnish
further deposit or reduce his/her exposure to be in compliance with margin
requirements. Such compliance measures are in very large part taken by the
trading system without human intervention. Failure to settle margins within a
short span of time would attract further action for compliance by the exchange.
In the derivatives market, the Trading Member needs a
Clearing Member who is willing to clear its trades – it is the Clearing
Member’s prerogative to allow his Trading Members to trade and set exposure
limits for them. The capital deposit is utilised not
merely in temporary margin shortfalls but also provides a buffer in the event
of a default by the member. Part of the contribution goes towards the Trade
Guarantee Fund which guarantees the trades in the exchange from default. The
exchange has a primary lien over the security deposited – superior to that of
external creditors. 11
In the derivatives market, if a Trading Member defaults,
action can be taken by the Clearing Member and the exchange. Further the
Clearing Member’s algorithms added to the Trading Member’s trading terminals
would automatically limit that trading member’s ability to transact contracts
which would increase its exposure liabilities. The Clearing Member can also
close out contracts of its trading members to reduce such excess exposure. In
case of any shortfall, the margin and other amounts can be utilised
to pay off the dues of such constituents. 12
The exchange has first lien over every property of a member in its possession.
The exchange also has right of suspension or declaration of default of the
member in case the member is not able to satisfy the shortfall within a
specified time.
There are position limits in each contract set by SEBI
and/or the exchange for one participant and also market wide limits for one
particular contract. Such restrictions are necessary to observe and restrict
potential manipulation in the derivatives market. Special limits were also
prescribed for Foreign Institutional Investors and Mutual Funds. These limits
are constantly reviewed and changed as liquidity demands change. 13
VI. System Regulations
A deeply divisive development was the role of so-called
“circuit breakers”. The two types of circuit breakers are the “collar” and the
market-wide trading halt. Individual collars restrict the trading beyond the
price band of 8 or 16 percent for a specified time. The collar has been removed
from the most liquid scrips.
Market-wide trading halts are designed, among other things,
to allow parties to ensure that their counterparties are solvent and facilitate
price discovery by providing time for value traders to enter the market. At the
same time, however, concerns have been expressed that they may prove
ineffective and, more significantly, they may create greater market
uncertainty, thereby contributing to more market difficulties.
The provision for suspension of a contract or of the market
is self-explanatory. A contract in a particular derivative or the entire market
can be suspended for the following reasons: 14
• suspension of trading in the underlying securities;
• for protection of the interests of investors;
• for the purpose of maintaining a fair and orderly market.
In this connection, a multitude of reforms have been
undertaken which have substantially strengthened the resilience and
effectiveness of the clearance and settlement system. While, of course, these
changes do not mean that additional steps, or constant vigilance, are
unnecessary, they are one area where the sustained efforts of the regulators
and the industry have produced real changes for the better.
The most notable change was the shift from T+5 to T+3
settlement. Recognizing that “time equals risk” the SEBI required the shift to
T+3 settlement in an effort to reduce that risk and helped harmonisation
of global settlement time frames, and better align stock settlement practices
with the derivative markets. Indeed, there is continued discussion of further
reducing the settlement time to T+2. In addition, as important as the shift to
T+3 settlement is the planned development of a same-day funds settlement system
– which is currently being delayed by system weaknesses in the Indian Banking
system. When effected, the shift would reduce overnight exposure and also
achieving greater conformity with the payment methods used in derivatives
markets, government securities markets and foreign markets.
The surveillance division of the exchange attempts to
ensure market integrity. The fact that the derivatives market is inherently
connected with the cash segment means that surveillance needs to be unified in
its approach. Ideally, surveillance should be coordinated between all exchanges
and to the extent possible between exchanges in different countries for the
same contract. 15
Large positions are monitored by the surveillance divisions and they regularly
send notices to members they consider might be involved in suspicious activity.
Since large transactions are automatically marked for review by the surveillance
division, a more cumbersome review of every trade would only be required where
small trades are reported to be in violation of some regulation.
VII. Default Regulations
The clearing corporation acts as the common agent of the
Members for clearing contracts between Members and for delivering securities to
and receiving securities from and for receiving or paying any amounts payable
to or payable by such Members in connection with any contracts and to do all
things necessary or proper for carrying out the foregoing purposes.
The clearing corporation stands as a counter-party 16
in the trade. Therefore in the event of default of any member, the settlement
is completed by pulling money out of the Trade Guarantee Fund and completing
the settlement. Subsequently the defaulting party is pursued by the exchange
which is holding the member’s deposits and margins in lien. The extent of loss
is usually limited in the event of default because of the T+3 settlement in the
cash markets and the daily settlement in the derivatives markets. A second
protection is the fact that if a client defaults the Member is responsible for
its actions. The third line of defence of course is
the fact that the clearing house stands as a guarantor/counter-party to each
trade. Payment for the guarantee/counter-party is made out of a Trade Guarantee
Fund. The last line of defence is an insurance cover
on the Trade Guarantee Fund if it gets completely depleted. Because of the
algorithm fed into the trading system, there is a real time/continuous
surveillance of positions of members and there is little systemic risk involved
as far as the solvency of the exchange is concerned.
On default the exchange may close out open positions of the
defaulting member. However, such close out creates a problem for people
clearing or trading through such member. Their positions would also normally be
closed out. This is a weak part of the regulations because clients or trading
members are faced with a close out of their entire portfolio despite the fact
that they were in good standing. However, the exchange leaves the possibility
of transfer of positions of such member to other clearing/trading member in the
derivatives segment. If the default of the Clearing Member is due to the
default of its Trading Member or the Trading Member’s client, then the clearing
house can exercise lien over such defaulting party’s properties. Closing out is
usually effected by auction or placing an order or using a formula to come to a
price.
A member can be declared defaulter if it defaults on any
payment obligations, or any other obligations imposed according to the
regulations, or if an arbitration order is not followed, or if it is declared
defaulter in another segment or another exchange. Suspension of membership
entails a temporary bar on trading/clearing rights of the person while
expulsion is a permanent exclusion of the persons from membership. Default in
one segment will automatically make a person a defaulter in all segments of the
exchange. Suspension in one segment will similarly entail suspension from all
segments of the exchange.
In the event of declaration of default of a member, all its
positions can be either closed out or at the discretion of the clearing house
transferred to another member willing to accept the exposure. The shortfall is
met by the Clearing House by invoking the Trade Guarantee Fund.
D. Use of the Trade Guarantee Fund
In the event of any default, the Trade Guarantee Fund pays
to the clearing house the amount of money that the member had defaulted in the
settlement in which the default was made. Such payments are made before the
beginning of the next settlement cycle which, in the absence of holidays, is
the next day. Such settlements can be withdrawn after giving notice, if
evidence of fraud or collusive behaviour are evident in the claim. The Trade
Guarantee Fund funds can be used for the settlement of the defaulting member in
the settlement in which it defaulted and no other. Further, all dues of the
defaulter are not covered by the fund but only the settlement dues of the
member.
E. The Investor Protection Fund
The fund was established to protect such investors who
suffer not as a result of a member defaulting its settlement dues, but for
making whole an investor who despite a proper settlement is not paid his/her
due by the member.
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1 Harry
Markowitz and William Sharpe
2 Though the Bombay Stock Exchange and BSE were never
officially known by that name, the moniker has stuck for decades. It was
originally the “Native Share and Stock Exchange”, then the “Stock Exchange,
3 See NSE’s Indian
Securities Market – A Review, 2001.
4 See Regulatory Implications of Monopolies in the
Securities Industry, J.R. Varma, Working Paper
No. 2001–09-05, September 2001, Indian
6 References made hereafter shall be to the Bombay Stock
Exchange. Rules, Bye-laws and Regulations shall thus refer to those of the BSE.
Since I was involved in the drafting and policymaking of the derivatives
segment for the BSE, I have followed their regulations more closely. However,
except for some minor differences in nomenclature (e.g., guarantee v.
counter-party), the structure and regulations of the exchanges reflect a
common schema.
7 See: “Looking Backward – Looking Forward”, Futures
& Derivatives Law Report Vol 17, No. 7, October
1997, Brandon Becker and
9 To the extent the contributions are non refundable base
minimum capital
11 See Vinay Bubna v. Stock Exchange, Mumbai AIR 1999 SC 2517 where
the court held that the rights of the Exchange were superior to those of
general creditors as far as assets with the exchange were concerned. That
judgment would be applicable mutatis mutandis to the derivatives segment
as well.
13 Initially there was a 15 percent open interest or Rs. 100 crore (1 crore = 10 million) limit for each Trading Member. A client
had a disclosure requirement for ownership of above 15 percent of a contract
though no exposure limits.
15 For instance NSE’s nifty
futures are traded on
16 In the case of BSE, the exchange gives an
unconditional guarantee instead.
Published by BNA
International Inc.