Clearing and settlement

system, clearing
process, Risk
containment measure,
Margin requirement

- Chaitra C
Muralidhara
Ishaan Bragta

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CONTENTS

1. Need for clearing and settlement system

2. Introduction to the clearing system

3. Clearing and settlement process

4. Settlement Cycle

5. Risk Management

6. Risk Contentment measures

7. Margin Requirement

8. Conclusion

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Need for clearing and Settlement System

“Systems for clearing and settlement of securities transaction should be subject to regulatory
oversight and designed to ensure that they are fair, effective and efficient and that they
reduce systemic risk” is one of the 30 principles of securities regulation enunciated by
IOSCO.
Safe and stable securities settlement systems (SSSs) are important to preserve the health of
the domestic and global financial markets. This is because they help in reducing the systemic
risks. It is for this reason that the Committee on Payment and Settlement Systems (CPSS) and
the Technical Committee of IOSCO (International Organization of Securities Commissions)
established the Task Force on Securities Settlement Systems in December 1999 to
recommend measure aimed at improving safety and efficiency of SSSs. The SSS in the
corporate securities market in India have witnessed several innovations during the last one-
decade in tune with the global developments. These include use of the state-of-art information
technology, compression of settlement cycle, dematerialization, electronic transfer of
securities, securities lending and borrowing, professionalization of trading members, fine-
tuned risk management system, introduction of straight through processing. emergence of
clearing corporation (CC) to perform the role of central counter party etc., though many of
these are yet to permeate to the entire market. However, in this report we restrict our
discussion to only the settlement systems adopted by the National Securities Clearing
Corporation Limited (NSCCL), the Clearing Corporation of NSE.
For all trades executed on a given day, it is important to determine the obligations standing at
the end of the day against parties to trade. This process of ascertaining obligations is known as
clearing, and the process of meeting or discharging these obligations is known as settlement.
NSCCL is the corporation that deals with all clearing and settlement activities at NSE.

Introduction

The transactions in secondary market pass through three distinct phases ,viz., trading, clearing
and settlement. While the stock exchanges provide the platform for trading, the clearing
corporation determines the funds and securities obligations of the trading members and
ensures that the trade is settled through exchange of obligations. The clearing banks and the
depositories provide the necessary interface between the custodians/clearing members for
settlement of funds and securities obligations of trading members.

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Several entities, like the clearing corporation, clearing members, custodians, clearing
banks, depositories are involved in the process of clearing. The role of each of these
entities is explained in detail :

Clearing and Settlement Processes

The transactions in secondary market pass through three distinct phases, viz., trading, clearing
and settlement. While the stock exchanges provide the platform for trading, the clearing
corporation determines the funds and securities obligations of the trading members and
ensures that the trade is settled through exchange of obligations. The clearing banks and the
depositories provide the necessary interface between the custodians/clearing members for
settlement of funds and securities obligations of trading members. The clearing process
involves determination of what counter-parties owe, and which counter-parties are due to
receive on the settlement date, thereafter the obligations are discharged by settlement. The
clearing and settlement process for transaction in securities on NSE is presented in Chart 5-1.
Several entities, like the clearing corporation, clearing members, custodians, clearing banks,
depositories are involved in the process of clearing. The role of each of these entities is
explained below:

Clearing Corporation:

The clearing corporation is responsible for post-trade activities such as the risk management
and the clearing and settlement of trades executed on a stock exchange. .The first clearing
corporation to be established in the country and also the first clearing corporation in the
country to introduce settlement guarantee is the National Securities Clearing Corporation Ltd.
(NSCCL),a wholly owned subsidiary of NSE.NSCCL was incorporated in August 1995.It was
set up with the objectives of bringing and sustaining confidence in clearing and settlement of
securities; promoting and maintaining short and consistent settlement cycles; providing
counter-party risk guarantee, and operating a tight risk containment system.

Clearing Members

Clearing Members are responsible for settling their obligations as determined by the NSCCL.
They do so by making available funds and/or securities in the designated accounts with
clearing bank/depositories on the date of settlement.

Custodians

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Custodians are clearing members but not trading members. They settle trades on behalf of
trading members, when a particular trade is assigned to them for settlement. The custodian is
required to confirm whether he is going to settle that trade or not. If he confirms to settle that
trade, then clearing corporation assigns that particular obligation to him. As on date, there are
13 custodians empanelled with NSCCL. They are Deutsche Bank, HDFC Bank Ltd.,
Hongkong Shanghai Banking Corporation Ltd., Infrastructure leasing and Financial Services
Ltd., ICICI Bank Ltd., Standard Chartered Bank Ltd., Stock Holding Corporation of India
Ltd., Axis Bank Ltd., DBS bank Ltd., JP Morgan Chase Bank N.A., Kotak Mahindra Bank
Ltd. State Bank of India and Citibank N.A and Orbis Financial Corporation Ltd.
Clearing Bank

Clearing banks are a key link between the clearing members and Clearing Corporation to
effect settlement of funds. Every clearing member is required to open a dedicated clearing
account with one of the designated clearing banks. Based on the clearing member’s obligation
as determined through clearing, the clearing member makes funds available in the clearing
account for the pay-in and receives funds in case of a pay-out. There are 13 clearing banks of
NSE, viz., Axis Bank Ltd, Bank of India Ltd., Canara Bank Ltd., Citibank N.A, HSBC Ltd.,
DFC Bank Ltd., ICICI Bank Ltd IDBI Bank Ltd., Indusind Bank Ltd ., Kotak Mahindra Bank,
Standard Chartered Bank, State Bank of India and Union Bank of India.

Depositories

Depository holds securities in dematerialized form for the investors in their beneficiary
accounts. Each clearing member is required to maintain a clearing pool account with the
depositories. He is required to make available the required securities in the designated account
on settlement day. The depository runs an electronic file to transfer the securities from
accounts of the custodians/clearing member to that of NSCCL and visa-versa as per the
schedule of allocation of securities.

Professional Clearing Member

NSCCL admits special category of members known as professional clearing members

(PCMs). PCMs may clear and settle trades executed for their clients (individuals, institutions
etc.). In such cases, the functions and responsibilities of the PCM are similar to that of the
custodians. PCMs also undertake clearing and settlement responsibilities of the trading
members. The PCM in this case has no trading rights, but has clearing rights i.e. he clears the
trades of his associate trading members and institutional clients.
Clearing Agencies ensure trading members meet their fund/security obligations. It acts as a
legal counter party to all trades and guarantees settlement for all members. The original trade
between the two parties is cancelled and clearing corporation acts as counter party to both the
parties, thus manages risk and guarantees settlement to both the parties. This process is called
novation.

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It determines fund/security obligations and arranges for pay-in of the same. It collects and
maintains margins, processes for shortages in funds and securities. It takes help of clearing
members, clearing banks, custodians and depositories to settle the trades.

The settlement cycle in India is T+2 days i.e. Trade + 2 days. T+2 means the transactions
done on the Trade day, will be settled by exchange of money and securities on the second
business day (excluding Saturday, Sundays, Bank and Exchange Trading Holidays). Pay-in
and Pay-out for securities settlement is done on a T+2 basis.

Please note that a clearing member is the brokerage firm which acts as a trading member and
clearing member of clearing agency where as custodians are only clearing members. Even if
the clients don’t meet their obligations clearing members are required to meet their
obligations to the clearing corporations.

1. Trade details from Exchange to NSCCL (real-time and end of day trade file).
2. NSCCL notifies the consummated trade details to clearing members/custodians who affirm
back. Based
on the affirmation, NSCCL applies multilateral netting and determines obligations.
3. Download of obligation and pay-in advice of funds/securities.
4. Instructions to clearing banks to make funds available by pay-in time.
5. Instructions to depositories to make securities available by pay-in time.
6. Pay-in of securities (NSCCL advises depository to debit pool account of custodians/CMs
and credit its
account and depository does it).
7. Pay-in of funds (NSCCL advises Clearing Banks to debit account of custodians/CMs and
credit its

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account and clearing bank does it).
8. Pay-out of securities (NSCCL advises depository to credit pool account of custodians/CMs
and debit its
account and depository does it).
9. Pay-out of funds (NSCCL advises Clearing Banks to credit account of custodians/CMs and
debit its
account and clearing bank does it).
10. Depository informs custodians/CMs through DPs.
11. Clearing Banks inform custodians/CMs.

Settlement Cycle
NSCCL clears and settles trades as per the well-defined settlement cycles (Table 5-1). Since
the beginning of the financial year 2003, all securities are being traded and settled under T+2
rolling settlement. The NSCCL notifies the relevant trade details to clearing
members/custodians on the trade day (T), which are affirmed on T+1 to NSCCL. Based on it,
NSCCL nets the positions of counterparties to determine their obligations. A clearing member
has to pay-in/ pay-out funds and/or securities. The obligations are netted for a member across
all securities to determine his fund obligations and he has to either pay or receive funds.
Members’ pay-in/ pay-out obligations are determined latest by T+1 and are forwarded to them
on the same day, so that they can settle their obligations on T+2. The securities/funds are
paid-in/paid-out on T+2 day to the members’ clients’ and the settlement is complete in 2 days
from the end of the trading day. (The activity schedule for the T+2 rolling settlement has
already been discussed in the policy development section).

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Risk Management

A sound risk management system is integral to an efficient clearing and settlement system.
The clearing corporation ensures that trading members’ obligations are commensurate with
their net worth. It has put in place a comprehensive risk management system, which is
constantly monitored and upgraded to prevent market failures. It monitors the track record
and performance of members in terms of their net worth, positions and exposure with the
market, collects margins. If the prescribed limits on positions and exposures are breached,
then automatically the members are disabled. To safeguard the interest of the investors, NSE
administers an effective market surveillance system to detect excessive volatility and prevents
price manipulation by setting up price bands. Further, the exchange maintains strict
surveillance over market activities in illiquid and volatile securities. The robustness of the risk
management system has been amply proved by the timely and default free settlement even on
extreme volatile days like May 14 th and 17 th , 2004.

Risk Containment Measures

The risk containment measures have been repeatedly reviewed and revised to be up to date
with the market realities. This section however discusses the measures prevailing as in June
2004.

Capital Adequacy Requirements

The capital adequacy requirements stipulated by the NSE are substantially in excess of the
minimum statutory requirements as also to those stipulated by other stock exchanges. A
person/entity seeking membership in the CM segment is required to have a net worth of Rs. 1
crore and keep an interest free security deposit of Rs. 1.25 crore and collateral security deposit
of Rs. 0.25 crore with the Exchange/NSCCL. The deposits kept with the Exchange as
part of the membership requirement are taken as base capital to determine the member’s intra-
day trading limit and/or gross exposure limit. Additional base capital is required to be
deposited by the member for taking additional exposure.

Trading and Exposure Limits

NSCCL imposes limits on turnover and exposure in relation to the base capital of a member.
Gross intra-day turnover of a member should not exceed 25 times of the base capital.
Similarly, gross exposure (aggregate of net cumulative outstanding positions in each security)
of a member at any point of time should not exceed 8.5 times the total base capital (not
utilized towards margin) up to Rs. 1 crore. If a member has free capital in excess of Rs. 1

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crore, his exposure should not exceed Rs. 8.5 crore plus 10 times of the capital in excess of
Rs. 1 crore. Members violating the intra-day gross turnover limit at any time on any trading
day are automatically and instantaneously disabled by the trading system. Members trading
facility is restored from the next trading day with a reduced intra-day turnover limit of 20
times the base capital till deposits in the form of additional base capital is deposited with
NSCCL. A penalty of Rs. 5,000 is levied for each violation of gross exposure limit and intra-
day turnover limit. In case of second and subsequent violation, the penalty in multiples of Rs.
5,000 for each such instance is charged. Non-payment of penalty on time attracts penal
interest of 15 basis points per day till the date of payment.

Gross Exposure Limits

The gross exposure of a member is computed across all securities and across all open
settlements. Open settlements are all those settlements for which trading has commenced and
for which pay-in is yet to be completed. It is arrived at by adding up the absolute values of all
the securities and the specified adjustment factor in which a member has an open position. For
this purpose, scrip’s have been classified in to three groups on the basis of market
capitalisation, impact cost and number of trades. Groups I, II and III have been assigned
adjustment factors of 1.25, 2 and 8.5 respectively.
Members exceeding the gross exposure limit are not permitted to trade with immediate effect
until their cumulative gross exposure is reduced to below the gross exposure limits (as defined
by the guidelines) or they increase their limit by providing additional base capital.

Early pay-in of funds/securities

If members meet funds/securities obligations prior to the funds pay-in day, after satisfying the
applicable conditions, then the margin payable by the member is re-computed. The value of
the advance pay-in made is reduced from the cumulative net outstanding position of the
member for the purpose of calculating gross exposure.

On-line Monitoring

NSCCL has put in place an on-line monitoring and surveillance system, whereby exposure of
the members is monitored on a real time basis. A system of alerts has been built in so that
both the member and the NSCCL are alerted as per pre-set levels (reaching 70%, 85%, 95%
and 100%) as and when the members approach these limits. The system enables NSCCL to
further check the micro-details of members’ positions, if required and take pro-active action.
The on-line surveillance mechanism also generates alerts/reports on any price/volume
movement of securities not in line with past trends/patterns. Open positions of securities are
also analyzed. For this purpose the exchange maintains various databases to generate
alerts.These alerts are scrutinized and if necessary taken up for follow up action. Besides this,
rumors in the print media are tracked and where they are found to be price sensitive,

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companies are approached to verify the same. This is then informed to the members and the
public.

Inspection and Investigation

There is a regulatory requirement that a minimum of 10% of the active trading members
should be inspected every year to verify their level of compliance with various rules, byelaws
and regulations of the Exchange. Usually, inspection of more members than the regulatory
requirement is undertaken every year. The inspection randomly verifies if the investor
interests are being compromised in the conduct of business by the members. On the basis of
various alerts further analysis is carried out. If it suggests any possible irregularity such as
deviations from the past trends/patterns, concentration of trading at NSE at the member level,
then a more detailed investigation is undertaken. If the detailed investigation establishes any
irregular activity, then a disciplinary action is initiated against the member. If the
investigation suggests suspicions of possible irregular activity across the stock exchanges
and/or possible involvement of clients, the same is informed to SEBI.

Margin Requirements
NSCCL imposes stringent margin requirements as part of its risk containment measures. The
categorisation of stocks for imposition of margins is as given below:
The stocks, which have traded at least 80% of the days during the previous 18 months, should
constitute as the Group I and Group II.
Out of the scrips identified above, those having mean impact cost of less than or equal to 1%
should be under Group I and the scrips where the impact cost is more than 1, should be under
Group II.
The remaining stocks should be under Group III.
The impact cost should be calculated on the 15 th of each month on a rolling basis considering
the order book snapshots of the previous six months. On the basis of the calculated impact
cost, the scrip should move from one group to another group from the 1 st of the next month.
The impact cost is required to be calculated for an order value of Rs. 1 lakh.
The daily margin is the sum of Mark to Market Margin (MTM margin) and Value at Risk-
based Margin (VaR-based margin). VaR margin is applicable for all securities in rolling
settlement.

VaR Based Margins

All securities are classified into three groups for the purpose of calculating VaR margin. For
the securities listed in Group I, scrip wise daily volatility is calculated using the exponentially
weighted moving average should be 3.5 times the volatility. For the securities listed in Group
II the VaR margin should be higher of scrip VaR (3.5  ) or three times the index VaR, and it

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should be scaled up by root 3. For the securities listed in Group III, the VaR margin would be
equal to five times the index VaR and scaled up by square root of 3. VaR margin rate for a
security constitute the following:

1. VaR margin calculated as shown above. The index VaR would be the higher of the daily
Index VaR based on S&P CNX NIFTY or BSE SENSEX. The index VaR would be subject to
a minimum of 5%...

2. Additional VaR Margin of 6% as specified by SEBI.

3. NSCCL may stipulate security specific margins for the securities from time to time. The
VaR based margin would be rounded off to the next higher integer (For e.g., if the VaR based
margin rate is 10.01, it would be rounded off to 11.00) and capped at 100%.The VaR margin
rate computed as mentioned above will be charged on the net outstanding position (buy value
minus sell value) of the respective clients on their securities across all open settlements. The
net position at a client level for a member are arrived, thereafter it is grossed across all the
clients of a member to compute gross exposure for margin calculation for him.

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 in all securities at the closing price of the securities as announced at the
end of the day by the NSE. Mark to market margin is calculated by marking each transaction
in scrip to the closing price of the scrip at the end of trading. In case the security has not been
traded on a particular day, the latest available closing price at the NSE is considered as the
closing price. In the event of the net outstanding position of a member in any security being
nil, the difference between the buy and sell values would be considered as notional loss for
the purpose of calculating the mark to market margin payable. MTM profit/loss across
different securities within the same settlement is set off to determine the MTM loss for a
settlement. The MTM losses for settlements are computed at client level.
Non-payment of the margin attracts penal charge @ 0.07% per day of the amount not paid
throughout the period of non-payment. Trades done by trading members on behalf of
institutions are, however, exempt from margin and exposure requirements.

Index-based Market-wide Circuit Breakers

An index based market-wide circuit breaker system applies at three stages of the index
movement either way at 10%, 15% and 20%. These circuit breakers bring about a coordinated
trading halt in trading on all equity and equity derivatives markets across the country. The
breakers are triggered by movements in either S&P CNX Nifty or Sensex, whichever is
breached earlier.

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 In case of a 10% movement in either of these indices, there would be a one-hour
market halt if the movement takes place before 1:00 p.m. In case the movement takes place at
or after 1:00 p.m. but before 2:30 p.m. there would be trading halt for ½ hour. In case
movement takes place at or after 2:30 p.m. there will be no trading halt at the 10% level and
market would continue trading.
In case of a 15% movement of either index, there should be a two-hour halt if the
movement takes place before 1 p.m. If the 15% trigger is reached on or after 1:00 p.m. but
before 2:00 p.m., there should be a one-hour halt. If the 15% trigger is reached on or after
2:00 p.m. the trading should halt for remainder of the day.
In case of a 20% movement of the index, trading should be halted for the remainder of
the day.

Conclusion

• A secure and effective SSS is crucial for the development of the market.

• The scope of the system should be as broad as possible to make use of economies of
scale.

• The infrastructure and practices for cleaning, settlement and custody should as a
minimum comply to the CPSS/IOSCO recommendations for SSS.

• In case of netting unwinding should be avoided and system should have an adequate
risk management in order to settle even in the event that the participant with largest
payment obligation is unable to settle.

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