Default waterfall

A clearing corporation guarantees settlement. When a member fails, somebody's money has to cover the gap. The default waterfall is the pre-agreed answer to "whose money, and in what order?"

The principle is simple: the defaulter pays first, and innocent members pay last. The water flows down a series of pools. Only when one pool is empty does the loss spill into the next.

Because the order is fixed in advance, every participant knows exactly how exposed it is before a default ever happens. That certainty is what lets the market keep trading calmly when a broker goes down.

The workbook (section 4.3.3) sets out the order in which the Settlement Guarantee Fund is used:

The cap in step (g) is the lower of 2 times the member's primary contribution to Core SGF, or 10% of the segment's Core SGF on the date of default in equity and debt segments, and 20% in the derivatives segment.

All figures here are illustrative; the percentages are the workbook's. A clearing member defaults in the equity cash segment, leaving a loss of Rs 150 crore. The segment's MRC is Rs 800 crore.

The loss is fully absorbed at step d(II). Not a rupee of any non-defaulting member's contribution has been touched.

Now the cap in step (g). A non-defaulting member whose primary contribution is Rs 2 crore, in a segment whose Core SGF is Rs 800 crore, could be asked for at most the lower of 2 x Rs 2 crore = Rs 4 crore and 10% x Rs 800 crore = Rs 80 crore. Its cap is Rs 4 crore.

Chapter 4 (Risk Management, section 4.3) covers the Core Settlement Guarantee Fund, its Minimum Required Corpus, its contributors and, in section 4.3.3, the default waterfall. Questions test the order: what is used first (the defaulter's own monies), where insurance sits, the 5% of MRC slice of CC resources, and what is left to the very end (a pro-rata haircut to pay-outs). The cap on additional contribution by non-defaulting members, with its equity/derivatives difference, is a natural numerical question.

• The defaulter's monies come before insurance. Insurance is step (b), not step (a).
• Clearing corporation skin in the game comes twice before non-defaulting members: 5% of segment MRC at step (c), then its Core SGF contribution of at least 25% of MRC at step d(II).
• Penalties are used before any contributor's money inside the Core SGF.
• The additional-contribution cap is "lower of" two tests, and the percentage test is 10% for equity and debt but 20% for derivatives.
• The haircut to pay-outs is the last resort, not an early step.
• The Rs 100 crore exclusion in step (e) applies only when remaining CC resources exceed Rs 100 crore.