Agenda

1. Reforming Payment and Securities Settlement Systems – Global Courseorganised by theWorld Bank and US Federal Reserve BoardSession onMain Environmental Issues inPayments and Securities Settlement Systems

2. Agenda • Issues in Payment and Settlement Systems • Sharing the Indian Experience • Current market structure • The process • Regulatory and legal framework • Supervisory framework • Governance and Ownership structure • Risk management • Managing the change

3. What drives the reforms • Settlement risks • Iliquidity • Market inefficiency • Basically benefit driven reforms • The strategic process and need for sequencing • PSS reform an integral part • of market reforms • Market process integrated • end to end • Hence sequencing needed • Manage the change • Efficient management • of change – regulatory support • Take market participants along • Assess end-users’ needs • Use technology and skill set • What drove PSS reforms in India • securities market critical to • the economy • Demand from the end users • SEBI – key driver of the change Issues in Reforming Payment and Securities settlement Systems © Reynolds and Hines, 2000

4. Sharing the Indian ExperienceCurrent market structure Full range of products in cash and derivatives market – • equity, bonds, government securities, exchange traded funds, index options and futures, stock options and stock futures, interest rate derivatives and propose to introduce currency derivatives. • OTC market for corporate bonds and government securities, and interest rate derivatives also exist

5. Sharing the Indian ExperienceCurrent market structure • The objectives of the reforms • in the securities settlement systems – •  Reduction and mitigation of systemic, • structural and operational risks • Increase speed of transaction, execution • and settlement of trade and facilitate •  Quicker settlement of transactions with finality • Safety of the settlement process •  Reduction of transaction costs and thereby • Make market more efficient and transparent • for investors and participants

6. Sharing the Indian ExperienceCurrent market structure (contd.)  T+2 Rolling Settlement  Central Counterparty providing novation and settlement guarantee  Electronic Transfer of Securities  99.99% settlement in dematerialised securities  Limited Straight Through Processing (not yet mandatory for participants)  Fine-tuned VaR based Risk Management System for cash and derivatives, including real time SPAN for derivatives  State of the art information technology  100% electronic trading which obviates need for trade confirmation Finality of settlement from the moment trade is executed  ISIN for securities  Electronic and automated communication standards

7. Sharing the Indian Experience – The process Market automation – National Stock Exchange set up in in 1994; SEBI first encouraged and then mandated automation of all 23 stock exchanges, which was completed by end 1997

8. Sharing the Indian Experience – The process Dematerialisation began with the setting up of NSDL under an Act in 1996. It gathered momentum from 1998 with SEBI mandating it for the market in a phased manner. By 2000 the market was settling in dematerialised securities.

9. Sharing the Indian Experience –The process • During this period several • other measures were taken • Broker domination was reduced from governing boards of exchanges • CCPs and Trade guarantee funds were set up at the exchanges to guarantee settlement BUT the trading in securities was still account period and derivatives had not picked up at all.

10. Sharing the Indian Experience –The process The automation of exchanges, dematerialisation and CCPs had prepared the market for a major transformation. This happened following an episode of major market misconduct in 2000. From June 2001 account period settlement was abolished by SEBI and T+5 rolling settlement was introduced. Derivatives trading began to take off

11. Sharing the Indian Experience – The process Between 2002 –till date rapid progress in market reforms Settlement cycles shortened to T+3 in April 2002, to T+2 in April 2003  Derivatives products expanded – to include single stock options and futures. The market picked up Margining system in cash and derivatives – VaR based and real time SPAN Risk management refined STP introduced

12. Sharing the Indian Experience – The process Between 2002 –till date rapid progress in market reforms (contd.)  Further changes in the governance of the stock exchanges  Role of brokers in the management of stock exchanges eliminated  Demutualisation of stock exchanges with segregation of trading ownership and management rights.  Electronic fund transfer introduced by RBI RTGS to be set up soon CCIL settles G-sec trading on NDS

13. EXCHANGE 1 CSACSA CSA 9 CLEARING BANKS DEPOSITORY 8 7 6 10 5 2 3 2 4 11 CUSTODIAN / CM Sharing the Indian Experience –The process For reforms of the Securities Payment and Settlement Systems to be effective, reforms must be sequenced so as to embrace every part of this process, as all the parts are integrally related

14. Sharing the Indian ExperienceRegulatory and legal framework • Regulatory framework for securities markets : • Securities and Exchange Board of India Act,1992 (SEBI set up under this Act); • Securities Contract (Regulation) Act, 1956 (Act to establish and regulate exchanges); • Depositories Act, 1996 (regulates depositories); • Companies Act, 1956 • SEBI regulates and supervises the securities markets through 23 Regulations and 2 Guidelines. • SEBI exercises powers under the first 3 Acts and some powers under Companies Act. In addition the bye laws, rules and regulations of exchanges approved by SEBI

15. Sharing the Indian ExperienceRegulatory and legal framework • Transparent and effective regulation and oversight of securities settlement system is thus largely based on statutes. • These statutes and regulations, together with the bye laws, rules and regulations of the exchanges, which are under constant review provide a well founded, clear and transparent legal basis for trading, settlement, enforcement of securities contracts and protection of investors interests.

16. Sharing the Indian ExperienceRegulatory and legal framework • Well founded, clear and transparent legal basis for trading, settlement, enforcement of securities contracts and protection of investors interests. • Transparent and effective regulation and oversight of settlement system largely based on statutes.

17. Sharing the Indian ExperienceSupervisory framework SEBI supervision over the stock exchanges,clearing houses and corporations, stock brokers, depositories and depository participants, through constant dialogue, periodical meetings, reporting and annual inspection and review. Any change in bye laws, rules and regulations of exchanges and depositories need the approval of SEBI The risk management of the cash and derivatives market laid down in consultation with SEBI

18. Sharing the Indian ExperienceGovernance and Ownership structure

19. Sharing the Indian Experience Risk management • All risk management measures need the approval of the Securities and Exchange Board of India • Capital adequacy norms • Trading and exposure limits • On-line exposure monitoring • Automatic disablement of members • VaR and MTM margining • Margining at client level • Market wide circuit breakers • Trade/settlement guarantee funds • History maintenance of members activities • Contingent plans • Inspection and investigation

20. Sharing the Indian ExperienceRisk management (contd) Margining For the Cash Market – • Securities categorised on measures of liquidity and volatility • For liquidity - using mean impact cost analysis on the basis of random snapshots (4 time a day) of daily order book over past six months on a rolling basis; • For volatility- using index sigma and stock sigma • Computation methodology disseminated to public through the web sites of the exchanges • Margins are on a gross basis – gross across securities for the same client, but netted for the same secuirtiy • All calculations systems driven – no manual intervention at any stage, except for setting the algorithms • Above methodology validated by extensive back testing

21. Sharing the Indian ExperienceRisk management (contd) Margining For the Cash Market – • VAR margin covers a confidence interval of 99% over a one day time horizon • Second line of margining for the balance 1% scenario • In addition Mark to market margin • Margins collected on T+1, before trading begins next day • Inability to pay margins results in automatic switching off of member terminal denying access for fresh orders • In addition members have gross exposure limits related to their capital which is on line monitored real time by the exchanges • Margins to be brought in cash and government securities (with hair cut) and bank guarantee from selected banks

22. Sharing the Indian ExperienceRisk management (contd) • Both models of CCP available – Clearing Corporation of National Stock Exchange set up by the exchange as wholly owned subsidiary, acting as CCP to all trades and novation with multi lateral netting • Stress tests done to check the adequacy of trade guarantee funds of the CCP • So far no occasion in which the CCP has failed on account of inadequacy of capital. The clearing corporation of NSE has back stop liquidity facility with the central bank by way of line of credit which it had no occasion to draw upon in the last 7 years even under conditions of extreme market volatility

23. Sharing the Indian ExperienceRisk management for the Derivatives Market • CCP • SPAN system • Real time SPAN monitoring • Gross margining • Margins paid upfront – cash or cash equivalent • Clearing member margin • Client level margins • Exposure limits – over all market wide position limits, clearing member position limits, client level position limits • Possible loss on entire portfolio of entire portfolio estimated under a variety of price and volatility scenarios • Entire margin system with automatic shut off of terminals in case of breach of exposures or non payment of margins

24. Sharing the Indian Experience Managing the change • Extensive consultative process with the market participants – helps build up consensus • Various consultative and advisory committees set up by SEBI comprising of market participants, experts, academics Reports of the committees put out for public comments • Consultation and coordination with other regulators • Frequent meetings with the stock exchanges and intermediary associations, chambers of commerce • Extensive programme of investor awareness.