RISK MANAGEMENT IN SECONDARY MARKET

The stock exchanges have developed a comprehensive risk management mechanism to promote a safe and efficient capital market. These include:

v Laying down trading rules and regulations for broker members.

v Setting up market surveillance systems to curb excess volatility.

v Creating trade/settlement guarantee fund to ensure timely settlements even if a member defaults to deliver securities or pay cash.

v Setting up a clearing corporation to guarantee financial settlement of all trades and thereby reduce credit risk in the settlement system.

The Risk Management structure of Secondary Market (or stock exchanges) has been discussed in detail in the following paragraphs to enable students to have a good grasp over the nuances of secondary market.
I. Trading Rules and Regulations

Strict rules and regulations have been framed to prevent unfair trading practices and insider trading. Stock exchanges impose different types of margins on brokers for individual stocks, depending upon the exposures taken by these brokers in these stocks, both on ownership basis and on behalf of clients. These margins are collected to prevent brokers from taking market positions in excess of their buying capacity. They are also used to settle any amount due to the stock exchange, clearing corporation and traders, in case the broker faces any shortage of amount.

Further, there is a real time monitoring of the intra-day trading limits and gross exposure limits by the stock exchanges. There is an automatic deactivation of trading terminals in case of breach of exposure limits. Also, SEBI stipulated that stock brokers and sub-brokers of one exchange cannot

deal with the brokers and sub-brokers of the same exchange either for proprietary trading or for trading on behalf of their clients. However, they can deal with the brokers and sub-brokers of another exchange for proprietary trading only.

Moreover, to ensure fair trading practices, the SEBI has devised insider trading regulations by prohibiting insider trading and making it a criminal offence. To ensure transparency in the takeover process, SEBI takeover regulations have been made.
I. Circuit Breakers to curb excess volatility

Circuit Breaker is a temporary halt or suspension of trading in any particular stock or index for certain period of time. The move is basically resorted to curb excess volatility in the stock market.

There are two methods by which circuit breakers are practiced:

1. Suspension of trade in a security or index for a certain period.

2. Suspension of trade in a security or index for the entire trading day.

In case of first option, trading activities are suspended for few hours to enable the market to settle down. This also allows market participants to make an informed decision by having a relook at the market. If the market is very volatile and it seems that it is going out of control, then the trading may be halted for the entire day.

Advantages of Circuit Breakers

(i) During the suspension period, circuit breakers allow participants to reassess the situation by gathering new information.

(ii) It helps in controlling panic among the investors.

(iii) It also helps exchange clearing houses to monitor their members.

(iv) It also helps investors to take a rational approach towards the security during the time the trading is suspended.

Disadvantages of Circuit Breakers

(i) Firstly, circuit breakers prevents true discovery of price for the period during which it is imposed.

(ii) Secondly, sometimes circuit breakers prove to be unfair to retail investors because well informed investors such as foreign institutional investors usually makes a move before the circuit breaker can be invoked leading to chaos and confusion among retail investors.

The extent of duration of the market halt and pre-open session is as given below:

Circuit Breaker

Trigger limit	Trigger Time	Market halt duration
10%	Before 1 p.m.	1 Hour
	At or after 1 p.m upto 2.30 pm	30 minute
	At or after 2.30 p.m	No halt
15%	Before 1p.m	2 hours
	At or after 1 p.m upto 2.30 p.m	1 hour
	On or after 2 p.m	Remainder of the day
20%	Any time during market hours	Remainder of the day

I. Trading and Settlement

Rolling settlement is basically settlement of transaction in stock market in a certain number of days after the trade is agreed.

Rolling settlement can be explained with the help of following table:

Rolling Settlement

Activity	Description of Activities	Day	Timings
Trading	Trading by investors	T day
Clearing	National Securities Clearing Corporation Ltd. (NSCCL)  confirms the trade from stock exchange. Then, NSCCL process and download obligation files to brokers.	T + 1	By 1.30 P.M.
Settlement	Pay-in of securities and funds to NSCCL. NSCCL gives pay out  of  securities and funds.	T + 2	By 10.30 A.M. By 1.30 P.M.

The above chart has been explained in the next paragraph: 

Trading Day (T Day) 

T stands for trading. Trading can be done during the entire day i.e. from 9.00 A.M. to 3.30 P.M. Trading can be done on any working day (except Saturday and Sunday and other holidays as intimated by the stock exchange from time to time). During the trading process, one investor buys

the shares and other investor purchases the shares. After the execution of trading, the buyer receives the shares and the seller receives money for the shares he parted. 

Clearing Activities (T+1 day) 

Clearing is a process of determination of obligations, after which obligations are discharged by settlement. On the T+1 day i.e. one day after the trading day, first of all, the National Securities Clearing Corporation Ltd. (NSCCL) confirms the trade executed during the day from the Stock Exchange which helps it to determine the obligation of each member (broker) in terms of funds and securities. After that, the netting of obligations is done. This entire process of determining the obligation is done by the custodians/clearing corporation which works under the NSCCL. Once the netting of obligation is done, all the files are processed and downloaded so that each broker knows what he has to pay-in and receive. 

Netting explained 

Suppose, an investor buys 100 shares @ Rs. 2000 each on Monday and sell those shares @ 2500 each on the same day. His net obligation in terms of funds and securities will be calculated on Tuesday. In terms of securities, his net obligation is nil as he has sold all the shares he bought. So, he will neither receive nor give any security. On the other hand, his net monetary obligations will be calculated taking into account his buying and selling amount. In this case, the net amount he is receiving is Rs. 50000 (100 shares x Rs. 2500 – 100 shares x Rs. 2000).This pay-in and pay- out of funds are calculated on T+2 day i.e. on Wednesday. 

Settlement Activities (T+2 Day) 

On the second working day i.e. T+2 day, all the brokers has to pay-in the required funds and securities to the NSCCL by 10.30 A.M. giving the required instructions to the respective clearing banks and members on the same day. Moreover, by 1.30 on the same day, brokers get the required funds through the NSCCL. This is called pay-out of funds. 

Pay-in and pay-out of funds explained 

Pay-in of funds take place when NSCCL gives the required funds to the clearing corporation by giving instructions to the clearing bank which credits the account of clearing corporation and debit the accounts of clearing bank. This is called pay-in of funds. After that, the NSCCL gives electronic instructions to the clearing banks to credit accounts of clearing members and debit accounts of the clearing corporation. This is called pay-out of funds and this completes the settlement cycle. 

Pay-in and pay-out of securities explained 

Pay-in of securities means that shares that the shareholder wants to sell are picked up from their Demat account and transferred to the broker's account. All these shares are then delivered to the clearing corporation. In pay-out of securities, the shares that the investor wants to buy are received from the clearing corporation and then transferred to the broker's account. After that, the shares are transferred from the broker’s account to the buyer’s demat account.

I. National Securities Clearing Corporation Limited 

In April 1995, the NSE set up the National Securities Clearing Corporation Limited (NSCCL), its wholly owned subsidiary, to undertake clearing and settlement at the exchange. It started operations from April 1996.The NSCCL undertakes the counter party risk of each member and guarantees settlement. Settlement guarantee is a guarantee provided by the clearing corporation for the settlement of all trading of products in the stock exchange. The organizations linked with Clearing Corporation in the clearing and settlement process are discussed as below: 

(a) Custodians/Clearing Members: NSCCL takes trading information from the exchange and pass the trade details to custodians/clearing members. Custodians confirm the obligations of the parties by netting. 

(b) Clearing Banks: They act as a link between clearing corporation and clearing member. Every clearing member is required to maintain a clearing account with one of the clearing banks. A clearing bank has to enter into an agreement with the NSCCL and clearing member and open clearing account with the depository. 

(c) Depositories: They hold securities in dematerialized form for the investors in their beneficiary account. Every clearing member is required to maintain a clearing pool account with the depositories. 

The clearing banks, on receiving electronic instructions from the NSCCL, debit accounts of clearing banks and credit accounts of the clearing corporation. This is termed as pay-in of funds and securities. The NSCCL, after providing for shortages of funds and securities, sends electronic instructions to the depositories and clearing banks to credit accounts of clearing members and debit accounts of the clearing corporation. Thus, the settlement cycle is completed once the pay out of funds and securities is done. 

II. Market Making System 

The job of the market maker is to provide liquidity to the stock market by providing a two way quote i.e. a buy and a sell quote. How the market makers do this? And what is the purpose. Consider a situation, when you want to purchase shares and there is no one there to sell his share. What will happen? Such a person has to wait until he finds a person who can sell his shares at a price quoted by him. The market maker resolves this problem. He sells shares at the quoted price. This way, the person gets the shares he wants to sell. Conversely, if a person wants to sell his shares, market maker may come at his rescue and purchase shares at the price quoted by him. So, he gets the shares he was so willing to purchase. Hence, market maker has devised a system in which anyone can buy and sell shares anytime. 

Market makers are basically large brokerage houses. But, how do they make money? And, there is a chance that they may suffer loss. For e.g. if they buy shares at a particular price and are not able to sell them later at a higher price because of fall in market price of shares, they will incur loss. To offset this loss, they purchase shares at a particular price (ask price) say Rs. 100 and sell them ata slightly higher price say Rs. 100.10 (bid price). This profit margin of 0.10 seems to be very nominal. But, when trading of millions of shares takes place in a day, the market maker at the end of the day managed to pocket a significant amount. 

The obligations and responsibilities of Market Makers (as per BSE website) 

The Market Maker shall fulfill the following conditions to provide depth and continuity on this exchange: 

a. The Market Maker shall be required to provide a 2-way quote for 75% of the time in a day. The same shall be monitored by the stock exchange. Further, the Market Maker shall inform the exchange in advance for each and every black out period when the quotes are not being offered by the Market Maker. 

b. The minimum depth of the quote shall be Rs.1,00,000/- . However, the investors with holdings of value less than Rs 1,00,000 shall be allowed to offer their holding to the Market Maker in that scrip provided that he sells his entire holding in that scrip in one lot along with a declaration to the effect to the selling broker. 

c. Execution of the order at the quoted price and quantity must be guaranteed by the Market Maker, for the quotes given by him. 

d. There would not be more than five Market Makers for a scrip. These would be selected on the basis of objective criteria to be evolved by the Exchange which would include capital adequacy, networth, infrastructure, minimum volume of business etc. 

e. The Market Maker may compete with other Market Makers for better quotes to the investors; 

f. Once registered as a Market Maker, he has to start providing quotes from the day of the listing / the day when designated as the Market Maker for the respective scrip and shall be subject to the guidelines laid down for market making by the exchange.Once registered as a Market Maker, he has to act in that capacity for a period as mutually decided between the Merchant Banker and the market maker. 

g. Further, the Market Maker shall be allowed to deregister by giving one month notice to the exchange. 

II. Securities Lending and Borrowing (SLB) 

Securities lending means lending of stocks, derivatives and other securities to investor or firm. Securities lending requires the borrower to pledge, whether cash, security or a letter of credit to the lender. When a security is lent, the title and the ownership are also transferred to the borrower. 

Why securities lending and borrowing is important? The Securities lending and borrowing has its importance in short selling. Basically, short selling is a facility in which a person (short seller) can sell shares which he does not own or possess. What is the advantage of doing that? The short seller borrows security to immediately sell them. He generally does that when he has a firm beliefthat security prices will come down in the near future. So, he borrows security hoping to profit by selling the security and buying it back at a lower price. The borrower of securities pays the lender interest on the value of the securities borrowed. 

The borrower of securities are usually brokers, speculators, market makers, custodian banks, clearing banks, clearing corporation, and finance companies. The lenders are mutual funds, insurance companies, custodian banks, finance companies, brokers and high net worth individuals. 

Further, the lender still remains the owner of stock after SLB and gets all beneficial rights such as dividend, rights or bonus shares in respect of the stock lent. The borrower, however, has the legal title of the borrowed securities and is eligible to trade and sell securities in any manner he thinks fit. Moreover, there is roll over facility also i.e. the lender and borrower can extend the period of their borrowing and lending respectively. 

Merits of Stock Lending and Borrowing 

(i) Provides facility to the borrowers who are anticipating fall in the market price of securities to sell securities which they don’t own. 

(ii) Provides an incentive to institutional investors such as banks, mutual funds, financial institutions and insurance companies to earn income by lending their idle stock in the market and earn interest income from borrowers. 

(iii) Increase liquidity of the stock as more and more people can sell or purchase stock inspite of shortage of money. 

(iv) Providing stability to stock market movements. 

(v) Helps to avoid delivery failures as it is routed through the clearing house and facilitates timely delivery. 

(vi) And, lastly, manipulation of stock prices is difficult. 

I. Straight Through Processing (STP) 

The concept of Straight Through Processing is designed to complete the transaction without human intervention. Straight through processing (STP) is an initiative that financial companies use to optimize the speed at which they process transactions. This is performed by allowing information that has been electronically entered to be transferred from one party to another in the settlement process without manually re-entering the same pieces of information repeatedly over the entire sequence of events. 

The primary purpose of STP is to streamline the processing of transactions across multiple points. By allowing information to pass along electronically, this eliminates the need for a hands-on reentry of data that has already been completed at the source. Additionally, information could be sent to more than one party simultaneously if it is appropriate for the transaction type. 

So, the purpose of STP is to eliminate costly delays during transaction processing period. Sincemanual assistance is not needed, there is no delay between one party receiving information and the other being able to proceed further. 

In normal processing, information must be handled by the multiple persons involved. This requires taking the time to accept and review the information, rekeying data as required, and then sending it forward to the next part of the transaction process. STP eliminates the human factor, allowing an automated process to complete any steps needed for a transaction to proceed. By eliminating these delays, the transactions can be more cost-effective as they require less time to manage. This is particularly attractive to investors looking for lower fee options. 

The benefit of STP can be explained with the help of an example. In a manual trade, the broker issues a contract note which is then passed on to the custodian or a depository participant. There are multiple data entries during the different stages of a manual trade which makes the process prone to errors, delays and manipulation. However, in STP, contract note is issued in electronic form and the trade is settled in computer leaving almost no scope for manipulation. Further, in comparison to manual trade, STP is quicker, risk free and eliminates any failure in trade. (Source : Investopedia) 

I. Margin Trading 

Margin Trading is a facility given to the investors in which they can invest in shares by part financing from the bank. In other words, investors can provide some amount of money from their pocket to invest in shares, and rest of the amount will be financed by the banks. Margin trading permits investors to buy shares by providing 40% of the total value as margin, while borrowing 60% from the banks. 

For example, an investor wants to buy 20000 shares worth Rs. 2,00,000 (price of one share is Rs. 10). But, he can invest only Rs. 80000 from his own pocket. However, under margin trading, he can buy as many as 20000 shares worth Rs. 200000 from his broker by paying Rs. 80000 as margin and by borrowing the balance Rs. 120000 from a bank through his broker. The broker pledges 20000 shares with the bank. The bank has collateral of Rs. 200000 backing the loan of Rs. 120000. 

Now, suppose, the market price of share moves upwards from Rs. 10 to Rs. 15. So, with the help of the facility of margin trading, the shareholder can sell his entire shareholding of 20000 shares and pocket a gain of Rs. 100000 (20000 shares x Rs. 15 – 20000 shares x Rs. 10). Conversely, if he hadn’t availed the facility of margin trading, he would have been able to sell only 8000 shares and pocketed a gain of Rs. 40000 only. The reason is that he would have purchased only 8000 shares because of paucity of funds. 

On the other hand, if the market price of shares fall below Rs. 10, the bank will give a margin call under which the investors will have to furnish additional funds/securities for the broker to pass on to the bank. 

Margin trading gives a unique opportunity to the bank to lend short term funds at a high rate of interest. However, banks have to evolve a suitable risk management mechanism to safeguard the loans given by them against collateral of securities. In the same way, it provides a facility to the investors to borrow to money from the bank and invest it in the stock market.