What is Risk Management?

A sound risk management system is integral to an efficient clearing and settlement system. The system must ensure that brokers / trading member’s obligations are commensurate with their networth.

Risk containment measures include capital adequacy requirements, margin requirements, position limits based on capital, online monitoring of client positions etc.

The main concepts of a Risk Management System are listed below:

• There should be a clear balance available in the client’s ledger account in the broker’s books.
  
  
• The clients are required to provide margins upfront before putting in trade requests with the brokers.
  
  
• The aggregate exposure of the client’s obligations should commensurate with the capital and net worth of the broker.
  
  
• Ideally, the client must square-up all the extra positions that have been created on an intra-day basis before 3.00 p.m.
  
  
• The clients must settle the debits, if any, arising out of MTM settlements.
  
  
• In futures and options segment, the positions are allowed based on the margin available to satisfy initial margin requirements of the Exchange. The clients are expected to pay the MTM margin as and when required failing which the client or the broker may square off the trade.
  

Capital Adequacy Requirements

Credit risks are inevitable in financial markets, and managing them is a crucial part of market functioning. In the equities and derivatives market, brokers’ capital adequacy is one of the two critical components of credit risk management, the other being daily margins.

The Capital Adequacy Requirements consists of two components i.e. the Base Minimum Capital and the Additional or Optional Capital related to volume of the Business.

Base minimum capital/ Additional Base Capital

Base Minimum capital is the deposit a stock broker has to make with the stock exchange to get trading rights on the exchange. Even then, the broker may take positions (the sum of his and his clients’) only up to a pre-specified multiple of this deposit amount.

As per the SEBI (Stock Brokers and Sub-Brokers) Regulations, an absolute minimum of Rs. 5 lakh as a deposit with the Exchange shall be maintained by member brokers of the Bombay and Calcutta Stock Exchange, and Rs. 3.5 lakhs by the Delhi and Ahmedabad Stock Exchanges.

This requirement is irrespective of the volume of business of an individual broker. The security deposit kept by the members in the exchanges shall form part of the base minimum capital.

Internal client account control

The stock broker shall segregate client funds from it’s own funds. Stock broker shall keep the client’s money in a separate bank account designated as client account and their own money in a separate bank account.

There are only certain circumstances in which the stock broker shall transfer funds from own account to the clients’ accounts and vice versa. The stock broker shall also not transfer funds from one client’s account to another. The stock broker shall not use clients’ funds for the purpose of self trading or other clients trading.

Margin Requirements – On what Basis it is Calculated?

One of the critical components of risk management for the futures and options segment is the margining system. The Exchange levies daily margin, Mark-to-Market (MTM) margin, Extreme loss margin in the equities segment and initial margin and MTM margin in case of futures and options segment. The daily margin is calculated based on Value at Risk (VAR).

The broker needs to maintain upfront capital with the exchange to cover his daily margin at the time of order placement. To ensure this, the broker collects upfront margin by way of funds/ shares from the client and deposits the same with the exchange.

Initial Margin is calculated on a portfolio basis and not on individual scrip basis. The margin calculation is done using SPAN (Standard Portfolio Analysis of Risk) a product developed by Chicago Mercantile Exchange. The margin is levied at trade level on real-time basis.

The rates are computed at 5 intervals one at the beginning of the day 3 during market hours and one at the end of the day. The objective of SPAN is to identify overall risk in a portfolio of futures and options contracts for each client.

The system treats futures and options contracts uniformly, while at the same time recognizing the unique exposures associated with options portfolios like extremely deep out-of-the-money short positions and inter-month risk.

On Gross Client Basis

The margin is required to be paid on the gross open position of the stock broker. The gross open position signifies the gross of all net positions across all the clients of a member, including the proprietary position of the member.

Thus, it is important for the stock broker at any time to know the position on both gross and net basis for all clients. Two types of margins are applicable for option writing – initial margin and mark to market margins.

Both are based on the standardised portfolio analysis of risk (SPAN) model. The initial margin and the mark-to-market requirements are based on a worst-case scenario calculated by valuing the portfolio under several scenarios of changes in market conditions over a trading day.

Mark-to-Market Margin

Mark to market is calculated by marking each transaction in security to the closing price of the security at the end of trading. In case the security has not been traded on a particular day, the latest available closing price is considered as the closing price.

In case the net outstanding position in any security is nil, the difference between the buy and sell values shall be is considered as notional loss for the purpose of calculating the mark to market margin payable.

Value at Risk (VaR) Margining

All securities are classified into three groups for the purpose of VaR margin.

• For the securities listed in Group I, scrip wise daily volatility calculated using the exponentially weighted moving average methodology is applied to daily returns. The scrip wise daily VaR is 3.5 times the volatility so calculated subject to a minimum of 7.5%.
  
  
• For the securities listed in Group II, the VaR margin is higher of scrip VaR (3.5 sigma) or three times the index VaR, and it is scaled up by root 3.
  
  
• For the securities listed in Group III the VaR margin is equal to five times the index VaR and scaled up by root 3.
  

The index VaR, for the purpose, is the higher of the daily Index VaR based on S&P CNX NIFTY or BSE SENSEX, subject to a minimum of 5%.The VaR margin rate computed as mentioned above is charged on the net outstanding position (buy value-sell value) of the respective clients on the respective securities across all open settlements.

There is no netting off of positions across different settlements. The net position at a client level for a member is arrived at and thereafter, it is grossed across all the clients including proprietary position to arrive at the gross open position.

Extreme Loss Margin

The Extreme Loss Margin for any security is higher of 5%, or 1.5 times the standard deviation of daily logarithmic returns of the security price in the last six months. This computation is done at the end of each month by taking the price data on a rolling basis for the past six months and the resulting value is applicable for the next month.

The Extreme Loss Margin is collected/ adjusted against the total liquid assets of the member on a real time basis. The Extreme Loss Margin is collected on the gross open position of the stock broker. The gross open position for this purpose means the gross of all net positions across all the clients of a member including its proprietary position.

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Compliances and Regulatory Reporting

Directives are issued by SEBI and the stock exchanges for stock brokers to follow. These include directives on margin requirements, smooth functioning of pay in/payout trading restrictions, base minimum capital, etc. Other requirements include submission of audit reports along with the annual reports to the exchanges and payments of turnover fees to SEBI.

It is the duty of the stock brokers to inform the exchanges of any defaulting clients or defaulting sub-brokers. The stock broker has also to inform the public/clients that his subbroker’s registration has been cancelled and that they are not to deal with them.

The stock broker shall obtain SEBI’s permission to continue dealing in securities in case there has been any change in his firm’s constitution or status. The stock brokers shall not enter orders into the systems of the exchange in order to lower or raise prices or manipulate markets.

Failure to maintain or furnish documents as prescribed under the various subsections of 15

Section 15A of the SEBI Act, 1992, prescribes penalty for failure to furnish information, return, etc. It reads as under:

If any person, who is required under this Act or any rules or regulations made thereunder,-

1. to furnish any document, return or report to the Board, fails to furnish the same, he shall be liable to a penalty of one lakh rupees for each such day during which such failure continues or one crore rupees, whichever is less;
   
   
2. To file any return or furnish any information, books or other documents within the time specified therefor in the regulations, fails to file return or furnish the same within the time specified therefor in the regulations, he shall be liable to “a penalty of one lakh rupees for each day during which such failure continues or one crore rupees, whichever is less;
   
   
3. To maintain books of accounts or records, fails to maintain the same, he shall be liable to a “a penalty of one lakh rupees for each day during which such failure continues or one crore rupees whichever is less.
   
   

Maintenance of different types of Books as prescribed under SC(R)R 1957

Rule 15 of the SC(R)R states that every member of a recognised stock exchange should maintain and preserve the following books of account and documents for a period of five years:

1. Register of transactions (Sauda book).
   
   
2. Clients’ ledger.
   
   
3. General ledger.
   
   
4. Journals.
   
   
5. Cash book.
   
   
6. Bank pass-book.
   
   
7. Documents register showing full particulars of shares and securities received and delivered.

Rule 15 of the said Rules also states that every member of a recognised stock exchange
should maintain and preserve the following documents for a period of two years:

• Members’ contract books showing details of all contracts entered into by him with other members of the same exchange or counter-foils or duplicates of memos of confirmation issued to such other members.
  
  
  
• Counter-foils or duplicates of contract notes issued to clients.
  
  
  
• Written consent of clients in respect of contracts entered into as principals.
  
  

Submission of various periodic reports

The stock exchanges have prescribed certain periodic reports to be submitted by the brokers in their compliance calendars. These include:

• System Audit Report – By 31 July yearly • Annual Returns – Within 6 months from the end of accounting year •
  
  
• Client wise Funding Report -Within seven days form the end of the month.
  
  
• Internal Audit Report Half yearly basis -Within 3 months from half year ended March and September
  
  
• Net worth certificate Half yearly basis – Within 3 months from half year ending.
  
  
• Networth certificate in Margin Trading for CM Segment-Within one month from the end of half year.
  
  
• Proof of Insurance cover – By July 31 yearly.
  
  
• Client details for Margin Trading facility – Before 9:00pm on the trade day.
  

Sending account statements to clients

Each stock broker is required to send a statement of account for both funds and securities at least on a quarterly basis, within a month from the end of the period, to each client. The stock broker is also required to send daily margin information to all the clients.

The said information shall contain Client Code and Name, Scrip wise Details of collaterals received returned from/to clients, Status of Collaterals held, Breakup of Margins held by the member viz. value of Collaterals, Bank Guarantees, Fixed Deposit Receipts (FDRs) held and Cash balance available, Details of amount utilized towards margins etc.

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