Risk Containment Measures In Derivatives Exchanges

Course: 205/Risk Management & Derivatives

Group Members Bhanupriya Gupta [2009] G. Venubabu [2012] Kshitiz Sinha [2018] Mithun Roy [2021] Saikiran K [2025] Sandeep K Biswal [2027]

Risk containment measures in derivatives exchanges: NSE (F&O)

1. Introduction National Securities Clearing Corporation Limited (NSCCL) which undertakes clearing and settlement of all trades executed on the futures and options (F&O) segment of the NSE has developed a comprehensive risk containment mechanism.

2. A few broad points on risk containment measures The financial soundness of the members is the key to risk management. Therefore, the requirements for membership in terms of capital adequacy (net worth, security deposits) are quite stringent. NSCCL charges an upfront initial margin for all the open positions of a Clearing Member (CM). It specifies the initial margin requirements for each futures/options contract on a daily basis. It follows Value-at-Risk (VaR) based margining computed through Standard Portfolio Analysis of Risk (SPAN). The CM in turn collects the initial margin from the Trading Members (TMs) and their respective clients. The open positions of the members are marked to market based on contract settlement price for each contract at the end of the day. The difference is settled in cash on a T+1 basis. NSCCLs on-line position monitoring system monitors a CMs open position on a realtime basis. Limits are set for each CM based on his effective deposits. The on-line position monitoring system generates alert messages whenever a CM reaches 70 %, 80 %, 90 % and a disablement message at 100 % of the limit. NSCCL monitors the CMs for Initial Margin violation, Exposure margin violation, while TMs are monitored for Initial Margin violation and position limit violation. CMs are provided with a trading terminal for the purpose of monitoring the open positions of all the TMs clearing and settling through him. A CM may set limits for the

TM clearing and settling through him. NSCCL assists the CM to monitor the intra-day limits set up by a CM and whenever a TM exceeds the limits, it stops that particular TM from further trading. A member is alerted of his position to enable him to adjust his exposure or bring in additional capital. Margin violations result in disablement of trading facility for all TMs of a CM in case of a violation by the CM. A separate settlement guarantee fund for this segment has been created out of deposit of members.

3. Risk containment measures in detail

3.1 Capital Adequacy Requirements As compared to the minimum statutory requirements as also those stipulated by other stock exchanges, the capital adequacy requirements stipulated by the NSE F&O are higher. The capital adequacy norms to be followed by members are presented in the following table.

Capital adequacy norms for membership on NSE F&O (Rs. in Lakh) Members of Professional Clearing Members of Requirement Net Worth Interest Free Security Deposit Collateral Security Deposit CM and F&O 100 125 25 CM, WDM and F&O 200 275 25 CM and F&O 300 34 50

Out of the total capital provided by the TM (Base Minimum Capital and Additional Base Capital), BMC can be utilized towards taking exposure/turnover only, whereas the amount provided as ABC can be utilized towards margin payment if not used up for taking Exposure/Turnover.

3.2 Margins

3.2.1 Categorization of stocks for imposition of margins The stocks which have traded at least 80% of the days for the previous 18 months shall constitute the Group I and Group II. Out of the stocks identified above, the stocks having mean impact cost of less than or equal to 1% shall be categorized under Group I and the stocks where the impact cost is more than 1%, shall be categorized under Group II. The remaining stocks shall be classified into Group III.

The impact cost shall be calculated at 15th of each month on a rolling basis considering the order book snapshots of the previous six months. On the basis of the impact cost so calculated, the securities shall move from one group to another group from the 1st of the next month.

3.2.2 Daily margins payable by members consists of the following: Value at Risk Margin (VaR) Mark to Market Margin (MTM)

Daily margin, comprising of the sum of VaR margin and mark to market margin is payable. The margins are computed at client level. A member entering an order needs to enter the client code. Based on this information, margin is computed at the client level, which will be payable by the trading members on T+1 basis.

Mark to Market Margin Mark to market margin is computed on the basis of mark to market loss of a member. Mark to market loss is the notional loss which the member would incur in case the cumulative net outstanding position of the member in all securities, at the end of the relevant day were closed out at the closing price of the securities as announced at the end of the day by the NSE.

Value at Risk Margin The VaR rate is applied to gross exposure to determine VaR-based margin. VaR rate is a single number, which encapsulates whole information about the risk in a portfolio. It measures potential

loss from an unlikely adverse event in a normal market environment. It involves using historical data on market prices and rates, the current portfolio positions, and models (e.g., option models, bond models) for pricing those positions. These inputs are then combined in different ways, depending on the method, to derive an estimate of a particular percentile of the loss distribution, typically the 99th percentile loss.

3.3 Settlement Guarantee

After the execution of trade, the clearing corporation becomes the counter-party to the transaction and ensures that funds and securities obligations are met. The clearing corporation provides the guarantee and key link between clearing and settlement activity. It operates like a self-insurance mechanism where members contribute to the Fund. In the event of failure of a trading member to meet settlement obligations or committing a default, the Fund is utilized to the extent required for successful completion of the settlement. This has eliminated counterparty risk of trading on the Exchange. As a consequence, despite the fact that the daily turnover at times exceeds Rs. 10,000 crore, credit risk no longer poses any threat in the market place. The market has full confidence that settlement shall take place in time and shall be completed irrespective of default by isolated trading members.

3.4 No-delivery Period

Whenever a book closure or a record date is announced by a company, the exchange sets up a no-delivery period for that security. During this period, trading is permitted in the security. However, these trades are settled only after the no delivery period is over. This is done to ensure that investors entitlement for the corporate benefits is clearly determined. However, there is no no-delivery period on account of book closures and record dates for corporate actions, such as, issue of dividend and bonus shares, in respect of the stocks which are traded in the compulsory dematerialized mode. The time gap between two book closures/record dates is 30 days.