Home >Opinion >Online-views >Does postponement of the interoperability question make sense?

It’s been over two years since the Securities and Exchange Board of India (Sebi) appointed a committee headed by K.V. Kamath to examine the viability of introducing a single clearing corporation or interoperability between different clearing corporations. Interoperability would allow trading companies to clear trades through a firm of their choice, rather than the current arrangement of necessarily going through the clearing house owned by the trading venue on which the trade was executed. For perspective on the interoperability proposal, see

Although the subject was complex, the time should have been sufficient for the committee to come up with firm recommendations. Instead, the main recommendation on interoperability comes across as a bit rushed. The committee said that “Sebi may keep the interoperability option open and consider the proposal for implementation when ground conditions are met, which, inter alia, include clear intent of the participants coming together and having a suitable framework in place to the satisfaction of Sebi."

This is, in effect, saying that when market participants get everything ready for interoperability to take off, Sebi can consider the proposal. There is hardly any incentive for competing clearing corporations to sit across the table and hammer out a framework for interoperability. The smaller clearing firms may fear, for instance, that market participants will take all of their clearing business to the larger, or better capitalised clearing firms. On the other hand, the largest firm may fear that it may lose its captive business—currently guaranteed because of a majority share in the trading business—as a result of undercutting by competitors. Besides, if not all, at least some clearing corporations will frown at the risk management practices of competitors, and vigorously resist being linked to firms that, in their opinion, are weakly managed. In this backdrop, there is no way market participants will come together.

It’s in this context that the Kamath committee’s main recommendation is disappointing. It should have either said that interoperability is not viable or, if it saw merit in the proposal, should have itself laid down a framework for its implementation.

Among other benefits of interoperability, it would result in better use of capital by trading firms, as well as better trading alternatives. As pointed out in this column earlier, there are many investors who now trade on only one exchange, just to avoid dealing with two clearing houses and cough up additional collateral.

To be fair to the Kamath committee, it has described the complexities involved in making interoperability work. This has largely to do with how a clearing house will manage its exposure if a clearing house, with which it is linked, defaults. But while the report has discussed various options, it hasn’t recommended any preferred method to address these issues.

It alludes to the regulation of commodity markets by Sebi from this year as one of the reasons interoperability shouldn’t be considered at this juncture. On one hand, this is a reasonable assessment. Operations of clearing companies run by commodity exchanges are quite different from those run by equity exchanges. For one, they are housed within the exchange, unlike their equity counterparts, which run clearing operations through a separate entity. But having said that, the requirement that commodity exchanges adhere to Sebi norms of separating their clearing operations is a strong reason why Sebi will soon have to revisit a related issue.

There are some small-sized commodity exchanges, which will find Sebi’s 300 crore minimum net worth requirement cumbersome to meet, at best, and impossible to meet, at worst. They would rather tie up with an existing clearing corporation to clear trades, than set up a new entity from scratch. It would have been nice if there were existing guidelines on how these companies were to go about this.

According to an expert in market microstructure, while interoperability has its benefits, it also brings along complicated questions such as risks posed by the clearing of over-the-counter (OTC) products, and the earlier mentioned question of handling the risk of a default by a linked clearing house. World over, there has been an increasing trend of centralised clearing of OTC products after the financial crisis. This has increased the possibility of failure of these clearing houses, given the difficulty in pricing and margining OTC products.

It won’t be surprising if, in this backdrop, a clearing house defaults. In such a scenario, it’s fair to ask the question if clearing corporations should be linked at all.

In India, OTC products are not cleared by entities regulated by Sebi—although the scenario could change in the future. For now, given that they clear exchange-traded products, the interoperability proposal could have been considered.

Of course, as is evident from the muted response to the committee’s proposals, it is evident that interoperability isn’t very high on the agenda of market participants. As such, they may well excuse the regulator for maintaining the status quo on this front.

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