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
The process
Regulatory and legal framework
Supervisory framework
Governance and Ownership structure
Risk management
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

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

6
Sharing the Indian Experience
Current market structure (contd.)


T+2 Rolling Settlement
Central Counterparty providing novation and settlement guarantee
Electronic Transfer of Securities
99.99% settlement in dematerialised securities
Limited Straight Through Processing (not yet mandatory for
participants)
Fine-tuned VaR based Risk Management System for
cash and derivatives, including real time SPAN for
derivatives
State of the art information technology
100% electronic trading which obviates need for trade confirmation
Finality of settlement from the moment trade is executed
ISIN for securities
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
1996. 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 2000.
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
10
5
8
6
1
2
2 3
4
11
9
7

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 Contract (Regulation) Act, 1956
(Act to establish and regulate exchanges);
Depositories Act, 1996 (regulates depositories);
Companies Act, 1956
SEBI regulates and supervises the securities
markets through 23 Regulations and 2 Guidelines.
SEBI exercises powers under the first 3 Acts and
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

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

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

17
SEBI supervision over the stock exchanges,clearing
houses and corporations, stock brokers,
depositories and depository participants, through
constant dialogue, periodical meetings, reporting
and annual inspection and review.

Any change in bye laws, rules and regulations of
exchanges and depositories need the approval of
SEBI

The risk management of the cash and derivatives
market laid down in consultation with SEBI
Sharing the Indian Experience
Supervisory framework

18
Sharing the Indian Experience
Governance and Ownership structure

Institution

Ownership Governance

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
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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

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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 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


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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
Second line of margining for the balance 1% scenario
In addition Mark to market margin

Margins collected on T+1, before trading begins next day
Inability to pay margins results in automatic switching off of
member terminal denying access for fresh orders

In addition members have gross exposure limits related to their
capital which is on line monitored real time by the exchanges
Margins to be brought in cash and government securities
(with hair cut) and bank guarantee from selected banks

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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


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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
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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