The Securities and Exchange Board of India (Sebi) is looking at the possibility of linking India’s clearing corporations, one of its executive directors said last week. Also known as interoperability between clearing houses, this will allow stock exchanges offer its members the option of clearing trades with a clearing corporation of their choice.
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Currently, each stock exchange has its own exclusive clearing corporation. With interoperability, an investor could trade on, say the Bombay Stock Exchange (BSE), and get the trade cleared through the National Stock Exchange (NSE), or vice versa. This will result in efficient use of capital for trading members who take positions on multiple stock exchanges. Some of these positions may be offsetting in nature and would hence result in a much lower outgo on margins and collateral.
Some investors may have other reasons for dealing with only one clearing corporation. For instance, they may be comfortable with the risk management practices of only one clearing corporation. With interoperability, such investors can park all their collateral with this one clearing house, and at the same time benefit from the better prices other trading venues may have to offer.
Besides, there are many investors who now trade on only the primary exchange, just to avoid dealing with two clearing houses and cough up additional collateral. In fact, there are investors who aren’t availing the benefit of smart order routing to save on trading costs because of the same reason. With smart order routing, investors can route their orders to the trading venue that offers the best price at any given point. Often, this results in a split order, with some of it getting executed on the primary exchange and the balance on the secondary exchange. But this then involves dealing with two clearing houses and posting collateral with both of them. To avoid this, many investors just stick to trading at the primary exchange. Needless to say, this gets in the way of better competition in the market place.
Additionally, when clearing corporations aren’t linked to just one exchange but offer clearing services to other venues as well, competition among trading venues is enhanced. In fact, this is one of the factors that drove competition in the US and European markets. Start-ups didn’t have to worry about establishing credibility for newly set up clearing corporations. They just used clearing services of existing providers, who were already established and trusted in the marketplace. Currently, this isn’t possible in the Indian marketplace. But with interoperability, new trading venues can approach already established clearing corporations to clear their trades.
Clearly, the marketplace will benefit when interoperability between clearing houses becomes operational. Having said that, its implementation should be a well-thought-out process, which culminates in a thorough legal and operational framework. Regulators in Europe have been working at introducing interoperability between clearing houses for around two years now. Progress has been slow because of concerns about systemic risk. If a fail-safe legal process is not in place, interoperability will introduce the risk of contagion, where one troubled clearing house can bring down others.
J.R. Varma of Indian Institute of Management, Ahmedabad, says that no one should be mistaken that making interoperability work is a trivial issue. According to him, issues such as what procedure is to be followed when a clearing member goes bankrupt and how the collateral related to a trade guaranteed by another clearing house is to be treated should be deliberated upon and a precise legal arrangement should be in place to deal with these issues.
At the Trade Tech conference in April this year, it became evident that while BSE is quite supportive of introducing interoperability, NSE is relatively more cautious. It looks like it won’t be long before one hears of charges that the latter is delaying the introduction of interoperability because of irrational fears. There were similar charges made when the implementation of smart order routing and mobile trading got delayed.
Needless to say, there will be divergent views about interoperability. In fact, even some investors such as pension funds will question the need for interoperability. All their trades result in delivery and with hardly any offsetting positions, they would not benefit from interoperability. On the other hand, exchanges and clearing houses would have to spend more on technology and risk management systems to make interoperability work smoothly. This will result in increase costs for investors. On the whole, however, it is clearly good for the marketplace and the regulator should start work on making it operational.
But if the process gets delayed because of divergent views on the subject, then no one else but the regulator is to blame. After all, the role of an independent regulator is to consider different views and make the final judgement. While the Sebi executive’s recent statement suggests that the issue of interoperability is in the regulator’s radar, it would do well to start taking market feedback and begin the process of making it operational.
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