settlement system

The settlement system in a stock exchange was quite primitive till the early 1990s when market reforms
stated to get introduced and with the advent of SEBI and the NSE, several transformational developments
took place in subsequent years such as electronic transfer of securities, narrowing down of settlement cycles
and finally, the rolling settlement system. The periodic settlement cycles were disbanded and all securities
were put on compulsory rolling settlement system based on T+2.
A further improvement to settlement systems came about when SEBI insisted on stock exchanges
establishing separate subsidiary companies to act as clearing corporations to settle trades and assume
counterparty risk. The trading obligations of members are downloaded to their systems by the clearing
corporation. The members or custodians acting on behalf of FPI clients make available the required securities

in their pool accounts with depository participants by the prescribed pay-in time for securities. The depository
transfers the securities fromthe pool accounts to the settlement account of the clearing corporation. On similar
lines, all members or custodians have to maintain trading bank accounts with designated clearing banks that
are tied up with the clearing corporation. Based on advices sent to members about their pay-in obligations,
the clearing corporation generates debit instructions to designated banks which will carry out the instructions
and transfer funds electronically to the settlement account of the clearing corporation. Under the T+2 rolling
settlements, both the processes relating to pay-in and pay-out of funds and securities, take place within two
working days after the trade date.
With the advent of clearing corporations, trades are settled by the exchange irrespective of default by a
counterparty and the risk is assumed by the clearing corporation. This provides hassle free trading experience
to members and reliability that trades will be honoured irrespective of the financial status of the counterparty.
The reason why clearing corporations are kept apart from the stock exchange as limited liability subsidiaries
is to ensure bankruptcy remoteness for possible risks arising from the guarantee function that they undertake.
In order to meet the requirements of any eventuality, the clearing corporation also maintains a settlement
guarantee fund.

RISK MANAGEMENT

Since electronic trading and settlement systems function on real time basis, they not only provide efficient
and transparent conduct of business but also come with zero tolerance to defaults or any sort of disruption.
Therefore, it is extremely important that the exchange enforces efficient surveillance and risk management
system that provides suitable checks and balances to counter any sort of rouge trading or excessive risk raking
by members. In recognition of this necessity, the exchanges and their clearing corporations employ risk
management practices to ensure timely settlement of trades. SEBI has also prescribed elaborate margining
and capital adequacy standards for members to secure market integrity and protect the interests of investors.
These measures ensure there is no domino effect in the event of a default by some members.
Firstly, the clearing corporation ensures that trades by each member entity are commensurate with its net
worth. The capital adequacy and net worth are monitored depending upon trading on a daily basis. Suitable
cash margin requirements are stipulated and in the event of an over-stretch by the member leading to funds
shortage in clearing bank account, trading in its account will be suspended temporarily. In addition, the track
record of a member is monitored continuously and position limits are revised based on net worth and other
parameters.
In addition to risk management arising from member defaults and counterparty risk, the stock exchange
also has in place efficient market surveillance system that generates timely and real time intelligence on trades
and market trends. The exchange seeks to curb excessive volatility, detect and prevent price manipulation and
follows a system of imposition of price bands. Further, the exchange maintains strict surveillance over market
activities in liquid and volatile securities.

For all scrips that do not have any derivatives on them, price bands are fixed by the exchange within the
range of 2% to 20%. In order to prevent excess price volatility, SEBI also prescribed system wide circuit
breakers that would bring the entire market to a coordinated halt, if the index breaches the specified band of
10, 15 or 20%. The exchange does not prescribe any trading price band for securities on which derivative
products are available or securities included in indices on which derivative products are available. In such
cases, in order to prevent members from entering bogus trades, the exchange imposes a price band of 20%.
Any order that falls above or below 20% over the base price, causes an alert to the exchange as a price freeze.
Similarly, system alerts are provided when there is a very large order (the size of a block deal) in value or
quantity that could lead to a quantity freeze.