Risk reduction mode
The restricted state a stock broker is put into when 90% of its collateral is used up by margins: pending orders are cancelled, only IOC and margin-checked orders pass, until utilisation falls below 85%.
In plain language
A broker's collateral with the clearing corporation is its safety cushion. When most of that cushion is already committed to margins, one more large trade could leave the broker unable to cover a loss.
Risk reduction mode is the automatic brake. When a broker crosses a set level of collateral utilisation - currently 90% - the system stops treating it as a normal member. Its pending orders are wiped out, and every new order is checked for margin before it is allowed. Orders that reduce positions go through; orders that add risk without margin are rejected.
The brake releases on its own once utilisation drops back below 85%. The gap between 90% and 85% stops a broker flickering in and out of the mode every few minutes.
How it works
From Chapter 4 (section 4.1.1.8 for the cash segment; section 4.1.2.3 applies the same to derivatives):
Trigger. Exchanges/clearing corporations must put a stock broker into risk reduction mode when 90% of its collateral available for adjustment against margins is utilised on trades under a margin system.
While in the mode:
- All unexecuted orders are cancelled once the 90% level is breached.
- Only orders with the Immediate or Cancel (IOC) attribute are permitted.
- All new orders are checked for sufficiency of margin. Orders reducing the open position are accepted; orders increasing it are rejected if margin is insufficient.
- Non-margined orders are not accepted.
- No orders with a custodial participant code, and no client or CP code modification.
Exit. The broker returns to normal mode when collateral utilisation falls below the level set by the clearing corporation - currently 85%.
With client-level collateral segregation, utilisation is measured in layers. At TM level: for each client, client margin in excess of 90% of that client's collateral is identified; the total of such excesses plus the TM's proprietary margin is assessed against the TM's proprietary collateral. CM level is built the same way, adding each TM's excess over 90% of its collateral and the CM's proprietary margin, assessed against the CM's proprietary collateral.
Intraday crystallised MTM losses (ICMTM) that exceed free collateral also put the entity into risk reduction mode.
A worked example
Illustrative figures; the 90% and 85% levels are the workbook's.
A trading member has proprietary collateral of Rs 10 crore and proprietary margin of Rs 8.2 crore. One of its clients, Farhan, has client collateral of Rs 50 lakh but his positions need Rs 48 lakh of margin.
- Farhan's allowed use before spilling over: 90% x Rs 50 lakh = Rs 45 lakh
- Farhan's excess: Rs 48 lakh - Rs 45 lakh = Rs 3 lakh
- Other clients' excesses total Rs 87 lakh
Amount assessed against the TM's proprietary collateral = Rs 8.2 crore + Rs 0.03 crore + Rs 0.87 crore = Rs 9.1 crore
Utilisation = Rs 9.1 crore / Rs 10 crore = 91% - above 90%, so the TM enters risk reduction mode.
Immediately: all its pending orders are cancelled; it can place only IOC orders; each order that would add to positions is checked for margin; it cannot place CP-code orders or modify client codes.
To exit, the assessed amount must fall below 85% x Rs 10 crore = Rs 8.5 crore - by squaring off positions or depositing more collateral.
Why NISM asks about it
Chapter 4 (Risk Management) lists risk reduction mode as a component of the risk management framework for both the cash segment (section 4.1.1.8) and the derivatives segment (section 4.1.2.3), and mentions it again under ICMTM. The two numbers (90% in, 85% out), the IOC-only rule and the cancellation of unexecuted orders are the facts most likely to be tested. Chapter 3's order types section explains the IOC attribute the mode depends on.
Common exam traps
- Enter at 90%, exit below 85%. Not "enter and exit at 90%", and not 80%.
- Unexecuted orders are cancelled, not merely frozen.
- Only IOC orders are permitted - not day orders.
- Position-reducing orders are accepted; only risk-increasing orders need sufficient margin.
- No CP-code orders and no client/CP code modification while in the mode.
- The percentages are "currently" set by the exchanges/clearing corporations and can change; answer with 90% and 85% as the workbook states.
- It is automatic, triggered by collateral utilisation - not a penalty imposed after inspection.
Where this is taught
- Series IV · Chapter 7: Clearing, Settlement and Risk Management of IRDintroduced here
- Series I · Chapter 7: Clearing, Settlement and Risk Management in ETCDintroduced here
- Series VII · Chapter 4: Risk Managementintroduced here
Related terms
- Immediate or CancelA time condition on an order: whatever can be matched the moment it reaches the market is executed, and any unmatched balance is cancelled immediately rather than waiting in the order book.
- Liquid assetsThe collateral a clearing member deposits with the clearing corporation, valued daily after haircuts, which must cover MTM losses, VaR margin, extreme loss margin and base minimum capital.
- Unique Client CodeThe single code a broker assigns to a client once KYC is complete, mapped to that client's PAN and demat account, under which every one of the client's orders must be entered on the exchange.
- Custodial participantA client allowed to trade through several trading members while clearing and settling through a single clearing member, identified by a unique CP code; its CM must confirm the trades.
- MarginThe money a buyer or seller must deposit before a trade is allowed to stand, so that the clearing corporation is covered if they fail to bring in funds or to deliver securities.
- SPANThe scenario-based system clearing corporations use to compute initial margin — it revalues a client's whole derivatives portfolio under sixteen what-if scenarios and charges the worst loss.
- Qualified Stock BrokerA stock broker designated each year by SEBI or the exchanges, because of its size and potential impact on investors, that must meet enhanced governance, risk, technology and investor-service obligations.
- Open positionAn outstanding, unsettled long (buy) or short (sell) position in a contract; margins, exposure limits, daily MTM and corporate-action adjustments are all applied to open positions.
- ICMTMIntraday Crystallized Mark to Market Losses: a real-time margin on losses from trades that are both executed and squared off on the same day, computed at weighted average prices and collected as it accrues.