New checks to ringfence markets from defaults, systemic risks

To safeguard stock markets from any systemic risks arising out of trade and payment defaults, regulator Sebi is bringing in a new regulatory regime next week to ensure timely payment settlements and to keep the systems robust by way of daily 'stress tests'.

The new mechanism, which would come into force from December 1, are aimed to mitigate the risks faced by overall markets due to defaults by certain entities and would also include setting 'default waterfall' marks to limit the liability of non-defaulting entities.
The new stress testing norms would require that at least on a monthly basis, the Clearing Corporation perform a comprehensive and thorough analysis of stress testing scenarios, models, and underlying parameters and assumptions used to ensure necessary default protection measures in light the of current and evolving market conditions.

The stress testing norms will also capture the risk posed due to possible default in institutional trades, as per the new guidelines.

Besides, a daily stress test would need to be conducted to determine the Minimum Required Corpus of Core Settlement Guarantee fund, which would be needed to be set aside from the overall Settlement Guarantee Fund of a market infrastructure institution.

This new core fund would be created within the existing Settlement Guarantee Fund (SGF), against which no exposure is given and which is readily and unconditionally available to meet settlement obligations of clearing corporation in case of clearing members failing to honour settlement obligation.

The stress tests would need to be conducted for credit risk, liquidity, adequacy of liquidity arrangements and for back testing for adequacy of margins, among others.

The new regime is aimed at enhancing the robustness of the present risk management system of the clearing corporations to enable them to deal with defaults of the clearing members much more effectively.

Sebi has from time to time put in place various risk containment measures to address the risks involved in the securities market. One such measure prescribed was norms for Settlement Guarantee Fund (SGF) at stock exchanges including corpus, contribution, management, usage and recoupment of the fund corpus.

The new norms are aimed at further strengthening the system to deal with settlement defaults, although there have been very few such cases in recent times, as settlement commitments have mostly been met even in times of freak trades and temporary outages on stock exchange platforms.

Clearing corporations are required to maintain sufficient resources to cover losses due to major defaults in the market so as to avoid any systemic risk.

The new guidelines, which were discussed by Sebi's board last week, have been finalised after extensive deliberations by Sebi's Risk Management Review Committee with clearing corporations, stock exchanges and various market participants.

The current practice followed by clearing corporations in the country for quantifying settlement guarantee resources is to also include margins of all members.

As margins are against positions, there are difficulties felt in estimating the correct value of resources readily available to meet settlement shortages in case of default by members.

"The new guidelines will remove these difficulties by creating the Core SGF as a second layer of defence, against which no exposure is allowed and thus will always be available in sufficiently liquid form," Sebi has said.

According to the regulator, at least 50 per cent of minimum required corpus for the new fund would be from clearing corporations and at least 25 per cent from stock exchange and upto 25 per cent from clearing member.

"Penalties levied by clearing corporations will also be credited to Core SGF," the regulator said.

As per the present 'default waterfall' of clearing corporations, residual losses after exhausting resources available in other layers of the waterfall are to be allocated to the non-defaulting clearing members. Thus, effectively under such circumstances there is no limit to the liability of non-defaulting members in the event of extreme loss.

The new guidelines have provisions regarding manner for limiting the liability of non-defaulting members. It would also harmonise default waterfall across clearing corporations and would adequately ring-fence each segment of clearing corporations from defaults in other segments.

While aligning the stress testing practices of clearing corporations in India with best global practices prescribed by IOSCO (global body of regulators), the new system would also take into account risk due to possible default in institutional trades.