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Informist, Monday, Dec. 2, 2024

 

By Rajesh Gajra

 

MUMBAI – The proposal of the Securities and Exchange Board of India to separate clearing corporations from their parent stock exchanges has the potential to disrupt and change the efficiency of these vital market infrastructure entities in a big way. SEBI wants a clean break between the parent and the subsidiary, by way of the parent exchange giving away its entire shareholding in the clearing corporation to the shareholders of the exchange on a pro rata basis.

 

It is hard to say with certainty whether the changes the proposal will bring about, if implemented, will be beneficial or negative for investors and market participants, but given how Indian securities markets are configured, the negative implications are likely to outweigh the benefits and could even cause disruption. Indeed, these changes could stymie or even undo the progress achieved so far in developing this vital part of the market infrastructure.

 

Currently, capital infusion, contribution to settlement guarantee fund, management resources, operating processes and technology resources, all flow from the parent exchanges to the subsidiary clearing corporations. Indeed, the work ethos and governance standards also flow the same way. The clearing corporations also benefit from the experience of the exchanges and from mutual discussions, which are presumably deep and meaningful given the nature of the relationship they share. This has fostered the evolution and progress of clearing corporations in the past 30 years when the setting up of the National Stock Exchange of India saw the equity market move away from settlement through a clearing house that was a department of a stock exchange to a separate corporate entity called the clearing corporation.

 

Without this change, the equity market would have been stuck far longer in the clearing house system, which could not have assessed or managed the counterparty risk for settlement of funds and securities in the age of automated, anonymous order book driven trading systems. Be that as it may, SEBI now does not want a clearing corporation to be indirectly controlled by the exchange.

 

SEBI is urging financial and operational independence of the clearing corporations because it believes that in the current system there is an incentive for them to do things which may have negative unintended consequences for investors and market participants.

 

An example of what SEBI may have in mind as negative unintended consequences is the levy of charges by clearing corporations on trades done on a stock exchange that is not its parent exchange. Since June 2019, when SEBI's mandate for clearing corporation interoperability became effective, one clearing corporation can settle trades of more than one stock exchange and not just the trades of its parent exchange.

 

Earlier this month, the BSE reiterated its demand for removing what it considers a skew in the clearing charges policy under the clearing interoperability agreement between exchanges and clearing corporations. Since September 2023, the BSE has been asking NSE Clearing Ltd., the clearing corporation subsidiary of NSE which has an over 85% market share, to reduce the clearing charges levied on BSE for clearing and settling trades of BSE brokers.

 

BSE's contention is that NSE Clearing levies clearing charges on equity derivatives on a per-contract basis, regardless of the value of the premium in a contract. Since BSE's equity options contracts are largely traded on the expiry day, when the premiums are lower, the premium per contract is low. BSE charges its brokers a transaction fee based on the value of this premium amount and not on a per-contract basis.

 

According to BSE, since trades on expiry day have a lower premium than previous days or weeks, the clearing charge on a per-contract basis eats into a chunk of its transaction fee income. For instance, in the September quarter, BSE's clearing and settlement fee expense was INR 1.2 billion, a major part of which was for equity derivatives transactions. It included payment to NSE Clearing and its own clearing corporation, but over three-fourths of it was paid to the former. This is just over one-third of the INR 3.5 billion transaction fee in equity derivatives earned by the BSE in the quarter.

 

The BSE claims this ratio of clearing cost to transaction fee income in equity derivatives is far higher than what it is for the NSE, where the percentage of expiry day premium turnover to total premium turnover is much lower than BSE's. The exchange has taken up the issue with the NSE Clearing in September 2023 and has even escalated to it SEBI but to no avail so far.

 

BSE believes when the clearing interoperability agreements between exchanges and clearing corporations were signed around five years ago, such a scenario was not envisaged due to the absence of weekly index derivatives on the BSE and the expiry-day volume phenomenon was not present in the same intensity as now.

 

If this kind of skewed situation is what SEBI wants to correct, then there are other solutions available. SEBI has enough regulatory powers to get any market infrastructure entity back in line if it goes off track.

 

Will the proposed clean break result in better outcomes in such 'perverse incentive' cases? Will the advantages that flow from a parent stock exchange to the subsidiary clearing corporation be available to the latter in an independent avatar, or will it end up weakening the clearing corporation gradually?

 

While recommending the drastic step of forced ownership change, SEBI does not seem to have thought through how exactly a clearing corporation will be independent of the parent stock exchange's control and also continue to have access to capital, manage to grow the settlement guarantee fund, and have access to the management resources and technology needed to run and grow the business. Take, for instance, the settlement guarantee fund, which is the core of a clearing corporation's strength. Without an adequate corpus for the fund, the clearing corporation cannot guarantee settlements.

 

The settlement guarantee fund rules, including guidelines for the fund's corpus, are set by SEBI. The market regulator sets a very high bar for the clearing corporations in order to prevent large settlement default rocking the stock markets in the event of a meltdown or a black swan event. This year, during the June quarter, the NSE contributed INR 5.87 billion to augment NSE Clearing's core settlement guarantee fund for the futures and options segment.

 

This resulted in a 6.4% rise in the corpus of the fund to INR 97.26 billion. The NSE made these payments from its standalone financials. SEBI wants the corpus to be raised further to INR 105 billion. NSE's contributions to NSE Clearing's settlement guarantee fund is as per the mandate fixed by SEBI. Under SEBI's rules on the corpus of the settlement guarantee fund, the parent exchange has to contribute at least 25% of the corpus. A minimum 50% has to come from the clearing corporation's own funds, which includes its retained profits, and a maximum 25?n be contributed by the clearing members.

 

If the clearing corporations were to be independent of exchanges, would SEBI be able to get the exchange to contribute the minimum 25% of the core settlement guarantee fund? Now, since the clearing corporation is a 100% subsidiary, a stock exchange has no issue if it contributes 25% or even higher if dictated by SEBI. After the change of ownership, an exchange may well object to a mandated minimum percentage contribution. Will independent clearing corporations then continue to get such high levels of contribution from the stock exchanges?

 

The BSE is already a listed entity and the NSE has been waiting to get listed. If the proposed ownership change is implemented, we run the risk of a battle between majority shareholders of a listed exchange and SEBI on the issue of a mandated contribution to the settlement guarantee fund, particularly if SEBI wants to raise the corpus. This could even lead to protracted litigation and to exchanges holding back contributions which will affect the ability of the clearing corporation to manage the very risk that they have been set up to manage.

 

These and other issues can pose serious hurdles in achieving the goal of having independent clearing corporations working fully in the interest of the investor. SEBI has so far not laid down the measures by which an independent clearing corporation will be able to augment the settlement guarantee fund. If the new rules result in a rise in clearing and settlement charges levied on clearing members or additional deposits being demanded from them, it will actually end up raising the transaction costs in the equity market, where the government-levied securities transaction tax is a major cost for investors and traders.

 

In addition to these issues, there can be legal complications in getting the entire shareholding of a clearing corporation allotted to the shareholders of the parent exchange. Two of the five stock exchanges in the country, the BSE and the Multi Commodity Exchange of India Ltd. are listed entities. The NSE, the National Commodity and Derivatives Exchange Ltd., and the Metropolitan Stock Exchange Ltd. are not listed, although NSE's application for an initial public offering may get the go-ahead from SEBI in the near future. All the stock exchanges have clearing corporation subsidiaries, and how the proposed change in ownership will play out for each of them may differ. Has SEBI thought about this?

 

Post-split, a stock exchange's valuation will fall due to the absence of the clearing corporation's financials from its consolidated financials, and this may not be appreciated by the shareholders of the exchange. Even though shareholders of the exchange will get shares of the clearing corporation, they will not be liquid as they are not listed. All this may have an adverse bearing on the management and functioning of the independent clearing corporations.

 

SEBI's proposal, therefore, does not seem to be the best way to achieve its objective. It may be better for SEBI to use its regulatory powers to prevent the instances of perverse incentives practised by clearing corporations.

 

The only such instance of perverse incentives seems to be the NSE Clearing charging a high fee to settle the trades done on the BSE. If this is the only problem, then clearly the cure seems to be worse than the disease. This problem can be easily solved by SEBI by asking NSE Clearing to maintain parity in fees charged for settlement, irrespective of the exchange. Finally, even if exchanges are listed and clearing corporations need to make money, they are still a public good, aren’t they? SEBI ought to have disclosed the extent of the problem it is trying to solve through the proposed measure.

 

Regulators such as SEBI need to be far-sighted in the discharge of their obligations. If having independent clearing corporations was a necessity, then SEBI should not have permitted stock exchanges to go public and list their shares without first getting their clearing corporation subsidiaries separated from them. Or, better still, it should have barred the listing of stock exchanges in order to prevent such perverse incentives from arising in the first place. Or, even better, it should allow the clearing corporations to list and should give a clear roadmap for this.  End

 

Edited by Saji George Titus

 

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