Risk Management — margins, collateral and the safety net

Why any of this exists

A clearing corporation provides a settlement guarantee — the settlement of securities and funds will take place even if a broker or clearing member fails to fulfil their obligation. That promise is only as good as the money standing behind it. Everything in this chapter is the machinery that collects and holds that money.

The risk management system must be well documented and made accessible to clients as well as the Exchange / Clearing Corporation.

The Clearing Corporation's risk management system, applicable to both cash and derivatives segments, has these features:

• On-line real time risk management, with online monitoring of margin against liquid assets and on-line position limit monitoring.
• A scientific way of identifying margin level, with different kinds of margins to cover all kinds of losses.
• Intra-day and end of day mark to market.
• Client level collateral segregation and margining.
• Alerts to members at various levels of collateral utilisation.
• Risk reduction mode.
• Automatic disablement from trading when limits are breached.
• Cross margining facility.
• Capital adequacy requirements of members and monitoring of member performance and track record.

The framework itself has five components: Margin, Liquid Assets, Base Minimum Capital, Pre-trade risk control and Risk Reduction Mode.

The cash segment: three margins

Margining is the process by which a clearing corporation computes the potential loss on the open positions held by members across all their clients, and then makes sure the liquid assets deposited are enough to cover it.

In the cash/equity segment the clearing corporation computes and collects three kinds of margin:

The member's liquid assets must at all times be adequate to cover all three.

VaR margin and the three liquidity groups

For margin purposes, securities are classified into three groups based on liquidity and impact cost:

All SME securities are classified as Group III securities.

The trading frequency and impact cost are calculated on the 15th of each month on a rolling basis, considering the previous 6 months for both. Securities then move from one group to another from the first of the next month.

For a stock listed less than six months, the entire trading history is used. For the first month, a newly listed stock is put in the group where its market capitalisation exceeds or equals the market capitalisation of 80% of the stocks in that group. If a corporate action changes the ISIN, the securities with the new ISIN are treated as a newly listed scrip for group categorisation.

Mean impact cost measures liquidity: the average percentage price movement caused by a hypothetical order of ₹1 lakh relative to the mean of the best bid and offer (the ideal price). It uses four random snapshots taken daily within fixed ten-minute windows over the previous six months, covering both buy and sell sides. Exchanges must use a common methodology and publish results on their websites.

Scrip sigma is the volatility of the security computed as at the end of the previous trading day, using the exponentially weighted moving average method on daily returns, as in the derivatives market.

The ETF concession applies only to ETFs tracking broad based market indices — not to ETFs tracking sectoral indices, which are treated at par with stocks.

Group III securities are monitored weekly. If a security has not traded for a week the rate goes up to 75%; if a 75%-rated security trades during the day, the rate is revised down to 50% from the start of the next trading day.

Collection of VaR margin:

• Collected upfront, adjusted against the member's total liquid assets at the time of trade.
• Collected on the gross open position of the member — meaning the gross of all net positions across all clients including the proprietary position.
• No netting of positions across different settlements.
• Released along with the pay-in, including early pay-in of securities.
• VaR margin rates are updated at least 5 times in a day — the previous day's closing price at the start of trading, then 11:00 a.m., 12:30 p.m., 2:00 p.m. and the end of the trading session.

Extreme Loss Margin

ELM is 3.5% for any stock and 2% for broad-based index ETFs (again, not sectoral ETFs). It is collected or adjusted against total liquid assets on a real time basis, on the gross open position, with no netting across different settlements, and is released on completion of pay-in.

The term Extreme Loss Margin replaces the older terms "exposure limits" and "second line of defence".

For securities in the Trade for Trade – Surveillance (TFTS) market, upfront margin (VaR + ELM) is 100%.

Mark to Market losses

MTM loss is calculated by marking each transaction to the closing price of the security at the end of trading. If the security did not trade that day, the latest available closing price is used. If the net outstanding position in a security is nil, the difference between buy and sell values is treated as a notional loss.

The critical rule: MTM profits and losses are computed for each client, but for collection from the broker the MTM is GROSSED across all clients — there is no set-off of one client's loss against another client's profit. Only the losses are added up.

So if Client A is down ₹900, Client B is down ₹1,100 and Client C is up ₹1,400, the broker deposits ₹2,000, not ₹600.

Other MTM rules:

• Collected from the member before the start of trading on the next day.
• Collected or adjusted against the cash / cash equivalent component of liquid assets.
• Collected on the gross open position: a client's positions are netted across securities, then all clients are grossed.
• In TFTS, each trade is marked to market against that security's closing price.
• No netting or set-off against MTM profits across two different settlements (T+1 and T+0); but within the day, netting or set-off against MTM profits is permitted.
• Released along with pay-in, including early pay-in.

Intraday Crystallised Mark to Market losses (ICMTM) apply to trades executed and closed out on the same trading day, calculated on weighted average prices, adjusted against liquid assets on a real time basis. Crystallised losses on one security for a client can be set off against crystallised profits on another security for the same client, but not across two rolling settlements. All client-level losses, including proprietary, are grossed up to the member level. ICMTM is not computed for TFTS securities and is included in the end-of-day MTM computation. If crystallised losses exceed the free collateral with the clearing corporation, the entity is put into risk reduction mode.

Two caps you should not forget

In a buy transaction in the cash market, VaR margins, extreme loss margins and mark to market losses together shall not exceed the purchase value of the transaction. In a sale transaction, VaR and ELM together shall not exceed the sale value, and mark to market losses shall also be levied on top.

Additional margin on highly volatile stocks

Intra-day price movement is the maximum of [High − Low], [High − Previous Close], [Low − Previous Close].

The same additional margin applies in the F&O segment.

Liquid assets — what the clearing corporation will accept

Liquid assets deposited by members are the core of the risk management system. They must cover four requirements: Mark to Market Losses, VaR Margins, Extreme Loss Margins and Base Minimum Capital.

Cash equivalents

Other liquid assets (non-cash component) — with two blanket restrictions: they cannot be used for mark to market losses, and the total of other liquid assets cannot exceed the total of cash equivalents.

Rules around them:

• Liquid assets are valued daily after applying haircuts.
• Mark to market losses must be paid in cash or cash equivalents.
• Cash equivalents shall be at least 50% of liquid assets — other liquid assets in excess of total cash equivalents are simply not counted as part of total liquid assets.
• Clearing corporations shall not accept collateral — FDs, BGs, equity or debt — issued by the clearing members or trading members themselves, or by their group or associate entities.
• Nor collateral acquired through bespoke transactions, where the CM is the sole subscriber of a corporate debt issuance.
• The overall daily exposure of a CC to a single bank (cash, FD, BG, equity and debt combined) through CM collateral shall not exceed 20% of total liquid assets.
• If an equity security stops meeting the liquid security criteria, the CM must replace it at the earliest.
• The clearing corporation generally publishes the list of approved securities monthly.

Institutional trades in the cash market

All institutional trades in the cash market are subject to margins, like everyone else. But TMs/CMs/Custodians are exempted from collecting UPFRONT margins on institutional transactions. Instead, institutional trades are margined on a T+1 basis, with the margin collected from the custodian upon confirmation of the trade.

Who counts as an institutional investor here:

• SEBI-registered Category I and II FPIs who are not corporate bodies, individuals or family offices.
• Mutual Funds.
• Public Financial Institutions under section 2(72) of the Companies Act, 2013.
• Banks as defined under section 5(1)(c) of the Banking Regulation Act, 1949.
• Insurance companies registered with IRDA.
• Pension Funds registered with PFRDA.

Note the carve-out: Category II FPIs who are corporate bodies, individuals or family offices are margined on an UPFRONT basis, like non-institutional trades.

Where the custodian confirms the transaction, margins are levied on the custodian. Where the custodian rejects or does not accept it, margins are levied on the member who executed the transaction.

For the call auction in the pre-open session — including for IPOs and re-listed scrips — risk management is at order level: every order is validated against applicable margins before acceptance, and if the member's available capital is insufficient, the order is not accepted.

Base Minimum Capital (BMC)

• BMC is meant to meet contingencies in any segment of the Exchange.
• For members registered on more than one segment of the same exchange, the highest BMC across segments applies.
• No exposure is granted against the BMC deposit.
• Exchanges may prescribe higher deposits than SEBI's norms based on their own risk perception.
• Minimum 50% of the deposit shall be in cash and cash equivalents.
• For brokers of exchanges without nation-wide trading terminals, the requirement is 40% of the above.
• Exchanges shall maintain BMC at ₹1 lakh if average daily turnover is less than ₹1 crore for any three consecutive months.

Pre-trade risk controls

Pre-order checks — applied before the order enters the trading system:

• Value/quantity limit per order: an order exceeding ₹10 crore per order cannot be accepted by the exchange for execution in the normal market. Exchanges also require brokers to set value/quantity checks based on each client's risk profile.
• Cumulative limit on unexecuted orders: brokers' trading algorithms must have a client level cumulative open order value check, limiting the total value of unexecuted orders from their terminals below a broker-set threshold.
• Dynamic price bands: SEBI advised scrip-wise price bands in 2001, ranging from 2% to 20%, for scrips in compulsory rolling settlement. Price bands do not apply to scrips with derivatives; for those, dynamic price bands prevent acceptance of orders beyond limits. Exchanges set dynamic price bands at 10% of the previous day's closing price / adjusted base price for stocks on which derivatives are available, index futures and stock futures. Flexing is tiered with increasing cooling-off periods — adjustments of 5%, 3% and 2% after 15, 30 and 60 minutes respectively — and the opposite band adjusts concurrently.
• UCC/PAN check: the exchange system does not allow order entry for clients whose UCC/PAN is not uploaded.

An alert message appears on the trading terminal when placing an order in a security under a surveillance measure such as GSM, ASM or ESM.

Pre-trade checks — applied before execution:

• Trade execution range — trades take place only if the price is within a range based on the contract's reference price (derivatives segment).
• Self-trade check — where pro/client orders from the same or different members would result in a self-trade because of the same PAN or CP code on the active and passive side, the active or passive order gets cancelled.
• Market price protection — the market-with-protection order.
• Kill switch — lets a member cancel all outstanding orders with one single command.
• Cancel on Logout (COL).

Index-based market-wide circuit breakers

Applied at three stages of index movement either way: 10%, 15% and 20%, and triggered by the movement of either the BSE Sensex or the NSE Nifty 50, whichever is breached earlier.

Risk Reduction Mode

Brokers are mandatorily put into risk reduction mode when a specified percentage — currently 90% — of the broker's collateral available for adjustment against margins is utilised.

In this mode:

• All unexecuted orders are cancelled the moment the 90% level is breached.
• Only orders with the Immediate or Cancel attribute are permitted.
• All new orders are checked for sufficiency of margins. Fresh orders that reduce open position are accepted; fresh orders that increase position are checked and rejected if margins are insufficient.
• Non-margined orders are not accepted.
• Members cannot place orders with a custodial participant code, and client and CP code modification is not permitted.
• The broker returns to normal mode when collateral utilisation falls below the level specified by the clearing corporation — currently 85%.

Note the asymmetry: you go in at 90% and come out at 85%. That gap stops brokers from flickering in and out of the mode.

Derivatives segment

The framework has five components: Margins, Liquid Net Worth and Liquid Assets, Pre-trade risk control, Risk Reduction Mode and Position Limits.

Initial margin and SPAN

Initial margin is payable on all open positions of clearing members, up to client level, and is payable upfront. It includes SPAN margins, margin on consolidated crystallised obligation, delivery margins and other additional margins specified by the clearing corporation.

Initial margin for client positions is netted at the level of the individual client and grossed across all clients at the trading/clearing member level, without any set-offs between clients. Proprietary positions are netted at member level without set-off between client and proprietary positions. Margins are aggregated first at the trading member level, then at the clearing member level.

SPAN is a product developed by the Chicago Mercantile Exchange (CME) and uses a scenario-based approach. Two features define it:

1. It generates 16 "what-if" scenarios, and the highest loss scenario determines the margin.
2. More importantly, it considers the entire portfolio of an investor for a portfolio-wide margin — the margin is not computed for each position separately.

Initial margin is based on 99% Value at Risk over a time horizon determined by the Margin Period of Risk (MPOR) of each product. SEBI has advised clearing corporations to estimate an appropriate MPOR, subject to a minimum of 2 days, per product, and to scale up the initial margins accordingly.

Scenario contract values shall be updated at least 5 times in the day — previous day's closing price at the start, then 11:00 a.m., 12:30 p.m., 2:00 p.m. and end of session. The same schedule as VaR in the cash segment.

Calendar spread charge

The benefit of offsetting positions across different expiries is NOT available on the day of expiry for contracts expiring on that day. If expiries fall on the 29th (current), 30th (next) and 31st (far), then on the 29th a spread between 29th and 30th, or 29th and 31st, gets no calendar spread treatment — but a spread between the 30th and the 31st still does.

Other derivative margins

Margin on consolidated crystallised obligation represents, intraday, payable crystallised obligations from closed-out futures positions plus payable/receivable premium at client level; and at end of day, payable obligations at client level considering all futures and options positions, comprising futures MTM to be settled, options premium payable/receivable, options exercise/assignment for expired contracts and futures final settlement for expired contracts. Released on completion of settlement. MTM must mandatorily be paid by all members before the start of trading the next day.

Net Option Value is the difference between long and short option positions valued at the last available closing price, updated intraday. It is added to the Liquid Net Worth of the clearing member — so the market value of short options is deducted and that of long options is added. Mark to market gains and losses shall not be settled in cash for options positions.

Upfront collection of option premium from option buyers was mandated because options carry very high implicit leverage; the upfront margin requirement includes net option premium payable at client level, applicable in the equity derivatives segment from February 01, 2025.

Delivery margins are levied on the lower of potential deliverable positions or in-the-money long option positions, four (4) days prior to expiry of a derivative contract that must be settled by delivery. If expiry is on a Thursday, delivery margins on potential ITM long option positions apply from the previous Friday end of day.

Extreme Loss Margin in derivatives:

For calendar spread positions in futures, ELM is levied on one third of the value of the far month contract. Where one leg expires on the same day, the ELM is computed without treating those futures as an offsetting calendar spread.

On the day of options expiry, an additional ELM of 2% is levied for short options contracts — applicable to all open short options at the start of the day and to short options initiated during the day that expire that day. This requirement applies to index option contracts.

Cross margining

Cross margining exists to improve the efficiency of the use of margin capital, and is available to all categories of market participants. Client positions in the cash market and F&O segments are considered to the extent they offset each other.

Eligible offsets include index futures against constituent stock futures, index futures against constituent stock positions in the cash market, ETF against constituent stock futures or cash positions, index futures against ETF in the cash market, stock futures against the underlying cash position, index futures on eligible equity indices, and offsetting positions in highly correlated indices.

Highly correlated indices means: positive correlation of more than 0.90; at least 80% of the constituents of one index present in the other; and constituents of the smaller index (by free float market cap) having at least 80% weightage in the larger index.

Spread margins:

For the 35% case, the expiry of the index futures may differ from that of its constituents, but the expiry of the futures contracts of all constituents must be the same. Where the two legs have different expiry dates, the benefit is revoked at the beginning of the expiry day of whichever position expires first.

Cross margining benefit is computed at client level on an online real time basis and passed on by the member to the client. For institutional investors it is provided after confirmation of trades.

Liquid Net Worth

Liquid Net Worth = total liquid assets deposited towards initial margin and capital adequacy MINUS initial margin and extreme loss/exposure margin applicable to the total gross open positions at any given time on all trades cleared through the clearing member.

A clearing member's liquid net worth shall not be less than ₹50 lakh at any point of time.

Position limits

Open Interest is measured at portfolio level as the net Delta adjusted open positions across futures and options for an underlying. Long futures have a delta of +1 times notional. For options, delta ranges between 0 and +1 times notional for long calls and between 0 and −1 times notional for long puts; for short positions, the effective delta of short calls is negative and that of short puts is positive. Gross addition of net Future Equivalent Open Interest (FutEq OI) across all UCCs gives the FutEq OI for the stock or index.

Market Wide Position Limit (MWPL) for a single stock is the LOWER of 15% of free float and 65 times Average Daily Delivery Value, with a floor of 10% of free float. Once market-wide open interest in a scrip exceeds 95% of the MWPL, members and clients may trade only to decrease their positions through offsetting positions — this is the ban period. A passive increase in position on account of movement in the scrip (delta) is not a breach.

For index derivatives, positions are also monitored against total market open interest at the end of the previous day's trade; if market OI drops, a participant can breach the limit without changing positions at all, and such passive breaches are not violations. Intraday position limits are monitored by exchanges through a minimum of four random snapshots during the trading day.

The pre-open session for the derivatives market extends to current-month futures contracts on single stocks and indices, and in the last five trading days before expiry it also extends to next-month futures contracts, because liquidity rolls over.

Margins from the client

Cash market segment: TMs/CMs must mandatorily collect a minimum 20% upfront margin (covering VaR and ELM) from clients before trade execution. Other margins — MTM, delivery, additional — are due when called, but members have until the settlement day to finish collection without penalty, provided full pay-in of funds and securities is completed. If a client completes full pay-in by settlement day, all other margins are deemed collected. Brokers are exempt from collecting MTM if initial margins sufficiently cover potential losses.

Derivatives segment: Initial Margins, Extreme Loss Margins and net option premiums from buyers must be collected upfront before any trade. Delivery margins and margins on consolidated crystallised obligations must be collected by T+1.

Both segments: actual short-collection or non-collection of margins must be reported to the Stock Exchange on a T+5 basis.

Penalties are severe and specific:

• All instances of non-reporting amount to 100% short collection, penalised accordingly.
• If inspection finds a member has falsely reported margin collected from clients, the member is penalised 100% of the falsely reported amount, along with suspension of trading in that segment.

How short collection is measured

• Clearing corporations send a minimum of four snapshots of client-wise margin requirements per day, randomly taken within pre-defined time windows.
• The client-wise margin file contains both the client's EOD margin requirement and the client's peak margin requirement across the intraday snapshots.
• The member reports margin collected from each client at EOD and the peak margin collected during the day. EOD obligation is compared with EOD availability, and peak obligation with peak availability.
• The HIGHER of the two shortfalls is used to levy penalty.
• Verification is done by exchanges/clearing corporations weekly, against the balances in the member's books.
• Intraday snapshot margin requirements in derivatives use fixed Beginning of Day (BOD) margin parameters, including all SPAN parameters and ELM. With effect from May 01, 2023, the EOD margin collection requirement in derivatives is also calculated on fixed BOD margin parameters.

Protecting client collateral

Margin pledge and re-pledge. Collateral from clients in the form of securities is allowed only by way of "margin pledge" created in the depository system — title transfer of securities to the TM's demat account for margin purposes was discontinued from February 25, 2020. The chain is: client pledges to TM → TM re-pledges to CM → CM re-pledges to the Clearing Corporation, with the complete trail reflected in the pledgor's demat account. The TM/CM opens a separate demat account tagged "Client Securities Margin Pledge Account", and re-pledges only out of that account. Client securities re-pledged to the CC shall be available to give exposure limit to that client only, and the CC shall not allow any exposure to the CM on re-pledged securities of the client or TM.

Segregation and monitoring of collateral at client level. TMs report disaggregated collateral information up to client level to the CM; CMs report up to the level of TM clients and TM proprietary collateral to the exchanges and CCs. A web portal lets clients view this reporting. The CC uses the allocation to ensure collateral allocated to a client is used only towards that client's margin obligation. CMs must maintain at least 50% of total collateral in cash or cash equivalents.

The blocking order on a client trade is: client collateral first, then the TM's proprietary collateral, then the CM's proprietary collateral. For a TM proprietary trade: TM proprietary collateral, then CM proprietary collateral. For a CM proprietary trade: CM proprietary collateral only.

Upstreaming of client funds. No client funds shall be retained by stock brokers or clearing members on an end-of-day basis. All client funds must be upstreamed to clearing corporations in one of only three forms: cash, a lien on an FDR created out of client funds, or a pledge of units of Mutual Fund Overnight Schemes (MFOS) created out of client funds. Those MFOS must deploy funds only into risk-free government bond overnight repo markets and overnight TREPS. Crucially, bank instruments provided by clients as collateral — client FDRs and BGs — cannot be upstreamed and are ineligible to be accepted as collateral in any segment of the securities market. The framework does not apply to bank-CMs (including bank custodians) or to proprietary funds of brokers and clearing members.

Trading supported by blocked amount (the UPI block facility). Instead of transferring funds upfront to the broker, funds remain in the client's own bank account but are blocked in favour of the clearing corporation, using RBI-approved UPI single-block-and-multiple-debits mandate service. The block lasts till its expiry date, till released by the CC, or till debited for the client's obligations, whichever is earlier. Settlement is done by the CC without the member handling client funds and securities. Qualified Stock Brokers must offer either this UPI block facility in the cash segment or a 3-in-1 Trading Account facility.

Daily margin statement. Brokers must send margin-related information across all segments daily, containing client code and name, trade day, margin deposit available with break-up (cash, FDRs, BGs, pledged/re-pledged securities), margin adjustments including MTM losses after adjusting MTM profit, and margin status at the end of T day. It should be issued on T-day itself.

Enhanced supervision of stock brokers

Key requirements from the SEBI committee on enhanced supervision:

• Uniform nomenclature for naming/tagging bank and demat accounts. All new bank and demat accounts must be named per SEBI's nomenclature and communicated to the exchanges within one week of opening. Two categories of client bank accounts: Up Streaming Client Nodal Bank Account (USCNBA) — where the broker receives client funds, named "Name of the SB/CM – USCNB account"; and Down Streaming Client Nodal Bank Account (DSCNBA) — from which payments to clients are made. Settlement accounts are named "Name of Stock Broker – Settlement Account". Brokers may maintain demat accounts only under the 6 categories specified by SEBI.
• Monitoring of clients' funds lying with the broker, through an alerting and reconciliation mechanism to detect mis-utilisation.
• Changes to internal audit — appointment, rotation of internal auditors, objective sample criteria, quality monitoring, timelines.
• Monitoring of the financial strength of brokers as an early warning system.
• Brokers must give the exchanges the PANs of all directors, key management personnel and dealers, and intimate any change within seven days.
• Brokers shall not grant further exposure to clients when debit balances arising from the client's failure to pay continue beyond the fifth trading day from the date of pay-in, except under the margin trading facility.

GSM, ASM and ESM. Graded Surveillance Measures (GSM) apply to securities with an abnormal price rise not commensurate with financial health and fundamentals — earnings, book value, fixed assets, net worth, P/E. Additional Surveillance Measures (ASM) apply on objective parameters such as price variation and volatility. Enhanced Surveillance Measure (ESM) was introduced for micro-small companies with market capitalisation of less than ₹500 crore, later extended to Main Board companies with market capitalisation of less than ₹1,000 crore, shortlisted on dynamic parameters — high-low variation, close-to-close price variation, market capitalisation, standard deviation, P/E.

The objective of all three is to alert investors to be extra cautious and to advise market participants to carry out due diligence. Surveillance actions include 100% margin, trade-for-trade settlement, ±2% to 5% price bands, periodic call auction, restricted trading (for example once a week) and additional deposits.

Compliance calendar highlights

Website: every stock broker and DP must maintain a designated website. The URL is reported to exchanges/depositories within a week, and any modification within 3 days.

Settlement of the running account and unpaid securities

Settlement of funds and/or securities shall be done within 1 working day of the pay-out, unless the client specifically authorises a running account in writing. Where a running account is authorised, there must be a gap of a maximum of 90 or 30 days between two settlements, as per the client's choice of quarterly or monthly.

Settlement of the running account for SECURITIES has been discontinued (SEBI circular of June 20, 2019), so the running account rules now apply to the client's funds only.

While settling, the member must simultaneously send a statement of accounts containing an extract from the client ledger for funds and an extract from the register of securities showing all receipts and deliveries, explaining any retention and giving details of any pledge.

Unpaid securities and CUSPA. For trades not covered by the margin trading facility, the pay-out of securities not paid for in full by the client is transferred directly to the client's demat account, followed by an auto-pledge (no client instruction needed) with the reason "unpaid", in favour of a separate account the TM opens called the Client Unpaid Securities Pledgee Account (CUSPA).

• The TM sends an email/SMS informing the client of the funds obligation and of the TM's right to sell.
• The TM's policy must specify the maximum period to meet the obligation, which shall not exceed five trading days from the pay-out date.
• Unpaid securities pledged to CUSPA may be counted for reporting client margin collection to the CC, but the TM shall not provide exposure to the client against such securities.
• If the pledge is neither invoked nor released within five trading days after pay-out, the depositories automatically release the pledge at the end of the sixth trading day, and the securities become free balance for the client.
• Securities pledged to CUSPA shall not be pledged or transferred to Banks or NBFCs for raising funds.
• In exceptional cases — the security is in lower circuit with only sellers, or trading is suspended or halted, or another valid unforeseen reason — the TM may request, by 6 p.m. on the fifth trading day after pay-out, an extension of the pledge for one additional calendar week. If the TM misses that window, the pledge is automatically released.

Annual Global Statement: all members must issue one to every client within 30 days from the end of the financial year, containing details of all transactions in the year and all charges.

Risk Based Supervision, FIU reporting and QSBs

Risk Based Supervision is a half-yearly assessment by exchanges — forward looking and preventive. Its four steps: Risk Assessment, Assigning Risk & Impact Rating, Determining Supervisory Risk Rating Score, and Supervisory Approach. Entities are placed in four groups: very low risk, low risk, medium risk and high risk, with the quantum of supervision and number of inspections varying accordingly. Data is submitted within 2 months of the end of each period.

Reporting to the Financial Intelligence Unit (FIU-IND), an intelligence arm under the Finance Ministry:

The Principal Officer shall record his reasons for treating a transaction as suspicious, and there must be no undue delay in reaching that conclusion.

Voluntary freezing/blocking of trading accounts: brokers must have a detailed policy covering the modes by which a client can request blocking, acknowledgement, the time within which the account is frozen, action after receipt, and the process for re-enabling the client.

Qualified Stock Brokers (QSBs) are designated by SEBI or the stock exchanges for their size, scale of operations and potential impact on investors and the market, based on five parameters with appropriate weightages, assessed annually:

1. Total number of active clients.
2. Available total assets of clients with the broker.
3. Trading volumes of the broker.
4. End of day margin obligations of all clients.
5. Proprietary trading volumes.

The list is released jointly by the stock exchanges in consultation with SEBI, annually, using parameters as on December 31. A broker that drops off the list must continue to comply with the enhanced obligations for an additional period of 3 financial years, or as MIIs specify.

The Core Settlement Guarantee Fund

SEBI requires a Core SGF for each segment of each recognised stock exchange, to guarantee settlement of trades in that segment. If a clearing member fails to honour settlement commitments, the Core SGF is used to fulfil that member's obligations and complete settlement without affecting the normal settlement process.

Minimum Required Corpus (MRC)

• The MRC is fixed for a month.
• By the 15th of every month, the CC reviews and determines the MRC for the next month, based on the daily stress tests of the preceding month, and also reviews the adequacy of contributions.
• For every day of the preceding month, the highest uncovered loss number across the various credit-risk stress tests is the worst case loss for that day.
• The average of all the daily worst case loss numbers is calculated.
• The MRC for the next month is the HIGHER of that average and the segment MRC as per the previous review. So the MRC can rise easily but never falls below the previous level in a single review.

Who contributes

No exposure is available to clearing members on their contribution to the Core SGF. Individual CM contributions are assessed pro-rata based on the risk they bring to the system. The CC may collect them upfront or staggered; in a staggered case the CC meets the balance itself.

Any penalties levied by the CC are credited to the Core SGF corpus. Interest on cash contributions accrues to the Core SGF and is attributed pro-rata to contributors in proportion to their cash contributions.

Contributions for any month must be made before the start of the month. If the Core SGF is used during a calendar month, contributors must immediately replenish it to the MRC — but replenishment by members is restricted to only once during a period of 30 calendar days, regardless of the number of defaults in that period, counted from the date of the notice of default. If a contributor fails to replenish, the shortfall is met temporarily first by the CC, then by the Stock Exchange.

The CC ordinarily accepts cash collateral for Core SGF contributions, but may accept CM contributions as bank FDs or Central Government securities. The Regulatory Oversight Committee (ROC) of the CC manages the Core SGF.

The default waterfall — memorise the order

In the event of a default, the Settlement Guarantee Fund is used in this order:

1. Monies of the defaulting member, including its own primary contribution to the Core SGF and its excess monies in other segments.
2. Insurance, if any.
3. CC resources equal to 5% of the segment MRC — the clearing corporation's "skin in the game".
4. Core SGF of the segment, itself in order: (I) penalties, (II) CC contribution to the extent of at least 25% of the segment MRC, (III) remaining Core SGF — CC contribution, Stock Exchange contribution and non-defaulting members' primary contributions, pro-rata.
5. A proportion of remaining CC resources, excluding its contribution to other segments' Core SGFs and excluding ₹100 crore, in the ratio of the segment MRC to the sum of all segment MRCs. The ₹100 crore is excluded only when remaining CC resources exceed ₹100 crore.
6. CC/SE contributions to Core SGFs of other segments (after meeting those segments' obligations) and remaining CC resources as approved by SEBI.
7. Capped additional contribution by non-defaulting members of the segment.
8. Any remaining loss covered by a pro-rata haircut to pay-outs.

The capped additional contribution by non-defaulting members is the lower of 2 times their primary contribution to the Core SGF or 10% of the segment's Core SGF on the date of default in equity and debt segments; the cap is 20% in the derivatives segment.

Notice the shape of the waterfall. The defaulter pays first. Then insurance. Then the clearing corporation puts its own money in before touching any non-defaulting member's contribution. Only near the very end are surviving members asked for more, and even then their exposure is capped. That ordering is deliberate and is a favourite exam question.

Beyond the book

The default waterfall stopped being theoretical for Indian markets in June 2019, when a mid-sized broker failed to meet its settlement obligations and the clearing corporation had to invoke its guarantee to complete settlement for everyone else. That episode, and the pledge-related misuse of client securities that came to light around the same period, is precisely why the margin pledge / re-pledge system replaced title transfer of client securities in 2020, and why upstreaming of client funds now leaves nothing in a broker's account overnight. When you memorise "no client funds shall be retained by SBs/CMs on an EoD basis", you are memorising the market's response to real defaults.