Risk Management for the Cash Market
Preface:-
SEBI has from time to time put in place various risk containment measures to address the risks involved in the cash and derivatives market. These measures have successfully and efficaciously addressed the market risks. But as the market is always in a dynamic state, the risk management system cannot remain static and has to constantly address the changing risk profile of the market. Besides, there are certain differences between the risk management system in the cash and derivatives markets. These differences need also to be addressed.
A discussion paper on the Risk Management for the Cash Market is placed on SEBI’s website www.sebi.gov.in for public comments. This discussion paper is based on the recommendations of the SEBI’s Advisory Committee on Risk Management for the Cash and Derivatives Market. The objectives of this paper is to review the risk management system for the cash market, to align and streamline the margining structure across the cash and derivatives markets and to consolidate the circulars on risk management for the cash market and issue a consolidated circular.
Comments on the discussion paper may be forwarded to Shri V.S. Sundaresan, Deputy General Manager, SEBI, World Trade Centre, Centre-1, 29th floor, Cuffe Parade, Colaba, Mumbai – 400 005 or sent by e-mail to aparnat@sebi.gov.in on or before December 17, 2004.
The core of the risk management system is the liquid assets deposited by members with the exchange/clearing corporation. These liquid assets shall cover the following four requirements:
a. MTM (Mark To Market) Losses: Mark to market losses on outstanding settlement obligations of the member
b. VaR Margins: Value at risk margins to cover potential losses for 99% of the days.
c. Extreme Loss Margins: Margins to cover the expected loss in situations that lie outside the coverage of the VaR margins
d. Base Minimum Capital: Capital required for all risks other than market risk (for example, operational risk and client claims).
At all points of time, the liquid assets of the member shall be adequate to cover all the above four requirements. There are no other margins in the risk management system.
The acceptable liquid assets and the applicable haircuts are listed below:
|
Item |
Haircut (see Note A) |
Limits |
|
Cash Equivalents |
||
|
Cash |
0 |
No limit |
|
Bank fixed deposits |
0 |
Limit on exchange’s exposure to a single bank (see Note B) |
|
Bank guarantees provided by banks with a net worth of more than Rs 5 billion |
0 |
Limit on exchange’s exposure to a single bank (see Note B) |
|
Securities of the Central Government |
10% |
No limit |
|
Units of liquid mutual funds or government securities mutual funds (by whatever name called which invest in government securities) |
10% |
No limit |
|
Other Liquid Assets 1. Cannot be used for mark to market losses (see Note C) 2. Total of Other Liquid Assets cannot exceed total of Cash Equivalents (see Note D) |
||
|
Liquid (Group I) Equity Shares (see section 3 for classification of equity shares on the basis of liquidity) |
Same as the VaR margin for the respective shares (see section 5.1 below) |
Limit on exchange’s exposure to a single issuer (see Note E) |
|
Mutual fund units other than those listed under cash equivalents |
Same as the VaR margin for the units computed using the NAV of the unit treating it as a liquid security (see section 5.1 below). |
|
|
Card value of eligible exchanges (see Note F) |
50% if the last sale or auction of card in the exchange took place during the last six months. 75% if the last sale or auction of card in the exchange took place during the last twelve months but not within the last six months. 100% if no sale or auction of card in the exchange has taken place during the last twelve months. |
Eligible only for Extreme Loss Margin |
Notes:
A. The valuation of the liquid assets shall be done on a daily basis except for the card value which shall be taken on the basis of the last sale or auction.
B. The exchanges shall lay down exposure limits either in rupee terms or as percentage of the Trade Guarantee Fund (TGF)/Settlement Guarantee Fund (SGF) that can be exposed to a single bank directly or indirectly and in any case the exposure of the TGF/SGF to any single bank shall not be more than 15% of the total liquid assets forming part of TGF/SGF of the exchange. The exposure as mentioned above would include guarantees provided by the bank for itself or for others as well as fixed deposits of the bank which have been deposited by members towards total liquid assets.
C. Mark to market losses shall be paid by the member in the form of cash or cash equivalents.
D. Cash equivalents shall be at least 50% of liquid assets. This would imply that Other Liquid Assets in excess of the total Cash Equivalents would not be regarded as part of Total Liquid Assets.
E. The exchanges shall lay down exposure limits either in rupee terms or as percentage of the Trade Guarantee Fund (TGF)/Settlement Guarantee Fund (SGF) that can be exposed to a single issuer directly or indirectly and in any case the exposure of the TGF/SGF to any single issuer shall not be more than 15% of the total liquid assets forming part of TGF/SGF of the exchange.
F. As a transitional arrangement pending demutualization of stock exchanges, the value of the membership card in eligible stock exchanges may be included as part of the member’s liquid assets only to cover Extreme Loss Margin. To be eligible for this treatment, the exchange shall maintain an amount equivalent to at least 50% of the aggregate card value of all members in the form of cash and liquid assets.
The securities shall be classified into three groups based on their liquidity:
|
Group |
Trading Frequency (over the previous six months – see Note A) |
Impact Cost (over the previous six months – see Note B) |
|
Liquid Securities (Group I) |
At least 80% of the days |
Less than or equal to 1% |
|
Less Liquid Securities (Group II) |
At least 80% of the days |
More than 1% |
|
Illiquid Securities (Group III) |
Less than 80% of the days |
N/A |
Notes:
A. For securities that have listed for less than six months, the trading frequency shall be computed using the entire trading history of the scrip.
B. For securities that have listed for less than six months, the impact cost shall be computed using the entire trading history of the scrip.
The trading frequency and impact cost shall be calculated on the 15th of each month on a rolling basis considering the previous six months for impact cost and previous eighteen months for trading frequency. On the basis of the trading frequency and impact cost so calculated, the securities shall move from one group to another group from the 1st of the next month.
For the first month and till the time of monthly review as mentioned in section 3.1, a newly listed stock shall be categorised in that Group where the market capitalization of the newly listed stock exceeds or equals the market capitalization of 80% of the stocks in that particular group. Subsequently, after one month, whenever the next monthly review is carried out, the actual trading frequency and impact cost of the security shall be computed, to determine the liquidity categorization of the security.
In case any corporate action results in a change in ISIN, then the securities bearing the new ISIN shall be treated as newly listed scrip for group categorization.
The mean impact cost shall be calculated in the following manner:
a. Impact cost shall be calculated by taking four snapshots in a day from the order book in the past six months. These four snapshots shall be randomly chosen from within four fixed ten-minutes windows spread through the day.
b. The impact cost shall be the percentage price movement caused by an order size of Rs.1 Lakh from the average of the best bid and offer price in the order book snapshot. The impact cost shall be calculated for both, the buy and the sell side in each order book snapshot.
c. The computation of the impact cost adopted by the Exchange shall be disseminated on the website of the exchange.
d. The exchanges shall use a common methodology for carrying out the calculations for mean impact cost. The stock exchanges which are unable to compute the mean impact cost calculations at their exchanges shall use the impact cost calculations of BSE/NSE. Such stock exchanges shall enter into a formal legal agreement with the relevant stock exchanges for liquidating the positions of their members if necessary, on that stock exchange.
e. The details of calculation methodology and relevant data shall be made available to the public at large through the website of the exchanges. Any change in the methodology for the computation of impact cost shall also be disseminated by the exchange.
Mark to Market Losses shall be collected in the following manner:
a. The Stock Exchanges shall collect the mark to market margin (MTM) from the member/broker before the start of the trading of the next day.
b. The MTM margin shall also be collected/adjusted from/against the cash/cash equivalent component of the liquid net worth deposited with the Exchange.
c. The MTM margin shall be collected on the gross open position of the member. The gross open position for this purpose would mean the gross of all net positions across all the clients of a member including his proprietary position.
d. The margin so collected shall be released along with the pay-in, including early pay-in of securities.
The VaR Margin is a margin intended to cover the largest loss that can be encountered on 99% of the days (99% Value at Risk). For liquid stocks, the margin covers one-day losses while for illiquid stocks, it covers three-day losses so as to allow the clearing corporation to liquidate the position over three days. This leads to a scaling factor of square root of three for illiquid stocks.
For liquid stocks, the VaR margins are based only on the volatility of the stock while for other stocks, the volatility of the market index is also used in the computation. Computation of the VaR margin requires the following definitions:
· Scrip sigma means the volatility of the security computed as at the end of the previous trading day. The computation uses the exponentially weighted moving average method applied to daily returns in the same manner as in the derivatives market.
· Scrip VaR means the higher of 7.5% or 3.5 scrip sigmas.
· Index sigma means the daily volatility of the market index (S&P CNX Nifty or BSE Sensex) computed as at the end of the previous trading day. The computation uses the exponentially weighted moving average method applied to daily returns in the same manner as in the derivatives market.
· Index VaR means the higher of 5% or 3 index sigmas. The higher of the Sensex VaR or Nifty VaR would be used for this purpose.
The VaR Margins are specified as follows for different groups of stocks:
|
Liquidity Categorization |
One-Day VaR |
Scaling factor for illiquidity |
VaR Margin |
|
Liquid Securities (Group I) |
Scrip VaR |
1.00 |
Scrip VaR |
|
Less Liquid Securities (Group II) |
Higher of Scrip VaR and three times Index VaR |
1.73 (square root of 3.00) |
Higher of 1.73 times Scrip VaR and 5.20 times Index VaR |
|
Illiquid Securities (Group III) |
Five times Index VaR |
1.73 (square root of 3.00) |
8.66 times Index VaR |
a. The VaR margin shall be collected on an upfront basis by adjusting against the total liquid assets of the member at the time of trade. Collection on T+1 day is not acceptable.
b. The VaR margin shall be collected on the gross open position of the member. The gross open position for this purpose would mean the gross of all net positions across all the clients of a member including his proprietary position.
c. The VaR margin so collected shall be released along with the pay-in, including early pay-in of securities.
The term Extreme Loss Margin replaces the terms “exposure margin” and “second line of defence” that have been used hitherto. It covers the expected loss in situations that go beyond those envisaged in the 99% value at risk estimates used in the VaR margin.
a. The Extreme Loss Margin for any stock shall be higher of:
· 5%, and
· 1.5 times the standard deviation of daily logarithmic returns of the stock price in the last six months. This computation shall be done at the end of each month by taking the price data on a rolling basis for the past six months and the resulting value shall be applicable for the next month.
b. The Extreme Loss Margin shall be collected/ adjusted against the total liquid assets of the member on a real time basis.
c. The Extreme Loss Margin shall be collected on the gross open position of the member. The gross open position for this purpose would mean the gross of all net positions across all the clients of a member.
d. The Extreme Loss Margin so collected shall be released along with the pay-in.
A. The Stock Exchanges shall have the BMC requirements as provided below:-
|
BSE, NSE and CSE |
Rs. 10 lakhs |
|
AhSE & DSE |
Rs. 7 lakhs |
|
Other Stock Exchanges |
Rs. 4 lakhs |
provided that the Stock Exchanges shall maintain the BMC at Rs. 1 lakh if the average daily turnover is less than Rs.1 crore for any three consecutive months.
B. Refund of excess BMC over Rs. 1 lakh
The excess of the BMC over Rs 1 lakh may be refunded to the members of the exchange subject to the following conditions:
C. Re-enhancement of BMC
If the average daily turnover of the exchange exceeds the prescribed level of Rs.1 crore for a period of one month at any time, the exchange shall enhance the requirement of the BMC of the members back to the level as prescribed in Para 1 above and shall obtain undertaking to this effect from the members.
Exchanges/clearing corporations have the right to impose additional risk containment measures over and above the risk containment system mandated by SEBI. However exchanges should keep three factors in mind while taking such action:
a. Additional risk management measures (like ad-hoc margins) would normally be required only to deal with circumstances that cannot be anticipated or were not anticipated while designing the risk management system. If ad-hoc margins are imposed with any degree of regularity, exchanges should examine whether the circumstances that give rise to such margins can be reasonably anticipated and can therefore be incorporated into the risk management system mandated by SEBI. Exchanges are encouraged to analyse these situations and bring the matter to the attention for SEBI for further action.
b. Any additional margins that the exchanges may impose shall be based on objective criteria and shall not discriminate between members on the basis of subjective criteria.
c. Transparency is an important regulatory goal and therefore every effort must be made to make the risk management systems fully transparent by disclosing their details to the public.
Members should have a prudent system of risk management to protect themselves from client default. Margins are likely to be an important element of such a system. The same shall be well documented and be made accessible to the clients and the Stock Exchanges. However, the quantum of these margins and the form and mode of collection are left to the discretion of the members.
With the advanced collection of margins and the introduction of the stringent margining structure, the following circulars would stand modified suitably:
a. Gross exposure limits stipulated vide circular No. SMDRP/Policy/2001 dated March 11, 2001 and press release No.45 /2001dated March 11, 2001.
b. Intra-day trading limits stipulated vide circular No. SMD/RCG/3737/96 dated August 13, 1996.
c. Additional Margin of 6% stipulated vide circular No. SMD/Policy/ Cir - 9/2003 dated March 11, 2003.
d. The form of maintenance of BMC and AC stipulated vide circular No. SMDRP/Policy/Cir-19/99 dated July 2, 1999.
e. As regards the valuation of membership card of the stock exchanges, the circulars No. SMD/SED/9012/93 dated May 14, 1993 and SMD/SED/CIR/93/22570 dated October 21, 1993 referred to above would stand modified accordingly.
f. The provisions of collection of margins from clients stipulated vide circulars No. SMDRP/policy/Cir-35/98 dated December 4, 1998, SMDRP/Policy/Cir-7/00 dated February 4, 2000, SMDRP/Policy/Cir-33/00 dated July 27, 2000 and SMDRP/Policy/Cir-12/2002 dated May 17, 2002.
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