Reforming Payment and Securities Settlement Systems – Global Course organised by the World Bank and US Federal Reserve Board Session on Main Environmental Issues in Payments and Securities Settlement Systems

2 Agenda  Issues in Payment and Settlement Systems  Sharing the Indian Experience Current market structure Current market structure The process The process Regulatory and legal framework Regulatory and legal framework Supervisory framework Supervisory framework Governance and Ownership structure Governance and Ownership structure Risk management Risk management Managing the change Managing the change

3 © Reynolds and Hines, 2000 What drives the reforms Settlement risks Iliquidity Market inefficiency Basically benefit driven reforms The strategic process and need for sequencing PSS reform an integral part of market reforms Market process integrated end to end Hence sequencing needed Manage the change Efficient management of change – regulatory support Take market participants along Assess end-users’ needs Use technology and skill set What drove PSS reforms in India securities market critical to the economy Demand from the end users SEBI – key driver of the change Issues in Reforming Payment and Securities settlement Systems

4 Full range of products in cash and derivatives market – equity, bonds, government securities, exchange traded funds, index options and futures, stock options and stock futures, interest rate derivatives and propose to introduce currency derivatives. OTC market for corporate bonds and government securities, and interest rate derivatives also exist Sharing the Indian Experience Current market structure Sharing the Indian Experience Current market structure

5 The objectives of the reforms in the securities settlement systems – Reduction and mitigation of systemic, structural and operational risks Increase speed of transaction, execution and settlement of trade and facilitate Quicker settlement of transactions with finality Safety of the settlement process Reduction of transaction costs and thereby Make market more efficient and transparent for investors and participants Sharing the Indian Experience Current market structure Sharing the Indian Experience Current market structure

6 Sharing the Indian Experience Current market structure (contd.) Sharing the Indian Experience Current market structure (contd.) T+2 Rolling Settlement T+2 Rolling Settlement Central Counterparty providing novation and settlement guarantee Central Counterparty providing novation and settlement guarantee Electronic Transfer of Securities Electronic Transfer of Securities 99.99% settlement in dematerialised securities 99.99% settlement in dematerialised securities Limited Straight Through Processing (not yet mandatory for Limited Straight Through Processing (not yet mandatory for participants) participants) Fine-tuned VaR based Risk Management System for Fine-tuned VaR based Risk Management System for cash and derivatives, including real time SPAN for cash and derivatives, including real time SPAN for derivatives derivatives State of the art information technology State of the art information technology 100% electronic trading which obviates need for trade confirmation 100% electronic trading which obviates need for trade confirmation Finality of settlement from the moment trade is executed Finality of settlement from the moment trade is executed ISIN for securities ISIN for securities Electronic and automated communication standards Electronic and automated communication standards

7 Sharing the Indian Experience – The process Market automation – National Stock Exchange set up in in 1994; SEBI first encouraged and then mandated automation of all 23 stock exchanges, which was completed by end 1997

8 Sharing the Indian Experience – The process Dematerialisation began with the setting up of NSDL under an Act in It gathered momentum from 1998 with SEBI mandating it for the market in a phased manner. By 2000 the market was settling in dematerialised securities.

9 Sharing the Indian Experience – The process During this period several other measures were taken Broker domination was reduced from governing boards of exchanges CCPs and Trade guarantee funds were set up at the exchanges to guarantee settlement BUT the trading in securities was still account period and derivatives had not picked up at all.

10 Sharing the Indian Experience – The process The automation of exchanges, dematerialisation and CCPs had prepared the market for a major transformation. This happened following an episode of major market misconduct in From June 2001 account period settlement was abolished by SEBI and T+5 rolling settlement was introduced. Derivatives trading began to take off

11 Between 2002 –till date rapid progress in market reforms Settlement cycles shortened to T+3 in April 2002, to T+2 in April 2003 Derivatives products expanded – to include single stock options and futures. The market picked up Margining system in cash and derivatives – VaR based and real time SPAN Risk management refined STP introduced Sharing the Indian Experience – The process

12 Between 2002 –till date rapid progress in market reforms (contd.) Further changes in the governance of the stock exchanges Role of brokers in the management of stock exchanges eliminated Demutualisation of stock exchanges with segregation of trading ownership and management rights. Electronic fund transfer introduced by RBI RTGS to be set up soon CCIL settles G-sec trading on NDS Sharing the Indian Experience – The process

13 Sharing the Indian Experience – The process CSACSA CLEARING BANKS CUSTODIAN / CM EXCHANGE DEPOSITORY CSA For reforms of the Securities Payment and Settlement Systems to be effective, reforms must be sequenced so as to embrace every part of this process, as all the parts are integrally related

14 Regulatory framework for securities markets : Securities and Exchange Board of India Act,1992 (SEBI set up under this Act); Securities and Exchange Board of India Act,1992 (SEBI set up under this Act); Securities Contract (Regulation) Act, 1956 Securities Contract (Regulation) Act, 1956 (Act to establish and regulate exchanges); (Act to establish and regulate exchanges); Depositories Act, 1996 (regulates depositories); Depositories Act, 1996 (regulates depositories); Companies Act, 1956 Companies Act, 1956 SEBI regulates and supervises the securities SEBI regulates and supervises the securities markets through 23 Regulations and 2 Guidelines. markets through 23 Regulations and 2 Guidelines. SEBI exercises powers under the first 3 Acts and SEBI exercises powers under the first 3 Acts and some powers under Companies Act. some powers under Companies Act. In addition the bye laws, rules and regulations of exchanges approved by SEBI Sharing the Indian Experience Regulatory and legal framework Sharing the Indian Experience Regulatory and legal framework

15 Transparent and effective regulation and oversight of securities settlement system is thus largely based on statutes. These statutes and regulations, together with the bye laws, rules and regulations of the exchanges, which are under constant review provide a well founded, clear and transparent legal basis for trading, settlement, enforcement of securities contracts and protection of investors interests. Sharing the Indian Experience Regulatory and legal framework Sharing the Indian Experience Regulatory and legal framework

16 Well founded, clear and transparent legal basis for trading, settlement, enforcement of securities contracts and protection of investors interests. Transparent and effective regulation and oversight of settlement system largely based on statutes. Sharing the Indian Experience Regulatory and legal framework Sharing the Indian Experience Regulatory and legal framework

17 SEBI supervision over the stock exchanges,clearing SEBI supervision over the stock exchanges,clearing houses and corporations, stock brokers, houses and corporations, stock brokers, depositories and depository participants, through depositories and depository participants, through constant dialogue, periodical meetings, reporting constant dialogue, periodical meetings, reporting and annual inspection and review. and annual inspection and review. Any change in bye laws, rules and regulations of Any change in bye laws, rules and regulations of exchanges and depositories need the approval of exchanges and depositories need the approval of SEBI SEBI The risk management of the cash and derivatives The risk management of the cash and derivatives market laid down in consultation with SEBI market laid down in consultation with SEBI Sharing the Indian Experience Supervisory framework Sharing the Indian Experience Supervisory framework

18 Sharing the Indian Experience Governance and Ownership structure Sharing the Indian Experience Governance and Ownership structureInstitutionOwnershipGovernance National Stock Exchange Domestic Financial Institutions and banks Owned by financial institutions Independent and Shareholders; no broker as office bearer Other exchanges Broker owned; in the process of demutualisation Independent and Shareholders; no broker as office bearer Clearing corporation 100% subsidiaries of exchanges Shareholder and independent directors NSDL, CDSL and CCIL Financial Institutions and banks RBI Shareholders and independent directors

19 All risk management measures need the approval of the Securities and Exchange Board of India Capital adequacy norms Trading and exposure limits On-line exposure monitoring Automatic disablement of members VaR and MTM margining Margining at client level Market wide circuit breakers Trade/settlement guarantee funds History maintenance of members activities Contingent plans Inspection and investigation Sharing the Indian Experience Risk management Sharing the Indian Experience Risk management

20 Sharing the Indian Experience Risk management (contd) Margining For the Cash Market –  Securities categorised on measures of liquidity and volatility For liquidity - using mean impact cost analysis on the basis of random snapshots (4 time a day) of daily order book over past six months on a rolling basis; For liquidity - using mean impact cost analysis on the basis of random snapshots (4 time a day) of daily order book over past six months on a rolling basis; For volatility- using index sigma and stock sigma For volatility- using index sigma and stock sigma  Computation methodology disseminated to public through the web sites of the exchanges  Margins are on a gross basis – gross across securities for the same client, but netted for the same secuirtiy  All calculations systems driven – no manual intervention at any stage, except for setting the algorithms  Above methodology validated by extensive back testing

21 Sharing the Indian Experience Risk management (contd) Margining For the Cash Market – VAR margin covers a confidence interval of 99% over a one day time horizon VAR margin covers a confidence interval of 99% over a one day time horizon Second line of margining for the balance 1% scenario Second line of margining for the balance 1% scenario In addition Mark to market margin In addition Mark to market margin Margins collected on T+1, before trading begins next day Margins collected on T+1, before trading begins next day Inability to pay margins results in automatic switching off of Inability to pay margins results in automatic switching off of member terminal denying access for fresh orders member terminal denying access for fresh orders In addition members have gross exposure limits related to their In addition members have gross exposure limits related to their capital which is on line monitored real time by the exchanges capital which is on line monitored real time by the exchanges Margins to be brought in cash and government securities Margins to be brought in cash and government securities (with hair cut) and bank guarantee from selected banks (with hair cut) and bank guarantee from selected banks

22 Sharing the Indian Experience Risk management (contd) Both models of CCP available – Clearing Corporation of National Stock Exchange set up by the exchange as wholly owned subsidiary, acting as CCP to all trades and novation with multi lateral netting Stress tests done to check the adequacy of trade guarantee funds of the CCP So far no occasion in which the CCP has failed on account of inadequacy of capital. The clearing corporation of NSE has back stop liquidity facility with the central bank by way of line of credit which it had no occasion to draw upon in the last 7 years even under conditions of extreme market volatility

23 Sharing the Indian Experience Risk management Sharing the Indian Experience Risk management for the Derivatives Market CCP SPAN system Real time SPAN monitoring Gross margining Margins paid upfront – cash or cash equivalent Clearing member margin Client level margins Exposure limits – over all market wide position limits, clearing member position limits, client level position limits Possible loss on entire portfolio of entire portfolio estimated under a variety of price and volatility scenarios Entire margin system with automatic shut off of terminals in case of breach of exposures or non payment of margins

24 Extensive consultative process with the market participants – helps build up consensus Various consultative and advisory committees set up by SEBI comprising of market participants, experts, academics Reports of the committees put out for public comments Consultation and coordination with other regulators Frequent meetings with the stock exchanges and intermediary associations, chambers of commerce Extensive programme of investor awareness. Sharing the Indian Experience Managing the change Sharing the Indian Experience Managing the change