Sebi takes a good first step in reviewing risk management

Securities and Exchange Board of India (Sebi) has made a break from the past by inviting public comments for its review of risk management of clearing corporations. In the past, the capital markets regulator has typically conducted internal reviews with the help of an advisory committee, before issuing a tersely worded circular that informs the market of changes to market structure.

To be fair to the regulator, its risk management review committee includes academics and representatives from domestic and foreign brokers, exchanges and clearing corporations. So it is already getting market voices in before making important decisions. Even so, some constituencies such as retail investors aren’t represented, and so the approach of releasing a discussion paper and inviting comments from the public makes immense sense.

In fact, one of the features of the proposed “Indian Financial Code”, drafted by the Justice Srikrishna Commission on financial sector legislative reforms, is that regulators first publish a draft of their proposed regulations. The Code adds that this draft should also state the objectives of the proposed regulations, the problems they seek to address, the expected outcome, and a cost-benefit analysis of the proposed regulations. While Sebi’s discussion paper isn’t as detailed, it describes the issues at hand fairly well.

The first proposal being considered by the regulator is a fairly straightforward one. In the current risk management framework, with the exception of institutional trades in the cash equity segment, trading members have to post margins for every trade with the exchange’s clearing corporation. But for one segment of the market, clients using the Internet trading facility of trading members, 100% of the cash/securities are blocked at the designated bank/depository participant before the trade is entered. As a result, this segment poses no risk of default to the broker. Still, the broker is required to pay upfront margin against these trades to the clearing corporation. Sebi has invited comments on whether this restriction can be lifted. Of course, it must be noted here that while there is zero risk from the client since the funds/securities are blocked, the clearing corporation will still face the risk of the broker defaulting. But this can be dealt with through operational tweaks to ensure that the risk to the clearing corporation is not compromised. Sebi is even willing to consider incentivizing customers that use this mode of trading, by means of lowering clearing fees, since they post no risk to the system. While this will be a good move for such investors, it must be noted that they represent a small portion of the overall market. And given where Internet usage is, it will be unreasonable to expect any meaningful shift to this form of trading. In any case, clearing fees form a minuscule portion of trading costs and are immaterial for customers using Internet trading facilities. While on the topic, Sebi must consider extending the same benefits to institutional investors who are willing to transfer funds/securities on a pre-trade basis.

Sebi’s other two proposals are more far-reaching, but at the same time are far more complicated. The current settlement system works on a “T+2” basis, which means that trades are settled two days after they are executed. As a result, the clearing corporation is, at any given point, carrying the risk of trades done in two trading sessions. If the settlement time is cut to “T+1”, its risk will reduce materially. Needless to say, cutting the settlement time is easier said than done. While domestic institutional investors as well as other investors based in tier-1 cities will manage to meet the deadlines for pay-ins of funds/securities, some overseas investors and those based in smaller towns are likely to struggle. Sebi must do a thorough cost-benefit analysis before seriously considering this proposal.

The other major proposal is to move towards segregation of client assets, so that they can be protected in the event of a trading member’s default. It’s heartening to note that Sebi is addressing this issue, even though warnings on this front have come from overseas incidents such as the failure of MAN Financial. A number of overseas regulators are also working on new regulations to protect client assets. According to one market expert, it’s incorrect to assume that regulations can protect investors from all risks. He adds that protecting client assets is an area which the regulator should study thoroughly so that any step it takes doesn’t lead to unintended consequences. In the Indian context, the good news is that trading members already collect margins and prepare detailed collateral reports in the equity derivatives market. One of Sebi’s two proposed models to protect client assets envisages taking this process forward, by allowing the clearing corporation to “enshrine” or preserve margins posted by clients and not use them to fulfil obligations of a defaulting trading member. Needless to say, Sebi is likely to receive a number of representations on why some of these proposals should not be implemented. The regulator will do well to respond to these concerns publicly, if it decides to overlook them eventually.

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