Secondary Markets — how a trade actually happens

Why this chapter matters most

Chapter 4 carries 20% of the paper — joint-largest with Chapters 2, 3 and 5. It is also the chapter that describes what you would actually see if you sat next to a dealer for a day. Read it as a sequence: a trade is placed, matched, cleared, settled, and if something goes wrong, redressed.

The paper is 120 minutes, 100 marks, 60% to pass, and there is no negative marking.

What the secondary market is

The secondary market is where securities once issued are bought and sold between investors. It trades securities issued in the primary market as well as those that were not — such as privately placed debt or equity securities and derivatives of primary securities created and traded by financial intermediaries.

The point that gets tested: transactions in the secondary market do not result in additional capital to the issuer, as funds are only exchanged between investors.

The six roles

1. Liquidity. Secondary markets provide liquidity and marketability to existing securities. A liquid market lets investors buy perpetual securities such as equity that are not redeemed by the issuer, risky securities whose future performance is unknown, and long-term securities maturing far into the future — because they can sell at a low cost and in a short span of time.

2. Price discovery. Each buy or sell transaction reflects the individual assessment of investors about the fundamental worth of the security, and the collective opinions of various investors are reflected in the real time trading information provided by the exchange.

This also helps issuers. Market valuation benefits issuers when they have to raise further capital, by giving an indication of the price at which new capital could be issued. The workbook's example: a company with equity shares of face value ₹10 trading around ₹100 could issue new shares at a price close to ₹100, which is the value determined by investors in the market.

3. Information signalling. The information-signalling function of prices works like a continuous monitor of issuing companies, and in turn forces issuers to improve profitability and performance. Efficient markets are those in which market prices of securities reflect all available information about the security.

4. Indicating economic activity. A market index is generated from market prices of a representative basket of equity shares, and a stock market index is viewed as a barometer of economic performance. A sustained rise in key market indices indicates healthy revenues, profitability, capital investment and expansion in large listed companies; a continuous decline or poor returns on indices is a signal of weakening economic activity.

5. Market for corporate control. If management is inefficient, a company could end up performing below its potential. Market forces will push down share prices of underperforming companies, leading to their undervaluation. Such companies can become takeover targets. Potential acquirers can acquire a significant portion of the target firm's shares, take over its board of directors, and improve its market value by providing better governance.

And the subtle part: an actual takeover need not happen; even the possibility of a takeover can be an effective mechanism to ensure better governance.

6. Bull and bear cycles. A bull market is when buyers are willing to pay higher and higher prices, as the overall optimism for better future performance of stocks is high. But a bull market can overdo its exuberance — prices move beyond what can be justified by the underlying intrinsic value, businesses overarch themselves, borrowing to fund expansion based on optimistic forecasts, and input costs and interest costs increase as the bull market reaches its peak. Unrealistic expansion in prices tends to correct itself with a crash.

In a bear market, sellers quit in despair, accepting a lower price and a loss. But as prices may fall well below intrinsic values, buyers who find the valuation attractive will start coming into stocks that now are priced reasonably, or lower. Lower interest rates lead to investment, and slowly the bear cycle gives way to the next bull cycle.

Three secondary markets, three regulators

The G-sec market and how it was fixed

Prior to 2005, the G-sec market was mainly an over-the-counter (OTC) market. Buy and sell orders were placed telephonically through approved G-sec brokers, deals were settled bilaterally, without the presence of any central counterparty, trades were executed by exchanging a physical document called the Subsidiary General Ledger (SGL) form, and payment was by means of a cheque. The workbook's verdict: this system was slow, inefficient and prone to operational and default risks.

The Clearing Corporation of India Ltd (CCIL) was set up in 2001 by banks and financial institutions at the behest of the RBI, to improve the clearing and settlement process and to broaden and deepen the G-sec market.

CCIL runs and manages the Negotiated Dealing System–Order Matching system (NDS-OM) — an anonymous, electronic, screen-based, order-driven system for trading of G-secs, and owned by the RBI. CCIL provides guaranteed settlement of G-sec transactions and has mitigated the counterparty and operational risk.

Two access points to remember: trading on the NDS-OM is restricted to institutional investors, but all types of investors can trade G-Secs on the stock exchange platforms. RBI has more recently permitted access of the NDS-OM platform to SEBI registered stock brokers to facilitate retail trades under a Separate Business Unit (SBU), and has introduced the RBI Retail Direct Scheme for retail individual investors to access both primary and secondary government securities markets.

Trades negotiated over the telephone, outside the NDS-OM platform, have to be compulsorily reported on the NDS-OM.

The commodities spot market

The spot market for commodities is regulated by individual state governments. Agricultural Produce Market Committees (APMC) are set up by state governments to regulate the sale of agricultural produce by farmers, with the objective of preventing exploitation of farmers by large retailers. Mandis or market yards are set up where farmers sell their produce through auction, and only licensed traders can buy at such auctions.

The government launched the electronic National Agricultural Market (e-NAM) in 2016, to provide an online market platform for agricultural produce by creating a unified network of existing mandis. The vision of e-NAM is "One Nation, One Market". It provides a bidding platform for farmers and buyers located at distant places away from the local mandi, an electronic payment facility so that farmers can receive payment without having to visit a bank, and information about commodity arrivals and quality assaying services.

The participants

Stock exchanges · Clearing Corporations · Investors · Issuers · Financial intermediaries · Regulator.

The three national level stock exchanges in India are the Bombay Stock Exchange (BSE), the National Stock Exchange (NSE) and the Metropolitan Stock Exchange of India Ltd (MSEI).

Members. Investors can trade in the secondary markets only through members of a stock exchange. Trading members are also called stock brokers; their agents are called Authorized Persons. Members are admitted only if they fulfil minimum requirements for capital, qualification, net worth and other criteria. Stock exchange members can be trading members, or clearing members, or play both roles.

Investors. A warning worth carrying: if investors buy and sell shares among themselves, such trades are called "off-market" and do not enjoy the benefits of regulatory and redressal provisions of the law. Investors complete KYC with a registered broker-member and receive a Unique Client Code (UCC).

Clearing corporations. They are set up as independent fully-owned subsidiaries of stock exchanges and function as counter-parties for all trades executed on the exchange they are affiliated with. All buyers pay funds to the clearing corporation, and all sellers deliver securities to the clearing corporation, and the clearing corporation completes the other leg by paying funds to sellers and delivering securities to buyers.

Named in the workbook: NSE Clearing Ltd., Indian Clearing Corporation Ltd. (ICCL) and Metropolitan Clearing Corporation of India Ltd. (MCCIL).

Depositories. For a security to be eligible to trade in the secondary markets, it should be held in electronic or dematerialised form. NSDL and CDSL are the two depositories in India, and investors open demat accounts with depository participants (DPs), who are banks, brokers or other institutional providers.

Custodians are authorised to hold funds and securities on behalf of large institutional investors and settle the secondary market trades for institutional investors. Several custodians are also clearing members and clearing banks.

Regulator. Secondary markets are regulated under the Securities Contracts (Regulation) Act, 1956 and the Securities Contracts (Regulation) Rules, 1957. SEBI has empowered stock exchanges to administer portions of the regulation pertaining to trading, membership and listing.

Interoperability of clearing corporations

Originally each stock exchange had to set up a clearing corporation as a separate legal entity, and trades executed on an exchange had to be cleared and settled by the CC of the same exchange. So brokers had to obtain membership of each exchange as well as its CC, deploying separate margins and meeting different capital requirements — producing less-than-optimal utilization of resources and higher transaction costs.

SEBI introduced the interoperability framework in 2018, and it was implemented in June 2019. Its benefits:

• Brokers can maintain margin deposits and capital funds at a single CC instead of three
• For computing margins, a client's positions in the cash, equity derivatives and currency derivatives segments are netted across all exchanges for the same expiry months and same strike price. The workbook's example: long 10 lots of XYZ September futures on NSE and short 6 lots of the same contract on BSE gives a net long position of 4 contracts
• It allows brokers to freely trade on multiple exchanges with smaller capital, encouraging healthy competition among the CCs

Scope: it applies to the capital market segment, equity derivatives, currency derivatives and debt segments — except the commodity derivatives segment, and to all recognized clearing corporations excluding those operating in the IFSC.

MII governance — the Gandhi Committee

SEBI issued procedural norms on recognition, ownership and governance for exchanges and clearing corporations by circular in December 2012, then constituted a Committee under Shri R. Gandhi, former Deputy Governor, RBI, which submitted its report in March 2018. Its recommendations included:

• Ownership of MIIs should be widely held
• The term of the Managing Director should be renewed only after a rigorous performance review by the Board
• Undertaking of unrelated activities by the MII should need prior permission of SEBI
• Key Management Personnel should be identified by the Nomination and Remuneration Committee or Board, with remuneration aligned with international principles and transparency in disclosure
• Rationalization of mandatory committees to prevent overlapping of their functions

Every MII must constitute: a Member Committee, a Grievance Redressal Committee, a Nomination and Remuneration Committee, and Oversight Committees — the latter comprising a Standing Committee on Technology, an Advisory Committee, a Regulatory Oversight Committee and a Risk Management Committee.

Public Interest Directors are required to chair each committee at the MIIs. And each MII must have a Business Continuity Plan (BCP) and Disaster Recovery Site (DRS) to maintain data and transaction integrity.

Brokers and client acquisition

A broker is a member of a recognised stock exchange who is registered with SEBI and permitted to trade on the screen-based trading system. An Authorized Person is an agent of the broker, previously referred to as a sub-broker, registered with the respective stock exchanges. Both can be individuals, partnership firms, private or public limited companies, including subsidiaries of banks and financial institutions.

Registered members must prominently display their membership details at their front offices so investors can verify they are dealing with a registered entity. Trades must be routed only through the trading terminals of registered members. Brokers can trade on their own account too, using their own funds — such transactions are called proprietary trades.

Capital adequacy is ensured by requiring brokers to deposit a base minimum capital with the stock exchange and limiting their gross exposures to a multiple of their base capital. Brokerage is the commission received, and maximum brokerage chargeable is fixed by individual stock exchanges.

A broker's six responsibilities

• Maintain record of client transactions and operate separate trading accounts for clients and for proprietary trades
• Maintain funds of clients in a separate account
• Issue a contract note to clients within 24 hours of the execution of the order
• Collect funds or securities from the client prior to the pay-in day
• Make delivery or payment to the client within 24 hours of pay-out from the stock exchange
• Appoint a compliance officer responsible for monitoring compliance and for redressal of investors' grievances

Opening an account

A trading member must complete KYC formalities and in-person verification (IPV) before opening client accounts. The KYC form captures personal details (name, gender, marital status, PAN, residential status, UID number, with proof of identity), address details with proof, income, occupation and net worth, bank and depository account details, and details of action taken on the client by any regulatory authority in the last three years.

The documents that must be issued to the client: the Rights and Obligations document (including additional rights and obligations for internet/wireless trading), the Uniform Risk Disclosure Document, a Guidance Note detailing Do's and Don'ts, an Index of documents, a tariff sheet specifying various charges including brokerage, and contact details of senior officials within the broking firm and the investor grievance cell in the stock exchange.

The policies a trading member must formulate, issue to clients and publish on its website cover: inactive accounts (definition, time period, return of client assets, reactivation procedure), setting up client exposure limits, applicable brokerage rate, imposition of penalty or delayed payment charges by either party, the right to sell clients' securities or close positions without notice on account of non-payment of dues, shortage of obligations arising out of internal netting of trades, conditions under which a client may not be allowed to take further positions, temporarily suspending or closing an account at the client's request, and deregistering a client.

The 3-in-1 account

A 3-in-1 account allows an investor to merge the savings bank, demat and trading accounts. If a bank provides it, the bank account and depository services are offered by the bank and the trading account usually through its subsidiary broking firm; if a broking firm provides it, the broking and depository services come from the broking firm and the bank account is held with a bank.

A 3-in-1 account uses a trading platform as its front end, with the bank and demat account linked in the background, opened with a single account opening form and common KYC. Importantly, it does not enable operating the underlying bank or demat account for any purpose other than settling trades completed on the trading account.

Its advantages: reduced manual paperwork involving cheques, fund transfers, contract notes, account statements and branch banking; no need to physically co-ordinate with the bank, broker and depository participant; and efficient trading, since the platform is linked through the broker's terminals to the live market.

From PoA to DDPI

Power of Attorney is a voluntary delegation of power by the investor to a broker or DP to facilitate the delivery and receipt of shares and funds to settle obligations arising out of a trade. PoA was not mandatory for opening a trading account but was required when an online 3-in-1 account was opened, since it enabled automatic debit from the bank account on purchase and from the demat account on sale.

SEBI clarified that the PoA was to be used only for (a) transferring securities from the client's Beneficial Owner account towards the securities pay-in obligation and (b) pledging or repledging securities in favour of the broker for meeting margin obligations.

But many brokers were found to be forcing their clients to execute a PoA although it was not mandatory, and there were instances of brokers misusing the PoA to misappropriate the client's securities.

So SEBI required a separate system of Demat Debit and Pledge Instruction (DDPI). Under it, the client may authorize his broker to access his beneficial owner account for the limited purpose of meeting the client's obligations towards securities pay-in and margins. After implementation of DDPI, PoA can no longer be executed for the above purposes, and the client has the authority to revoke or cancel the DDPI at any time.

Trade execution

Stock exchanges offer two types of trading systems: open outcry and online trading. Under open outcry, traders gather physically on a trading floor and shout or signal their bid and offer prices. Trading in India at BSE, NSE and MSEI is carried out through online screen-based systems.

Mobile trading is preferred for ease of placing orders, checking order status, live market updates and notification alerts, and especially by the younger generation of retail investors. Its key problems are poor mobile connectivity, especially in remote locations or hilly areas, small screen size and slow speed.

Algorithmic trading is trading with a computer program that places buy and sell orders on the basis of predefined rules and conditions — the workbook's example being "buy stock of ABC Ltd when the price rises above its 10-day moving average and sell when it dips below." Institutional investors often use algorithms to break up a large buy or sell order into multiple small orders to minimize the market impact. Its benefits are speed and accuracy of execution and that the use of computers prevents human emotions from interfering with trading decisions. Its risk: there could be an error in the design of the algorithm — testing is required by the exchanges, but if some errors are not uncovered during testing, it may lead to wrong execution.

High-frequency trading (HFT) is a subset of algorithmic trading, used mainly by large investment banks, hedge funds and sophisticated institutional investors. The features defined by the Securities and Exchange Commission of the USA:

• Use of fast and sophisticated computer programs for placing, routing and executing orders
• Very small holding periods, typically minutes or seconds
• Firing of a huge number of orders per second and instantly removing them before they are executed, resulting in very high order-to-trade ratios
• Ensuring that most trading positions are closed by end of the day so that there are no significant overnight positions

The distinction to remember: HFT concentrates on very short-term trading opportunities that disappear within milliseconds. Algorithmic trading focuses on trade execution strategies with the objective of minimizing the cost of execution within certain constraints imposed by risk and timing of the trade.

Co-location is the facility provided by a stock exchange to its brokers to locate their computer servers at the premises where the exchange's own computer servers are located — to reduce their latency. Latency is the lapse of time from the moment a signal is sent to its receipt; in trading, the time between the placement of an order by the trader and actual receipt of the order by the exchange. It depends heavily on the distance travelled by the data signal. Co-location services are offered for a fee and are an important source of revenue for the exchanges.

Direct Market Access (DMA) has been permitted by SEBI for institutional clients since 2008. Normally an order travels: (a) order entry by the client, (b) receipt by the broker's server, (c) routing to the exchange's server after risk management checks at the broker's end, (d) entry into the electronic order book ranked by price-time priority. DMA connects the institutional client's orders directly to the exchange's order book, bypassing the broker's server — eliminating travel time, reducing risks associated with manual order entry and lowering overall transaction costs. The broker has to specifically authorize its clients for DMA after conducting due diligence and fulfilling KYC requirements.

The sequence of trade execution: (a) placing an order with the broker · (b) routing of order by broker to trading system · (c) display of order on the trading screen · (d) matching of order electronically · (e) confirmation of trade · (f) generation of contract note.

Orders

An order is complete only if it correctly indicates the name of the listed company, whether to buy or sell, and the number of shares. It is mandatory for an order to be identified by the Unique Client Code of the investor.

Each security has a securities symbol and a unique International Securities Identification Number (ISIN) — a unique 12-digit number that identifies a security in the depository system. The example given: Hindalco Industries Ltd has the symbol HINDALCO and the ISIN INE038A01020.

Stop-loss, worked: a trader places a limit order to buy 1000 shares of XYZ Industries at ₹1000 and a stop-loss sell order at a trigger price of ₹990. If the stock reaches ₹1000 the buy executes; if the price then falls to ₹990, the sell order is triggered to close the position. On the sell side: sell limit at ₹1000 with a stop-loss buy at a trigger of ₹1010.

The structural definition: stop-loss orders are limit orders where a position is created on one side, and on reaching the trigger price as indicated, a limit order on the opposite side is executed.

Orders once placed can be modified or cancelled till they are matched. Once order matching is complete, no modification or cancellation is possible.

The electronic market

Trading is conducted from Monday to Friday, from 9.15 am to 3.30 pm. Different timings apply to non-equity segments — the Debt Market segment on NSE starts at 9.00 am and closes at 5.15 pm. There are no trades on Saturdays, Sundays and public holidays.

The pre-open session runs for 15 minutes before trading starts, in three parts:

• The first 7 or 8 minutes — order placing, modification or cancellation. The order entry period is randomly stopped between the 7th and 8th minute
• The next four minutes — order matching and trade confirmation
• The last three minutes — buffer time to transition to the regular trading session

Its purpose: to determine the opening price of a security and reduce the huge rush of orders that would otherwise be placed in the opening minutes.

A buy order is called a bid; a sell order is known as an ask. The system matches so that a buyer gets a price equal to or less than his bid price, and a seller gets a price equal to or more than his asking price.

The four features of an electronic trading system:

• Order-driven — there are no intermediaries that introduce buyers to sellers; price and quantity are matched by the computer
• Transparent — all bid and ask prices (quotations) can be seen on the screen
• Anonymous — all bids and asks are accepted without revealing the identity of the investor
• Price-time priority — orders are arranged in order of prices, and orders at the same price are arranged by time. Each order gets a unique order number, based on which a complete audit trail can be generated, which is very useful for resolving disputes

Active versus passive orders. Active orders are orders to buy or sell at the prevailing market price and immediately get matched — so market orders are active orders, they are "reactive", and they drain liquidity from the market. Passive orders are orders lying unmatched in the order book — buy orders below and sell orders above the prevailing market price — so limit orders are passive orders, they are "proactive", they create new levels in the order book and add to its depth, and they add to the liquidity in the market. The farther the order price is from the prevailing market price, the more passive is the order.

Bulk deals and block deals

The block deal windows: the morning window from 8.45 am to 9.00 am and the afternoon window from 2.05 pm to 2.20 pm.

The reference prices: the previous day's closing price for the morning window; for the afternoon window, the volume-weighted average price of trades executed in the stock from 1.45 pm to 2.00 pm.

The band: the difference between the order price and the reference price should not be more than +/- 3 percent.

And the settlement rule: all block deals are required to be settled by actual delivery and cannot be squared off or reversed.

Why block deals exist at all: execution of large orders in the open market could lead to distortion in the market price and result in the order getting filled on unfavourable terms, so parties negotiate the price and quantity outside the exchange and then enter the orders for execution, preserving the confidentiality of the deal.

Circuit breakers

A circuit breaker is a pre-determined value in percentage terms, which triggers an automatic halt in trading whenever there is a rapid movement in an index or any security, either in the upward or downward direction. Such heavy movement is called "hitting the circuit breaker".

The purpose: to allow market players to assess the situation, instead of putting through panic-driven transactions that can push the price down or up by too much, leading to a possible payment crisis during settlement.

Daily price bands for individual stocks are fixed at 2 percent, 5 percent, 10 percent, or 20 percent, depending on factors such as liquidity, volatility and trading activity. Exchange authorities can narrow the price bands in specific scrips in order to contain volatility or speculative activity.

The exception: stocks that are included for trading in the derivatives market do not have a price band, though the exchange may fix an operating range to prevent erroneous price entries. But stocks on which no derivative products are available but which form part of an index derivative will also have appropriate price bands.

Market-wide circuit breakers halt all trading in equity and equity derivatives markets, and are triggered by the movement of either the BSE Sensex or the Nifty 50, whichever is breached earlier. Limits are calculated on a daily basis based on the previous day's closing level of the index, rounded off to the nearest tick size, and the market re-opens after the halt with a pre-open call auction session.

The contract note

A contract note is a confirmation of trades in equity shares completed on a particular day for and on behalf of a client, and is a proof of transaction for both parties, referred to in case of dispute.

To be valid, a contract note must:

• Be signed by the authorised signatory of the trading member
• Be in the format prescribed by SEBI and the stock exchanges
• Contain the unique client code and PAN of the client
• Contain the name, address and SEBI registration number of the trading member
• Contain order number, trade number, trade time, security name, quantity, price, brokerage, settlement number and details of any other levies such as STT and GST
• Show separately the trade price for the shares and the brokerage and any other levies charged
• Display the arbitration clause stating that the trade is subject to the relevant jurisdiction

It must be issued within 24 hours of execution of trades. Two copies are generated — one each for the broker and the client — and once the client has verified the details, the second copy of the physical contract note should be returned to the trading member duly signed and acknowledged.

Electronic Contract Notes (ECNs) may be sent by email only on the consent of the client, must be digitally signed, tamper-proof and password protected, and are simultaneously published on the website of the trading member with client specific login and password.

Details in the note should match the trade details in the trade confirmation slip, and any discrepancy should be reported to the trading member.

What a trade actually costs

Trading costs fall into three categories: user charges, statutory levies, and spread and impact cost.

User charges. Brokerage is the broker's commission — maximum brokerage is specified in the Stock Exchange Regulations, brokerage on intra-day transactions is usually lower than on delivery trades, and clients who trade for large amounts may negotiate lower rates. Stock exchanges collect exchange transaction charges from brokers; depositories charge DPs, who in turn charge investors.

Statutory charges: Securities Transaction Tax (STT), Goods and Services Tax (GST), Stamp Duty, and SEBI's Turnover Tax.

STT — equity segment:

All are computed on the value of the taxable securities transaction based on the volume weighted average price.

STT — derivatives segment:

GST is charged at 18 percent on brokerage. Both STT and GST go to the Central Government.

Stamp duty is levied on the value of shares transferred, under a uniform stamp duty regime across the country. It is collected on behalf of the State Government by the Stock Exchange or Clearing Corporation or Depositories; the Central Government has also notified CCIL and the Registrars to Issue and Share Transfer Agents as collecting agents, who deduct a specified percent of the collected stamp duty before transferring the same to the state government.

SEBI Turnover Fees: 0.0001 percent (₹10 per crore) on all sale and purchase transactions in securities other than debt securities, and 0.000025 percent (₹2.5 per crore) on debt securities.

Bid-ask spread and impact cost are not fees directly imposed on investors — they arise because of market imperfections or lack of liquidity.

In the workbook's order book, the best buy is ₹350 and the best sell ₹400. If an investor buys 1000 shares and sells them off immediately, he has lost ₹50 per share — that gap is the bid-ask spread. The more illiquid the market, the fewer the trades and the greater the bid-ask spread.

Impact cost is a measure of the cost incurred due to the bid-ask spread. Compute the "ideal" price as the average of the best buy and sell prices — here (350+400)/2 = ₹375 — then the deviation. The buy price at ₹400 is ₹25, or 6.67 percent, higher than the ideal price, so the impact cost of buying 1000 shares is 6.67 percent. Lower the impact cost, higher is the liquidity and lower is the trading cost to the investor.

An illustration on ₹1 lakh of traded value: brokerage 0.3% = ₹300; DP charges 0.02% = ₹20; STT 0.1% = ₹100; GST 18% on brokerage = ₹54; stamp duty 0.015% = ₹15; SEBI turnover tax 0.0001% = ₹0.10. Total ₹489.10, or 0.4891 percent.

Clearing and settlement

Clearing is the process of identifying what is owed to the buyer and seller in a trading transaction; settlement is the mechanism of settling the obligations of counter parties in a trade.

Earlier, trades done on day T were settled T+2. SEBI reduced the settlement cycle to T+1 day, announced in a phased manner from February 2022, and since 27 January 2023 all trades in equity shares, exchange-traded funds and bonds traded in the equity segment are settled on a T+1 basis. SEBI has since introduced an optional T+0 rolling settlement cycle in addition to the existing T+1 cycle.

Delivery versus squaring-off. Rolling settlement trades are trades for delivery, sometimes known as inter-day trading. Alternatively traders can buy or sell on a trading day and reverse the trade before the market closes the same day — squaring off. The net position in a square-off is nil, so squaring off is also known as intra-day or day-trading, and brokerage charges and statutory levies are lower on day trading transactions.

Netting. Outstanding obligations are netted at client level and trading member level. At the trading member level, netting is across all securities so that each trading member has to either pay or receive funds. Not all trades are settled (gross settlement); only net positions are settled (net settlement).

The workbook's example: buy 100 XYZ, sell 50 XYZ, buy 100 MNO, buy 50 DEF, sell 150 DEF → pay for and receive 50 XYZ and 100 MNO, and deliver 100 DEF while receiving funds for it.

Certain categories of clients — Indian institutional clients, foreign institutional clients, NRIs and PMS clients — are required to settle their trades through a SEBI registered custodian.

The three broad steps: identification and communication of settlement obligation · pay-in · pay-out.

• Securities Pay-in: delivering securities to the clearing corporation to settle a sale transaction
• Funds Pay-in: transfer of funds to the clearing corporation to pay for purchase transactions
• Securities Pay-out: receiving securities from the clearing corporation to complete a purchase
• Funds Pay-out: transfer of funds from the clearing corporation to complete a sale

Margins

A margin is the amount of funds that one has to deposit with the clearing corporation in order to cover the risk of non-payment of dues or non-delivery of securities. Margins are collected by brokers when the order is placed; stock exchanges collect margins from brokers when the order is executed.

Why margins vary by stock: the tendency to default is higher when share prices vary a lot. Volatility creates default risk because of the probability that share prices may decline between purchase and pay-in period — if the price falls, the buyer may be less inclined to pay; if it rises, the seller may not want to give delivery at the lower price. Shares with greater price volatility have higher default risk and therefore higher margin requirements.

The margin on equity shares is imposed daily and is the sum of three margins:

• Value at Risk (VaR) Margin — a statistical technique used to measure the probability of loss of value in a stock over a period, based on an analysis of historical prices and volatility. It is defined as a multiple of volatility and expressed as a percentage of the stock price, and VaR margin rates are updated at least five times each trading day
• Extreme Loss Margin (ELM) — aims at covering the losses that could occur outside the coverage of VaR margins. The Extreme Loss Margin shall be 3.5% for any stock
• Mark to Market (MTM) Margin — computed at the end of each trading day by comparing transaction price with the closing price of the share. It is payable at the start of the next trading day

Members in the cash segment are mandatorily required to collect upfront VaR margins and ELM from their clients. SEBI has a penalty structure for short-collection, non-collection and false or incorrect reporting of margin collection. But if the member collects a minimum 20 percent upfront margin in lieu of VaR margin and ELM from the client, then the penalty for short-collection or non-collection is not applicable.

Cross-margining gives a reduction in the margin payable where the client's positions in the cash and derivatives segment offset each other. In the workbook's example, a client buys shares of MNO Industries in the cash segment and simultaneously takes a short position in MNO futures equivalent to the number of shares purchased — the overall risk is negligible, so the exchange charges a spread margin equal to 25 per cent of the applicable upfront margin on the offsetting positions, with the normal margin charged on the rest of the portfolio.

The six eligible position types: index futures hedged by futures on the constituent stocks · index futures hedged by cash positions in the constituent stocks · cash positions in individual stocks hedged by futures on those stocks · ETFs and constituent stocks · ETFs and constituent stock futures · ETFs and relevant index futures — each to the extent they offset each other.

SEBI has extended cross margining to off-setting positions in highly co-related equity indices, where exchanges charge a spread margin of 30 percent of the total applicable margin.

When settlement fails

Short delivery is when a member is not able to pay-in securities, fully or partially, on the settlement day — also called securities shortage. Bad delivery is when shares are delivered but rejected by the depository for technical reasons such as incorrect signatures or names or details.

In both cases the buyer has paid good money and needs to receive delivery, so the clearing corporation conducts an auction session to buy the required shares and deliver to the buyer. The clearing member has to close out the short delivery by paying the clearing corporation an amount equal to the value of the short delivery — the number of shares short times the last closing price on the settlement day — and any difference in the price paid to acquire the shares in the auction has to be made good by the clearing member.

Funds shortage: a penal charge on the amount outstanding at the end of the day has to be paid until full payment has been made, the trading or clearing facility is withdrawn until the shortages are made up, and repeat defaulters may be asked to maintain a deposit equal to their cumulative funds shortage as "funds shortage collateral".

Corporate actions

Corporate actions such as bonus, rights, split, merger, dividends or warrants impact the price of the equity share, and variations in prices purely due to corporate actions have to be adjusted.

They divide into two categories: stock benefits and cash benefits. The rule to memorise: apart from cash dividends, all other corporate actions are categorised as stock benefits.

The record date is the date on which all those who are on record as shareholders get the benefit of the corporate action. A 1:1 bonus implies that all shareholders on record at the record date get one additional equity share for each share owned.

Cum basis means the security incorporates the benefit of the corporate action in its price; once it goes ex-basis, the buyer no longer has the benefit.

The exchange carries out adjustments to the traded price on the last day on which a security is traded on cum basis, after the close of trading hours, and the principle is that the value of a position on the cum and ex dates remains the same.

Worked: a share with face value ₹10 trading at ₹500 announces a split reducing face value to ₹2. One share at ₹500 becomes 5 shares, and the price is adjusted by the same factor to ₹100 — so the investor who had 1 share of ₹500 will now have 5 shares of ₹100 each. The purpose of price adjustment is to prevent gains or price fluctuations due to such events.

From the investor's side

Beyond the mechanics, some practical points:

• The investor must allocate the required amount of funds for trading — this earmarks or blocks funds so they cannot be withdrawn. Funds not blocked against pending orders can be de-allocated and withdrawn
• The broker sends an email at the end of each day showing details of all orders placed
• The online trade book shows details of all orders executed during the day; the online order book shows the status of various orders placed
• Contract notes are sent digitally within 24 hours
• Brokers usually allow clients to do a short sale in the Margin segment — selling of securities which are not owned by the client. Such short positions have to be compulsorily squared off before the time specified by the broker before the end of the trading day. Short sale positions cannot be carried overnight
• On a purchase, the broker deducts the purchase consideration from the linked bank account on the trade date itself
• If there is a short delivery by the selling broker, there can be a delay of a few days in receiving the security

Trading supported by blocked amount. Beyond the traditional route of transferring funds upfront to trading members, Qualified Stock Brokers must offer investors either trading supported by blocked amount in the cash segment using the UPI block mechanism, or a 3-in-1 account — the investor may opt for either.

Securities Lending and Borrowing (SLBM)

SLBM is a facility of borrowing securities on a temporary basis from a lender for an agreed period of time and in return for a specific fee. While this practice is widely prevalent in developed countries, it is usually conducted in the OTC market there. In India it is conducted on the exchange platform, since it was introduced in 2008.

SLBM is useful for market participants who wish to do a short sale — selling securities which one does not own. Institutional investors such as mutual funds, insurance companies and high net worth investors who own large quantities of eligible shares can lend these shares on the SLB segment for a fee.

The mechanics: contracts are listed on the stock exchanges; exchanges offer monthly and yearly contracts on all securities available for trading in the F&O segment; lending and borrowing is permitted in dematerialized form only; and the lending fee is market-determined and depends upon the demand for and supply of the security.

Each SLB contract has two legs. The first leg involves the delivery of the security by the lender to the borrower. The second leg is known as the reverse leg and refers to the return of the borrowed security by the borrower to the lender. Both the borrower and lender are allowed to repay or recall the security before the expiry date. And the crucial protection: the settlement of the contract is guaranteed by the clearing corporation of the exchange.

The strategies it enables: short-selling to execute a bearish view, reverse cash-and-carry arbitrage to profit from an undervalued futures contract, and pairs trading — buying an undervalued security and shorting an overvalued security. It also helps in meeting any delivery shortages for settlement completion.

The benefits to lenders: earning risk-free income by lending securities on the exchange platform, protection of all rights as an owner of securities, settlement guarantee from the clearing corporation, and improvement in portfolio performance by earning additional income.

Market information

Market capitalisation is the number of shares outstanding multiplied by the market price per share — it measures the market value of the company's share capital.

• Blue-chip or large cap stocks — the largest companies by market cap that also enjoy a high level of liquidity
• Mid cap stocks — a good level of liquidity but medium in terms of size
• Small cap stocks — smaller in size and therefore do not enjoy much liquidity

In bull markets, mid-caps tend to run ahead of large caps, and in bear markets, they tend to fall more than large caps. The summary line: if large cap stocks represent liquidity and stability, mid-caps represent momentum and opportunity. The ratio of market cap to GDP is used as an indicator of the size and importance of the stock market of a country.

Market turnover indicates how much trading activity took place, in value terms (rupees) or volume (number of shares). Higher the turnover in a stock, better the liquidity. The turnover ratio for the market as a whole is the ratio of turnover in rupees to market capitalisation.

Indices. Most leading indices are weighted by market capitalisation, and stocks included in an index are quite liquid, making it possible for investors to replicate the index at a low cost.

The Sensex was back calculated to 1979 when it was released.

The uses of an index: real time data on market movements is easily available to the investing public; the index value is a leading indicator of overall economic or sector performance; and a representative index serves as a performance benchmark against which the returns earned by equity mutual funds or other investment vehicles are compared.

Reading the ticker: it shows the last traded price and the change in price in comparison with the previous day's closing price. A green upward arrow shows the price has moved up compared to the previous day's close; a red downward arrow shows it has fallen.

Listing agreement. Companies sign a Listing Agreement with the stock exchange, executed under the common seal of the company, undertaking to: provide facilities for prompt transfer, registration, sub-division and consolidation of securities · give proper notice of closure of transfer books and record dates · forward copies of unabridged Annual Reports, Balance Sheets and Profit and Loss Accounts · file shareholding patterns and financial results at periodic intervals · intimate promptly any happenings likely to materially affect financial performance and stock price · comply with the conditions of Corporate Governance. Failure may result in disciplinary action including suspension or delisting of securities.

Risk management systems

When a large volume of trades happen it makes the market very liquid, efficient and low cost. However, the systemic risk also increases. Default of a member can have disastrous and catastrophic impact on the other members and the exchange as a whole.

Base Minimum Capital (BMC) slabs:

Minimum 50 percent of the BMC shall be in the form of cash and cash equivalents, and no exposure is granted against the BMC deposit. Stock exchanges prescribe suitable deposit requirements over and above the SEBI norms.

Liquid assets consist of Cash, Fixed Deposits, Bank Guarantees, Government Securities, and securities traded on the Exchange, and must at all points of time be adequate to cover MTM Losses, VaR Margins, Extreme Loss Margins and BMC.

Penalties. In case of shortfall of margins, the terminals of the trading member are immediately de-activated. Once pay-in is successfully completed, margins are returned to respective members. Margins are collected by adjusting payments due against total liquid assets of a member, excluding base minimum capital. On a pay-in shortfall, trading facilities are withdrawn, securities pay-out is withheld, and the exchange levies a penalty on the shortfall on a daily basis.

Core Settlement Guarantee Fund. The clearing corporation is the counterparty to all trades and assumes counterparty risk completely, by settling all trades even if the trading member defaults. Some of this risk is managed through the levy of margins; any residual risk is funded by a separate pool of funds known as the Core Settlement Guarantee Fund.

Online monitoring gives alerts if members build up abnormal sale or purchase positions or if margins are inadequate relative to exposure, and the clearing corporation can pro-actively carry out a detailed check and reduce open positions if necessary.

Price monitoring actions on abnormal movements: imposition of special margins on scrips showing unusually large price or volume movements, which may be imposed on client-wise net outstanding purchases, or sales or both · reducing circuit filter limits so that trading halts with a smaller rise in prices than usual · shifting a scrip from settlement to the trade-to-trade segment, which forces members to give or take delivery and so minimises volatility due to intra-day closing.

Inspection: the stock exchange conducts an inspection of the books of trading members of each market segment at least once a year.

Rights, obligations and grievance redressal

Investors have the right to: get a UCC allotted · get a copy of KYC and other documents executed · get trades executed in only his or her UCC · place orders on meeting the norms agreed with the member · get the best price · get a contract note · know details of charges levied · receive funds and securities on time · receive statements of account · ask for settlement of accounts · take up a complaint against a member with the exchange · take up a complaint against a listed company · file arbitration against a member · challenge the arbitration award before a court of law.

Investors have the obligation to: execute KYC documents and provide supporting documents · understand the voluntary conditions agreed with the member · understand the rights given to the members · read the Risk Disclosure Document · understand the product and operational framework and deadlines · pay margins · pay funds and securities for settlement on time · verify details of trades · verify bank and DP accounts for funds and securities movement · review contract notes and statements of account · take up a complaint within reasonable time · support complaints with appropriate documents · provide additional information called for in dispute resolution · participate in dispute resolution meetings.

The ladder

Step 1 — the exchange's Investors Grievance Division (IGD). Complaints are lodged in the format prescribed by the Exchange along with supporting documents, and the Exchange has a mechanism of resolving disputes by coordinating with the member and the complainant.

What the exchange cannot resolve: claims for notional loss, opportunity loss for the disputed period or trade; complaints pertaining to trades not executed on the trading system of the Exchange; and compensation for mental agony and harassment.

Step 2 — arbitration. Arbitration is a quasi-judicial process of settling disputes between trading members, brokers, investors or clearing members. Once arbitration proceedings are initiated, investors do not have recourse to the other grievance redressal panels of the exchange.

The timelines matter:

• Depending on the amount of the claim, the exchange may appoint a single arbitrator or a panel of arbitrators
• The arbitrator must issue the award within 30 days from the date of appointment — an extension of 30 days is also allowed
• A party aggrieved by the award may appeal to the appellate panel of arbitrators within 7 days of receiving the award
• A party aggrieved with the decision of the appellate arbitrator may appeal to the High Court
• Since July 2022, proceedings of the Grievance Redressal Committee and Arbitration may be conducted in hybrid mode
• The scope has been enlarged to include disputes between a shareholder and a listed company, Registrar to the Issue or Share Transfer Agent arising from transfer/transmission of shares, demat/remat of securities, issue of duplicate shares and corporate benefits
• Exchanges can release interim relief to the investor in a phased manner, according to the stage of the grievance redressal process

Step 3 — SCORES. The online investor grievance redressal mechanism set up by SEBI to deal with complaints of investors related to all products and entities regulated by it — including companies who have made share issues, mutual funds, portfolio management schemes, venture capital funds, and intermediaries such as brokers, merchant bankers, depositories and DPs, registrars and transfer agents, distributors and financial advisors. Acknowledgement is generated instantaneously with a unique complaint registration number, and the entity must resolve the complaint within 21 days after receiving intimation from SEBI, uploading an Action Taken Report.

Step 4 — ODR. The investor must first lodge a complaint directly with the concerned market participant. If not redressed satisfactorily, escalate through the SCORES Portal. After exhausting all available options, if still not satisfied, online dispute resolution through the ODR portal can be initiated. Alternatively, an aggrieved investor can initiate ODR if the grievance lodged with the market participant was not satisfactorily resolved or is pending at any stage of the subsequent escalations, and the market participant may also initiate ODR after giving due notice to the investor.

All MIIs have established a common ODR portal where all listed companies, specified intermediaries and regulated entities have enrolled. MIIs have empaneled ODR Institutions to operate the portal, which provide the services of qualified arbitrators and conciliators and charge a fee, and conduct conciliation and arbitration in online mode, enabling online or audio-video participation.

The two funds

Investor Protection Fund (IPF). SEBI has made it mandatory for stock exchanges to set up and maintain a separate fund for the protection of investors. The IPF compensates investors who have suffered losses due to default by a broker who is a member of the exchange, and is administered by a Trust. The IPF Trust compensates investors when the defaulting broker's assets are not sufficient to meet the admitted claim, and the maximum amount to be paid per investor is decided by the Exchange. It is also used for promoting investor education, awareness and research.

Investor Protection and Education Fund (IPEF). Created by SEBI under the SEBI (Investor Protection and Education Fund) Regulations, out of contributions from SEBI, donations from the government and other specified sources. Crucially, amounts disgorged from any person who has made profits by violating any securities law are also credited to the IPEF, and can be used to make restitution or compensate eligible investors who have suffered losses as a result of violation of securities laws.

An aggrieved investor can claim restitution from the disgorged amount only up to 7 years from the date on which such claims were invited by SEBI. Any amount remaining after compensating eligible investors can be used for investor education and awareness.

The corporate bond market

Unlike the anonymous, screen-based trading in the government securities market, corporate bonds are still mainly traded in the OTC market, with deals negotiated directly between the buyer and seller and settlement bilateral. The corporate bond market in India is much smaller and lacks the breadth and depth of the government securities market.

SEBI's measures, in order:

• 2007 — SEBI authorized stock exchanges to set up reporting platforms to capture the details of OTC trades in corporate bonds, reported on the exchange website on a real-time basis. Later, brokers must report all OTC trades in corporate bonds on the reporting platform of any exchange within 15 minutes of the trade
• A centralized database of corporate bonds has been created by the depositories, NSDL and CDSL, available in the public domain
• 2009 — SEBI made it compulsory for OTC trades in corporate bonds to be cleared and settled by the clearing corporations of any of the exchanges, to mitigate settlement risk
• 2013 — guidelines for a dedicated debt segment on stock exchanges, offering a screen-based trading system with online and mobile trading, and two separate platforms: the retail platform for trading publicly issued bonds, and the institutional platform for privately placed bonds with a minimum market lot of ₹1 crore
• 2015 — the NSE introduced a web-based negotiated trade platform on which trades negotiated between buyers and sellers of corporate bonds are reported
• The Request for Quote (RFQ) platform — an electronic platform where institutional investors like mutual funds and insurance companies can request a quote for buying or selling corporate bonds and negotiate a trade, expected to lead to pre-trade transparency. SEBI made it mandatory for mutual funds and portfolio management services to execute a certain portion of their secondary market trades in corporate bonds on the RFQ platform, and has further allowed stock brokers registered under the debt segment, AIFs and FPIs to use the RFQ platform to place or seek bids

Beyond the book: the IFSC

An IFSC deals with flows of finance, financial services and products to and from offshore customers, i.e. those outside the jurisdiction of the domestic economy. London, New York, Singapore and recently Dubai and Shanghai are counted as the major IFSCs in the world.

The problem it addresses: several regulatory restrictions have prevented foreign investors from actively trading in Indian financial markets, so active trading in Indian stock, index and currency derivatives was conducted outside India, in IFSCs like Singapore and Dubai — a loss of revenues and employment opportunities for the Indian economy.

Gujarat International Finance Tec-City (GIFT city) has become India's first IFSC, set up in Gandhinagar. NSE IX and India International Exchange (IndiaINX) are international stock exchanges set up by NSE and BSE respectively. Participants enjoy exemption from securities transaction tax, commodities transaction tax, capital gain tax and income tax, and index and stock futures and options on Indian companies are traded there but denominated in dollars.

The Indian International Bullion Exchange (IIBX) in the IFSC deals in bullion spot trading and bullion depository receipts, and all bullion imports for domestic consumption are routed through the IBE ecosystem for efficient price discovery and assurance in the quality of gold.

And the outcome that shows the policy worked: since July 2023, the derivatives contracts on Nifty which used to be traded on the Singapore Exchange (SGX Nifty derivatives) are being traded exclusively on the NSE IX, and SGX Nifty has been delisted.