India’s famed equity market infrastructure has had a settlement failure. A headline like this would have created shock waves at first, and invited a chorus of protests later. Chief among the protestors would be NSE Clearing Ltd, which happens to be where the failure has occurred. Certain Nifty options trades that should have settled in end-June are still in a state of limbo, because the legal system of the country is coming to grips with an alleged fraud committed by one of the counterparties to the trades.

NSE Clearing often waxes eloquent about its robust risk management framework. One would have thought troubles at one counterparty should not affect the settlement of a trade, since, after all, the clearing corporation becomes the legal counterparty to each trade through a process known as novation. But defendants of India’s clearing infrastructure will be quick to point out that the settlement in question has not failed, but delayed, because NSE’s hands are tied by a court order.

For background, broking firm Allied Financial Services allegedly stole its clients’ mutual fund units to post collateral and create a large Nifty options position. The said securities are now frozen by the Economic Offences Wing. IL&FS Securities, which acted as the clearing member for Allied, has applied for an annulment of the trades in question, citing that the collateral it received in good faith has vanished.

A moot question is where Securities and Exchange Board of India (Sebi) stands on all this. A number of trading firms have been hung out to dry, with no sign of the funds they were supposed to receive from the Nifty options trade. Will Sebi ensure the novated trades get settled and rise to protect the image of India’s equity market infrastructure? This should have been a no-brainer; in fact, many may even wonder why Sebi wasn’t listed as the likely protestor-in-chief.

But Sebi, unfortunately, has been found wanting in this case. It has dithered on ruling on IL&FS’s application, despite being told off by Securities Appellate Tribunal to dispose the case in a time-bound manner. NSE Clearing has already rejected the application to annul the trades.

Interestingly, NSE Clearing still has enough collateral from IL&FS to clear the disputed trades. This is because Sebi has, since March this year, mandated collection of collateral in cash in the case of options that are in the money. This means IL&FS Securities at some point had to post cash collateral with NSE Clearing for this particular trade. As such, the attachment of the disputed mutual fund units has resulted in a hole in IL&FS’s books, and not those of the clearing corporation.

As J.R. Varma, professor of finance, IIM Ahmedabad, points out in his blog, “This is a petty dispute that has been holding the Indian market to ransom."

“The burden of preventing this tragedy lies primarily with the regulator who has the responsibility and mandate to draw the judiciary’s attention to the systemic issues and national interest involved in the smooth functioning of our market infrastructure. A $50 million dispute should not be allowed to threaten the integrity of a $2 trillion stock market," he adds.

As things stand, Sebi is taking the lead in engaging in confusing legalese, rather than standing up to its true identity of being the protector of India’s markets. Sebi should instead rise to the occasion and point out to the courts that NSE Clearing has the funds to settle the disputed trade, and that the dispute between IL&FS Securities, Allied and its clients is a separate matter that can be dealt with by the courts independently.

As Varma says, the judiciary cannot be expected to understand the import of the above dispute. It’s Sebi that has to pitch in with the big picture view.

As a country, we can fool ourselves that this is a one-off case and that the image of India’s equity market infrastructure will not be tarnished as a result. But whether you call the failure to settle trades a delay or a technical default, the fact remains that a number of firms haven’t been paid their dues by the country’s largest clearing corporation. Similarly, the attachment of collateral raises questions of its own. Who will want to clear trades if it can disappear into thin air on an allegation of fraud? Then, there are questions on how securities can be stolen from the depository in the first place.

Sebi should stand up and provide clear answers and direction on each of these matters. By being reticent, it is undermining confidence in India’s market infrastructure.

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