Internal shortage
A shortage that arises inside a single member's book when a selling client fails to deliver shares that were netted off against a buying client's purchase, so no obligation reached the clearing corporation.
In plain language
Netting is meant to make settlement efficient, but it can quietly hide a problem. If one client sells shares and another client of the same broker buys the same quantity of the same shares, the two positions net off and the broker has no obligation to the clearing corporation at all.
But what if the selling client never actually delivers those shares? The broker still owes shares to its buying client — the netting hid the shortfall from the clearing corporation, but it did not make the shortfall disappear. That gap is an internal shortage.
How it works
The workbook (Chapter 6, section 6.5.1.1) describes this exactly: a selling client fails to deliver shares sold in a settlement, but because another buying client of the same member bought a similar quantity of the same security, the two positions were netted off for settlement purposes — so the member has no security obligation from the clearing corporation to fall back on.
To fix this, the clearing corporation lets the member submit details of such internal shortages on pay-in day, so a self-auction can be conducted. These internal shortages are clubbed with the normal shortages in that settlement, and the auction is run for the combined shortage quantity by the clearing house/corporation.
SEBI has separately advised that where such shortages arise from inter-client netting alongside direct pay-out of securities to client accounts, TM/CM must handle them through this same auction process, and must not levy any charges on the client beyond what the clearing corporation itself charges. Clearing corporations may not provide any settlement guarantee for the auction of internal shortages — and if the shortage cannot be sourced through auction, it is closed out under the ordinary guidelines.
A worked example
Broker Sundar Securities has two clients trading the same stock on the same settlement day.
| Client | Transaction | Quantity |
|---|---|---|
| Client X (seller) | Sells | 4,000 shares |
| Client Y (buyer) | Buys | 4,000 shares |
Because the broker's net position in this security is nil (4,000 sold against 4,000 bought), the clearing corporation shows no obligation for Sundar Securities in this security. But Client X fails to deliver the 4,000 shares.
Sundar Securities now has to get 4,000 shares from somewhere to deliver to Client Y, even though the clearing corporation never asked it for any. It reports this as an internal shortage of 4,000 shares on pay-in day. The clearing corporation clubs this 4,000-share shortage with the settlement's ordinary market-wide shortages in the same security and runs one combined self-auction, buying shares from the open market to cover both.
Why NISM asks about it
Chapter 6 (section 6.5.1.1, Self Auction / Auction for Internal Shortages) explains this scenario right after the ordinary auction process, precisely because it is the case netting is normally silent about. Expect a question describing this exact fact pattern — one client's failed delivery netted against another client's purchase — and asking what mechanism the broker uses to source the shares (self-auction for internal shortage).
Common exam traps
- An internal shortage exists even though the clearing corporation shows no obligation for the member — netting hides it from the CC, it does not resolve it.
- The member itself must report the internal shortage on pay-in day — the clearing corporation does not detect it automatically.
- Internal shortages are clubbed with the settlement's ordinary shortages into one combined auction, not run as a separate process.
- No settlement guarantee applies to the auction of internal shortages — unlike the guarantee the clearing corporation gives on ordinary settlement.
- The broker cannot charge the client extra for handling an internal shortage beyond the clearing corporation's own charges.
Check yourself
1.Which statement about self auction for internal shortages is correct?
- a)The clearing corporation provides a settlement guarantee, as with a normal auction
- b)The CC may charge fees for facilitating it, and may not provide any settlement guarantee for it
- c)The broker may recover additional charges from the client
- d)Internal shortages are always closed out without any auction
Show the answer
Answer: (b) The CC may charge fees for facilitating it, and may not provide any settlement guarantee for it
CCs may charge fees for facilitating such internal auction. Further, CC may not provide any settlement guarantee for auction of internal shortages.
That second half is the key distinction from a normal auction, where the clearing corporation is the guaranteeing counterparty. An internal shortage never reached the clearing corporation at all — due to netting, there is no security obligation for member from clearing corporation — so the CC facilitates the process without standing behind it.
Option C is expressly prohibited: SEBI advised TM/CM in above cases not to levy any charges on the client over and above the charges levied by the CCs.
How the situation arises: a selling client has failed to deliver the shares sold in a settlement to a member. However, this may not result in failure of the Member to deliver the shares to the Clearing House as there was a purchase transaction by his other buying client in the same security and the same was netted off for the purpose of settlement. As selling client is not able to deliver the shares, member is not able to make delivery to buying client.
The process: members have been given an option by clearing corporation to submit the details of such internal shortages on pay-in day for conducting self-auction. These shortages are clubbed with the normal shortages in a settlement and the auction is conducted by the clearing corporation for the combined shortages.
And if it fails: where clearing corporation is not able to obtain securities, member shall close-out such shortages as per guidelines provided by Clearing Corporations.
Where this is taught
Free preparation for NISM Series VIIRelated terms
- Buy-in auctionThe auction a clearing corporation runs through the exchange system on settlement day to buy shares a selling member failed to deliver, so the buying member still receives them.
- Close outSettling an undelivered sale in cash instead of shares: the defaulting seller is charged at a penal close-out price, used when an auction finds no sellers or is not held at all.
- Netted obligationA settlement method in which all of a member's purchase and sale transactions in a security are netted into one pay-in or pay-out figure, rather than settled trade by trade.
- Valuation debitThe amount a member is debited when it fails to deliver securities on pay-in day, equal to the shortfall quantity valued at a valuation price fixed by the clearing corporation.
- Short deliveryA member's failure to pay in securities, fully or partly, on the settlement day — closed out at the shares' last closing price and made good by the clearing corporation through an auction.