[By Tamanna Das Patnaik]
The author is a student of National Law University, Odisha.
Introduction
Financial Market Infrastructures (FMIs) play a vital role in the economy. They serve as coordinating mechanisms and bring a network of counterparties together for the efficient operation of financial markets. Clearing Corporations (CCs) are one such important category of FMIs that deal with the clearing and settlement of transactions, management of counterparty credit risks and protection of transactional systems.
Given the vital role that they play, it becomes essential to maintain vigilant oversight over these entities. Regular reforms and timely adjustments are continuously required to avert any potential systemic risks. In light of the same, on July 20, 2023, the Securities and Exchange Board of India (SEBI) released a consultation paper titled ‘Prudential Norms for Clearing Corporations’.
In the course of their usual business operations, CCs interact with various bank and non-bank entities, through deposits of their own funds, or collaterals like Fixed Deposits, Bank Guarantees, stock or debt instruments etc. This makes them susceptible to credit concentration risks arising from over-reliance on a single party. Thus, if there is any imbalance in the solvency or stability of that counterparty, it will significantly affect the CC and in turn, the entire financial system. The Consultation Paper aims to minimize such exposure and concentration risk of CCs by the means of adequate diversification and liquidity.
Current regime
The existing guidelines rely on a vague set of principles, which makes their supervision and enforcement difficult. CCs are required to frame an Investment Policy, the foundation of which must give the greatest priority to safety and reduction of market risks. This entails them tailoring their investment strategy and focusing on a particular set of allowed instruments, such as Fixed Deposits made at banks with more than INR 500 crore net worth and A1 or equivalent rating, Central Government Securities, Liquid schemes of debt mutual funds and Overnight Funds.
However, the total amount invested in Liquid Funds and Overnight Funds have to be restricted to 10% of the CC’s total investible resources. Furthermore, adherence to exposure limits is also compulsory. According to the guidelines, the CC’s overall exposure to debt or equity securities of any company cannot be greater than 15% of its total liquid assets. Moreover bonds, considered as non-cash components, must be limited to a maximum of 10% of the clearing member’s total liquid assets.
Proposed changes
The proposed norms aim to closely oversee the exposure of CCs by presenting a comprehensive list of the type of exposures that require monitoring. This list comprises of the CC’s own funds and core Settlement Guarantee Fund (SGF) with a bank, balances with the bank acting as a clearing bank, fixed deposits (FDs) and bank guarantees (BGs) lien, pledged or re-pledged equity shares, debt instruments and mutual funds and lastly, exposure through economically reliant subsidiaries.
The selection criteria for banks have also been made more well-defined. Assessment of financials, capital adequacy and credit worthiness are pre-requisites. Only banks with a minimum net worth of more than INR 5000 crore, unsupported long-term rating of AA or above and fulfilment of capital adequacy requirements given by the Reserve Bank of India (RBI) are eligible for exposure via cash, FDs and BGs. Investment is allowed only in specific financial instruments like FDs, treasury bills, government securities and liquid mutual funds.
Further, in case the bank’s rating downgrades from the specified criteria, CCs have to adjust the exposure within three months of such occurrence.
Coming to credit rating impacting the selection of a bank, a balance must be maintained between liquidity and diversification. Exposure to banks with credit rating AAA and between AAA to AA should be capped at 15% and 10% of the average daily exposure of the past three months respectively. An extra 5% exposure will be afforded to CCs only in exceptional circumstances, provided they undertake action to reduce the same within permissible limits within three months.
Additionally, exposure concerning equity and debt instruments provided by a single clearing member (CM) should be within 15%, in both cash and F&O segments. Acquisition of collateral from CMs should not occur through bespoke transactions or comprise of FDs, BGs or debt or equity instruments issued by them themselves or their associates. Exposure to such corporate bonds should also be subject to the issuer’s credit rating. As a matter of prudence, total daily exposure should never surpass 20% of the total exposure and overall exposure limits should be lowered proportionally if there is a fall in credit rating.
Periodic objectives should be integrated in the internal policies of CCs to ensure adherence to the exposure limits. Real-time monitoring of exposure and a buffer of limits to ensure that it stays within the specified limits without encountering operational challenges should be made certain. The guidelines also give out a list of timelines for the smooth implementation of the above measures in a phased manner.
The dichotomy between preserving the autonomy of CCs and having a pre-determined list
There are several benefits of letting CCs devise their own criteria for selection of banks. Each CC has its own distinct risk tolerance threshold and method of operation. Given this diversity, a predefined list by RBI or SEBI outlining permissible banks may prove to be ineffective. Thus, allowing CCs to formulate their own criteria for selection will ensure that their risk management policies respond better and more promptly to address the changing market conditions and associated risks. In such cases, a one-size-fits-all approach can prove to be detrimental.
On the contrary, a predetermined list by regulatory bodies like RBI or SEBI can guarantee a standard process of creating a level playing field and setting a benchmark of creditworthiness that all banks strive to achieve, thereby enhancing the overall health of the financial system. The list will also ensure that all banks are assessed based on a common set of criteria, reducing potential inconsistencies and guaranteeing a uniform risk assessment process. It will also simplify regulatory oversight and enable easier adherence to the stipulated framework for faster detection of lapses in compliance. It will also be less resource-intensive, saving time and efforts of both the CCs and regulators.
Suggestions and Conclusion
To get the best of both worlds, a hybrid strategy that offers both flexibility and autonomy to CCs while also minimizing the scope of lapses in regulatory monitoring should be devised. A baseline pre-defined list for creditworthiness can be created. CCs can venture beyond the list with prior regulatory approval.
Other than this, there is still scope for incorporating other changes in the norms to ensure their efficacy. First of all, the scope of collateral management done by CCs should be enhanced to include not just the monitoring of concentration of collateral at various bank or non-bank entities, but also supervising the procedure by which such collateral was secured. This will help affirm the value and quality of collaterals obtained, which will guarantee their sufficiency and minimise any credit risks.
The proposed norms also rely heavily on quantitative aspects only, namely net worth, capital adequacy and credit ratings. However, such metrics offer only a limited perspective and do not provide an overall picture of the bank’s risk profile. Therefore, qualitative aspects like risk management practices, corporate governance standards and operational efficiency should also be required to be considered by CCs to conduct a more holistic evaluation of the bank’s suitability.
Moreover, the norms emphasise on the importance of individual diversification only, failing to look at the bigger picture. Because credit ratings are heavily relied on to set the exposure limits, it can lead to concentration of exposure of all the CCs in a small group of highly rated entities only. Akin to putting too many eggs in one basket, in the event that a financial downturn hits this group of entities, the entire financial system will be affected.
Provisions for scenario-based contingency planning should also be included. Detailed steps to be taken in case of specific circumstances should be provided, so CCs will have a quick reference guide during emergencies, and will not need to waste time formulating an entire strategy from scratch. They can just make modifications to the plans to cater to their individual needs. The specific circumstances for which such steps need to be given can range from unexpected counterparty defaults to abrupt market downturns.
A standardised and transparent review procedure for exposure limits can be created by specifying particular rating agencies whose ratings will be taken into account, also guaranteeing better regulatory oversight.
Lastly, the norms should also promote enhanced transparency and reporting requirements of the exposure data to market participants and stakeholders via various newspapers and websites of the CCs, SEBI, stock exchanges and RBI to enhance market confidence and promote responsible risk-taking behaviour.
In conclusion, the creation of a more resilient framework will require venturing beyond qualitative methods of evaluation, and introducing unique parameters to ensure that CCs are better equipped to navigate the complexities of today’s modern-day financial landscapes.