Post-Trade Operations in the Indian Capital Market — Part 2
In Part 1 of our blog series, we explored the post-trade operations in the Indian capital market, focusing on clearing and settlement processes, as well as the management of counterparty risk.
Now, in Part 2, we will delve deeper into the critical aspect of risk management strategies employed in the Indian capital market. These strategies play a crucial role in ensuring market stability, investor confidence, and long-term sustainability.
Types of Risks
Schuermann and Kuritzkes (2007) defined a mutually exclusive, collectively exhaustive taxonomy of risk.
- Market Risk — Market risk is the possibility that an individual or other entity will experience losses due to factors that affect the overall performance of investments in the financial markets. It is also known as systematic risk, this is the risk that arises from overall market movements.
It is beyond the control of individual investors and affects the entire market. Market risk includes factors such as economic conditions, interest rates, inflation, and geopolitical events. - Credit Risk — It is the set of risks resulting from the default of other parties to whom you have exposure. Within the capital markets, credit risk largely stems from counterparty credit risk. (See Part 1)
- Asset/Liability Risk — It is also known as liquidity risk and stems from a potential mismatch between a firm’s asset and liability profile. Such a mismatch may lead to a firm being unable to meet short-term financial demands.
Defining Risk
Risk is the deviation from expectations. In our context, the risk is known, as it can be identified and quantified ex-ante (known beforehand).
Within a distribution of potential outcomes, the expected value may be negative. For example, an investor may anticipate that there will be expected losses on his stock portfolio. But this is not in itself a risk, as the expected value is known and the investor can diversify and hedge against short-term volatility.
Risk is an unexpected value: the volatility around that expectation.
Trade Lifecycle
“What is a trade?” For many, a trade simply refers to the moment that two counterparties — the buyer and seller — engage in a transaction, such as the exchange of cash for the bond or equity trade or the exchange of two currencies in the case of an FX trade.
Trade lifecycle refers to the sequence of events that occur and the processes that are implemented when a trade takes place.
One of the key elements of the pre-trade stage is the process of client onboarding and KYC. Moreover, counterparty credit risk is understood to ensure the suitability of counterparties. Appropriate collateral is collected and managed. Risks associated with positions are understood and managed.
In the trading stage, the clients must communicate and authorize the institution to place orders on its behalf. The nature of a trade order can vary. Some orders require that trading take place at a specific price, while other orders do not. Some orders placed in the market may be executed immediately, while others may be executed upon a specified price level being met. The processes in the post-trade stage were discussed in Part 1.
Risk Management in Capital Market
Within Capital Markets, risk management is a function of:
Risk (market entity, trade lifecycle, product, instrument) → Financial Risk (Figure 1)
where market entity = [broking firm, stock exchange, clearing corporation], product = [margin trading] and instrument = [equities, derivatives]
Appropriate controls are put into practice throughout the trade lifecycle to mitigate the financial and non-financial risks.
Financial Risk Management
1. Pre-Trade Risk Controls
The major risks at this stage are credit and liquidity risks.
- Organizational structure: Brokerage firms have the organizational structure in the form of CRO org to manage day-to-day activities and to ensure that policies, procedures, and controls are firmly in place to measure and monitor risks. Further, internal and external audit provides independent testing and evaluation of the effectiveness of risk management.
- Capital and Liquidity: All key stakeholders in capital markets firms, including regulators and investors, maintain a keen focus on ensuring adequate capital and liquidity levels.
The core of the risk management system is the liquid assets (collateral) deposited by the Broking firms with the Exchange. The liquid assets cover:
- Base Minimal Capital (BMC) — The Base Minimum Capital is the deposit maintained by the stockbroker with the Exchanges, against which no exposure for trades is allowed. At BSE, the BMC requirement is Rs.10 lakhs.
- Additional Capital — The additional capital requirement comes into play to cover exposure to trades mandated by the Exchanges during the settlement cycle. The following sections will explain the workings of the Margin.
2. Trade Risk Controls
The major risk at this stage is market risk.
Circuit Breakers and Market Halts
Circuit breakers and market halts are risk management mechanisms employed by stock exchanges to manage extreme market volatility and protect investors from sudden and drastic price movements. These mechanisms aim to maintain orderly and stable market conditions, prevent excessive panic selling or buying, and avoid potential systemic risks.
- A circuit breaker is a predefined mechanism that temporarily halts trading activity on an exchange when certain predetermined thresholds are breached.
- The primary purpose of circuit breakers is to provide a cooling-off period during periods of intense market stress, allowing market participants to reassess their strategies and avoid irrational trading decisions.
- When triggered, circuit breakers halt trading for a specified period (e.g., 15 minutes) before resuming normal trading operations.
In NSE and BSE, the index-based (BSE Sensex or the Nifty 50) market-wide circuit breaker system applies at 3 stages of the index movement, either way viz. at 10%, 15% and 20%. These circuit breakers when triggered bring about a coordinated trading halt in all equity and equity derivative markets.
A similar setup exists for securities and it is called “price bands”. Exchange defines a price range for each security which is pre-defined percentage of the base price of the security. When the price of a security hits the upper or lower band limit set by the exchange, orders will remain pending at that circuit price for that particular stock.
The operating range mechanism is implemented in order to prevent erroneous order entry by market participants beyond operating range.
3. Post-Trade Risk Controls
The major risks at this stage are counterparty credit and market risks.
Understanding Margin
In the stock markets, there is uncertainty in the movement of share prices. This uncertainty leading to risk is addressed by the margining systems of stock markets.
Suppose an investor, purchases 1000 shares of ‘ABC’ company at Rs.100 on January 1, 2023. The investor has to give the purchase amount of Rs. 1,00,000 (1000 x 100) to his broker on or before January 2, 2023 (T + 1 settlement). The stockbroker, in turn, has to give this money to the stock exchange on January 2, 2023.
There is always a small chance that the investor may not be able to bring the required money by the required date. As an advance for buying the shares, the investor is required to pay a portion of the total amount of Rs.1,00,000 to the broker at the time of placing the buy order. The Stock Exchange in turn collects a similar amount from the broker upon execution of the order. This initial token payment is called the Margin.
Remember, for every buyer there is a seller and if the buyer does not bring the money, the seller may not get his money and vice versa. Therefore, the margin is levied on the seller also to ensure that he gives the 100 shares sold to the broker, who in turn gives it to the stock exchange.
Margin payments ensure that each investor is serious about buying or selling shares.
In the above example, assume that the margin is 15%. That investor has to give Rs.15,000 (15% of Rs.1,00,000) to the broker before buying. Now suppose that the investor bought the shares at 11 am on January 1, 2023. Assume that by the end of the day, the price of the share falls by Rs.25. That is, the total value of the shares has come down to Rs.75,000. That is, the buyer has suffered a notional loss of Rs.25,000. In our example, the buyer has paid Rs.15,000 as margin but the notional loss, because of the fall in price, is Rs.25,000. That is, the notional loss is more than the margin given. In such a situation, the buyer may not want to pay Rs.1,00,000 for the shares whose value has come down to Rs.75,000. Similarly, if the price has gone up by Rs.25, the seller may not want to sell the shares at Rs.1,00,000.
To ensure that both buyers and sellers fulfill their obligations, irrespective of price movements, notional losses have to be collected at the time of trade.
Prices of shares move every day. Margins ensure that buyers bring money and sellers bring shares to complete their obligations, even though the prices have moved down or up.
Types of Margin to cover Financial Risk in Cash Market
- MTM (Mark-To-Market) Losses, Value at Risk (VaR) Margins, Extreme Loss Margins (ELM)
Types of Margin to cover Non-Financial Risk
- Base Minimum Capital: Capital required to cover all risks other than the market risk (for example, operational risk and client claims).
- Special Margin: A special margin is collected as a surveillance measure.
We will discuss these concepts in Part 3.
During and after the trading hours, the cash obligation of Broking firms is calculated and the cumulative margin is deducted from the liquid assets (collateral) deposited by the firm.
Non-Financial Risks
The operational risks include:
- Internal and external fraud — misappropriation of assets, tax evasion, intentional mismarking of positions, bribery, theft of information, hacking, third‐party theft and forgery.
- Clients, products, and business practice — market manipulation, antitrust, improper trade, product defects, fiduciary breaches and account churning.
- Business disruption and systems failures — utility disruptions, software failures and hardware failures.
- Execution, delivery, and process management — data entry errors, accounting errors, failed mandatory reporting and negligent loss of client assets.
These risks are mitigated through internal modeling of operational risks, stress testing and scenario analysis to test the vulnerability of firms to operational risk losses.
Summary
Beyond regulatory requirements, capital markets firms in India have developed their own in-house approaches used to measure, monitor, and manage risks. These range from simple exposure levels, which are easily understood, to more complex internal “economic capital” measures that attempt to combine multiple risk types in a common metric.
In sum, the risk controls are in place to minimize the potential impact of market, credit, liquidity, and operational risks. The effectiveness of these controls is closely monitored and regularly updated to adapt to changing market conditions and evolving risks.
In Part 3 of this series, we will delve deeper into the margin and its calculation. We will also discuss the trading product ‘Margin Trading’ and the associated risk management strategies with ample examples.
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