Risk Management & Indian Capital Markets.

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Reforming Payment and SecuritiesSettlement Systems –

Global Course organised by theWorld Bank and US Federal Reserve Board

Session onMain Environmental Issues inPayments and Securities

Settlement Systems



y

2

Agenda

Issues in Payment and Settlement Systems

Sharing the Indian Experience

Current market structure The process

Regulatory and legal framework

Supervisory framework Governance and Ownership structure

Risk management

Managing the change



3 © Reynolds and Hines, 2000

What drives the reforms• Settlement risks

• Iliquidity

• Market inefficiency

Basically benefit driven reforms

The strategic process and

need for sequencing• PSS reform an integral part

of market reforms

• Market process integrated

end to end

Hence sequencing needed

Manage the change

• Efficient management

of change – regulatory support

• Take market participants along

• Assess end-users’ needs

• Use technology and skill set

What drove PSS reforms in

India• securities market critical to

the economy

•

Demand from the end usersSEBI – key driver of the change

Issues in Reforming Payment and

Securities settlement Systems



4

Full range of products in cash and derivatives

market – • equity, bonds, government securities,

exchange traded funds, index options

and futures, stock options and stock

futures, interest rate derivatives and

propose to introduce currency derivatives.

• OTC market for corporate bonds and

government securities, and interest rate

derivatives also exist


Current market structure



5

The objectives of the reforms

in the securities settlement systems –

Reduction and mitigation of systemic,

structural and operational risks

Increase speed of transaction, execution

and settlement of trade and facilitate

Quicker settlement of transactions with finalitySafety of the settlement process

Reduction of transaction costs and thereby

Make market more efficient and transparent

for investors and participants


Current market structure



6


Current market structure (contd.)

T+2 Rolling Settlement

Central Counterparty providing novation and settlement guarantee

Electronic Transfer of Securities99.99% settlement in dematerialised securities

Limited Straight Through Processing (not yet mandatory for

participants)

Fine-tuned VaR based Risk Management System for

cash and derivatives, including real time SPAN forderivatives

State of the art information technology

100% electronic trading which obviates need for trade confirmation

Finality of settlement from the moment trade is executed

ISIN for securities

Electronic and automated communication standards



7

Sharing the Indian Experience – The process

Market automation –

National Stock Exchangeset up in in 1994; SEBI

first encouraged and then

mandated automation ofall 23 stock exchanges,

which was completed by

end 1997



8


Dematerialisation

began with the setting upof NSDL under an Act in

1996. It gathered momentum

from 1998 with SEBI

mandating it for the marketin a phased manner . By 2000

the market was settling in

dematerialised securities.



9


During this period several

other measures were taken

Broker domination was

reduced from governing

boards of exchanges

CCPs and Trade guarantee

funds were set up at the

exchanges to guaranteesettlement

BUT the trading in securities was still

account period and derivatives had not

picked up at all.



10


The automation of exchanges,

dematerialisation and CCPs had

prepared the market for a major

transformation.This happened following an

episode of major market

misconduct in 2000.

From June 2001 account periodsettlement was abolished by SEBI

and T+5 rolling settlement was

introduced.

Derivatives trading began to take

off



11

Between 2002 –till date rapid progress

in market reforms

Settlement cycles shortened to T+3in April 2002, to T+2 in April 2003

Derivatives products expanded –

to include single stock options and

futures. The market picked upMargining system in cash and

derivatives – VaR based and real

time SPAN

Risk management refined

STP introduced




12

Between 2002 –till date rapid progress in

market reforms (contd.)

Further changes in the governanceof the stock exchanges

Role of brokers in the management of

stock exchanges eliminated

Demutualisation of stock exchanges withsegregation of trading ownership and

management rights.

Electronic fund transfer introduced by RBI

RTGS to be set up soon

CCIL settles G-sec trading on NDS




13


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BANKS

CUSTODIAN /

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EXCHANGE

DEPOSITORY

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For reforms of the Securities Paymentand Settlement Systems to be effective,

reforms must be sequenced so as to

embrace every part of this process,

as all the parts are integrally related



14

Regulatory framework for securities markets :

Securities and Exchange Board of India Act,1992 (SEBI

set up under this Act); Securities Contract (Regulation) Act, 1956

(Act to establish and regulate exchanges);

Depositories Act, 1996 (regulates depositories);

Companies Act, 1956

SEBI regulates and supervises the securitiesmarkets through 23 Regulations and 2 Guidelines.

SEBI exercises powers under the first 3 Acts and

some powers under Companies Act.

In addition the bye laws, rules and regulations of exchanges

approved by SEBI

Sharing the Indian ExperienceRegulatory and legal framework



15

Transparent and effective regulation and oversight of

securities settlement system is thus largelybased on statutes.

These statutes and regulations, together with the

bye laws, rules and regulations of theexchanges, which are under constant review

provide a well founded, clear and transparent

legal basis for trading, settlement, enforcement

of securities contracts and protection of

investors interests.

Sharing the Indian ExperienceRegulatory and legal framework



16

Well founded, clear and transparent legal basis

for trading, settlement, enforcement ofsecurities contracts and protection of investors

interests.

Transparent and effective regulation and

oversight of settlement system largely basedon statutes.


Regulatory and legal framework



17

SEBI supervision over the stock exchanges,clearing

houses and corporations, stock brokers,

depositories and depository participants, throughconstant dialogue, periodical meetings, reporting

and annual inspection and review.

Any change in bye laws, rules and regulations of

exchanges and depositories need the approval ofSEBI

The risk management of the cash and derivatives

market laid down in consultation with SEBI

Sharing the Indian ExperienceSupervisory framework



18

Sharing the Indian ExperienceGovernance and Ownership structure

Institution Ownership Governance

National Stock Exchange Domestic FinancialInstitutions and banksOwned by financialinstitutions

Independent and

Shareholders; nobroker as office bearer

Other exchanges Broker owned; in theprocess ofdemutualisation

Independent and

Shareholders; no

broker as office bearer

Clearing corporation 100% subsidiaries ofexchanges

Shareholder andindependent directors

NSDL, CDSL and

CCIL

Financial Institutions andbanks

RBI

Shareholders andindependent directors



19

All risk management measures need the approval of

the Securities and Exchange Board of India

Capital adequacy norms Trading and exposure limits

On-line exposure monitoring

Automatic disablement of members

VaR and MTM margining

Margining at client level Market wide circuit breakers

Trade/settlement guarantee funds

History maintenance of members activities

Contingent plans

Sharing the Indian ExperienceRisk management



20


Risk management (contd)

Margining For the Cash Market –

Securities categorised on measures of liquidity and volatility For liquidity - using mean impact cost analysis on the

basis of random snapshots (4 time a day) of daily orderbook over past six months on a rolling basis;

For volatility- using index sigma and stock sigma

Computation methodology disseminated to public throughthe web sites of the exchanges

Margins are on a gross basis – gross across securities forthe same client, but netted for the same secuirtiy

All calculations systems driven – no manual intervention atany stage, except for setting the algorithms

Above methodology validated by extensive back testing



21


Risk management(contd)

Margining For the Cash Market –

VAR margin covers a confidence interval of 99% over a

one day time horizon Second line of margining for the balance 1% scenario In addition Mark to market margin

Margins collected on T+1, before trading begins next day

Inability to pay margins results in automatic switching off ofmember terminal denying access for fresh orders

In addition members have gross exposure limits related to their

capital which is on line monitored real time by the exchanges

Margins to be brought in cash and government securities

(with hair cut) and bank guarantee from selected banks



22


Risk management(contd)

Both models of CCP available – Clearing Corporation of

National Stock Exchange set up by the exchange as

wholly owned subsidiary, acting as CCP to all trades and

novation with multi lateral netting

Stress tests done to check the adequacy of trade

guarantee funds of the CCP

So far no occasion in which the CCP has failed on

account of inadequacy of capital. The clearing corporation

of NSE has back stop liquidity facility with the central

bank by way of line of credit which it had no occasion to

draw upon in the last 7 years even under conditions ofextreme market volatility



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Sharing the Indian ExperienceRisk management for the Derivatives Market

CCP

SPAN system

Real time SPAN monitoring

Gross margining Margins paid upfront – cash or cash equivalent

Clearing member margin

Client level margins

Exposure limits – over all market wide position limits,

clearing member position limits, client level position limits Possible loss on entire portfolio of entire portfolio

estimated under a variety of price and volatility scenarios

Entire margin system with automatic shut off of terminals

in case of breach of exposures or non payment of margins



24

Extensive consultative process with the market

participants – helps build up consensus

Various consultative and advisory committees setup by SEBI comprising of market participants,

experts, academics Reports of the committees

put out for public comments

Consultation and coordination with other

regulators

Frequent meetings with the stock exchanges and

intermediary associations, chambers of

commerce

Extensive programme of investor awareness.


Managing the change

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