Proposals to strengthen the clearing corporations

The core of risk management for any clearing corporation (CC) is collateral deposited by the stockbroker or trading or clearing member with the CC. Participants bring risk to the system by way of trades which the CC is obligated to settle with guarantee and the CC in turn tries to mitigate this risk by collateralization. The present system in India has certain unaddressed risks and further steps could be taken to mitigate them.

The Bankruptcy Law Reform Committee (BLRC), set up by the Department of Economic Affairs to study the “corporate bankruptcy legal framework in India”, has submitted a report on reforming the system, which contains a detailed analysis of safe harbour provisions in response to a submission received from the Securities and Exchange Board of India (SEBI). The BLRC agrees with SEBI’s proposal to amend the Securities Contracts (Regulation) Act, 1956 (SCRA), to provide safe harbours for CCs and stock exchanges in the event of the insolvency of clearing or trading members in the interest of settlement finality in the markets.

Key features

The salient features of SEBI’s proposals are: (1) In case of bankruptcy of clearing members, the collateral/assets which they have kept with a CC as mandated under the securities laws will not be subject to any other claim. (2) A CC’s priority rights to the collateral, deposits and assets of a clearing member in case of winding up or insolvency of a clearing member become essential, because the CC provides novation and counterparty guarantee to all trades, like a buyer to every seller and seller to every buyer. (3) Settlements in accordance with the rules, bye-laws and regulations of a CC/stock exchange before any order declaring any client or stockbroker or clearing member or the CC itself as bankrupt should be final, and any bankruptcy order should not have the effect of reversing such settlements, unwinding netting and recalculating net positions. (4) Settlement of trades which are executed to terminate or close out/square off open positions, after a bankruptcy order, should also be final and irrevocable. (5) A CC should have the first right over the collateral, deposits and other monies in whatever form contributed by a client or trading or clearing member towards its settlement or other obligations and any order of bankruptcy should not affect this right of a CC. However, any excess collateral left after defraying the settlement or other obligations should be returned to the defaulter or official liquidator.

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Settlement finality

According to SEBI, the above treatment of liabilities of defaulting brokers, which may be achieved by amending the SCRA, is necessary to ensure settlement finality with respect to transactions in stock exchanges and priority of a CC’s rights in settlements in order to rule out all other claims (court orders, execution petitions, claims by creditors, claims by stockbrokers, etc.) which would vitiate the settlement process.

The proposed amendment to the SCRA is also in line with section 23(4) of the Payment and Settlement Systems Act, 2007, which provides similar protection for settlement finality in the payment and settlement systems.

The basic purpose of the amendments to be made to the SCRA is to ensure: (a) priority rights for CCs in the collateral posted with them by clearing participants; and (b) settlement finality in the Indian capital markets.

Essential principles

The Principles of Financial Market Infrastructures (FMIs), published by the Committee on Payment and Settlement Systems and the International Organization of Securities Commissions, contain several principles which are considered to be essential in order to establish and operate efficient FMIs while minimizing systemic risks in the financial system.

When trades go through a CC, the market is protected from a situation where transactions fail to go through because the entity at the other end has defaulted. Thus, giving the CC powers to carry out the process of settlement of trades without interference, including from court orders, will provide confidence in the securities market, as there should be a high degree of certainty that actions taken by the FMI under such rules and procedures will not be voided, reversed or subject to stays.

The number of stock exchanges, depositories and CCs in an economy is limited due to the nature of their business, although they serve the entire marketplace. Any failure of such a market infrastructure institution (MII) could lead to bigger collapses that may result in an overall economic downfall that could extend beyond the boundaries of the securities market or the country. Therefore, such MIIs are considered systemically important institutions. SEBI’s proposals to the BLRC to empower CCs are a move to bring India in line with global practices.

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Suhail Nathani is a partner and Yogesh Chande is an associate partner at Economic Laws Practice. This article is intended for informational purposes and does not constitute a legal opinion or advice.