The unification in clearing and settlement services can reduce chances of systematic default or trade disruption.
By Kushankur Dey
Interoperability in clearing and settlement services rendered by clearing corporations, which are subsidiaries of national-level stock exchanges, is likely to be in effect from June 1. This is a welcome move by the capital markets regulator. Interoperability can improve functioning of equity/commodity market and their derivative counterpart. The unification in clearing and settlement services can reduce chances of systematic default or trade disruption. Interoperability can bolster regulatory supervision.
SEBI has emerged as regulator of both stocks and commodities post the 2015 SEBI-FMC merger; it directed issuing of unified licences to brokers/members for trading on stocks and commodities simultaneously. The idea of interoperability dates to 2013, when a committee headed by KV Kamath was constituted, but its recommendation on effectuation of interoperability was conservative.
In 2014-15, with improvisation in trading architecture (high-frequency trading/algorithmic trading and trading colocation), SEBI explored the feasibility of interoperability and invited proposals from clearing corporations, which were then placed before the Secondary Market Advisory Committee (SMAC) in December 2017. The reports of working sub-groups (on risk management, technology, and finance and taxation) were reviewed by SMAC in 2018. In agreement with the working group suggestions, SMAC gave the ascent for a phase-wise implementation, with interoperability of clearing corporations clearing securities in the first phase and corporations clearing commodity derivatives and long-dated options in the second.
So, what are the benefits of interoperability?
First, interoperability of clearing corporations can reduce trading or impact costs, improve trade execution, and maintain optimal utilisation of margin and capital resources in securities market. It gives choices to trading member/market participants to consolidate and clear their trade through a clearing corporation of their choice instead of going through the concerned exchange where the trade is held.
Second, it may curb potential chances of trade disruption due to any systematic risk occurring on one exchange and the member would be able to trade on other exchanges without paying additional margin that can foster efficiency in the capital market and enable members participate in broad-based and product-driven trading platforms.
Third, it can catalyse competition among existing clearing houses in terms of prices and services they offer, and can affect their margin requirement from the members and commission they charge on clearing.
Fourth, execution risk can be decoupled from settlement risk as there can be an ‘arm’s length’ relationship between the exchange and adjunct clearing corporation.
Fifth, it can potentially discourage the possibilities of inter-exchange arbitrage and agency risk since the working of clearing corporations together may bring down the inefficiency issue and improve market microstructure.
Sixth, exchanges and clearing corporations may not be required to maintain the settlement guarantee fund since the collateral margins deposited by members will be maintained by a unified account through an interoperable link among clearing corporations.
What framework of interoperability has SMAC suggested? As per the working sub-group proposal, peer-to-peer link is suggested. However, merits/demerits of the framework need to be understood. A peer-to-peer interoperable framework can potentially mitigate inter-clearing corporation default risk through existing margining system and deployment of additional financial resources. Additional capital may be required to maintain as a buffer and aid in the absorption of losses due to default by an interoperable clearing corporation that is not linked to core settlement guarantee fund. Under interoperability arrangement, two clearing corporations are likely to interpose between the two counterparties that can potentially mitigate chance of credit default and improve the novation and risk management.
Going forward, are stock exchanges ready to implement a robust interoperable link among their clearing houses? Have they adequate bandwidth to implement it? Can commodity exchanges replicate interoperability for their clearing subsidiaries? We need to wait to review the development.
The author teaches finance at IIM Bodh Gaya. Views are personal.