Definition of Liquid Net Worth (Clause 4.1)

Even an accurate 99% "value at risk" model would give rise to end of day mark to market losses exceeding the margin approximately once every six months. Obviously, the futures market should not be subject to a payments crisis every six months, and this means that there must be a second level of defence in the form of the broker's net worth. The group is of the view that that given the reality of the Indian situation, liquid net worth is a far more meaningful defence against market risk than book net worth.

Liquid net worth means:

1. total liquid assets deposited with the exchange/clearing corporation towards initial margin and capital adequacy, Less

2. initial margin applicable to the total gross open positions at any given point of time of all trades cleared through the clearing member.

The group examined the evidence from the backtesting exercise showing that over an eight year period, a margin shortfall (mark to market losses exceeding the initial margin) of more than 3% of the previous day's mark to market value happens only twice in the case of Nifty and does not happen at all in case of Sensex. The group also took into account the recommendation of the LCGC that the clearing member's liquid net worth must be at least Rs 50 lacs.

The group recommends that the clearing member's liquid net worth must satisfy the following Conditions 1 and 2 on a real time basis:

1. Condition 1: Liquid Net Worth shall not be less than Rs 50 lacs at any point of time.

2. Condition 2: The mark to market value of gross open positions at any point of time of all trades cleared through the clearing member shall not exceed 33-1/3 times the members' liquid networth.

As recommended by the LCGC, liquid assets for the purposes of initial margins as well as liquid net worth includes cash, fixed deposits, bank guarantees, Treasury bills, government securities or dematerialised securities (with suitable haircuts) pledged in favour of the exchange/clearing corporation or bank guarantees.

The group deliberated on the question of the acceptability of bank guarantees in the futures market where (unlike in the cash market) banks and institutions are themselves subject to margins. The question also arose as to whether a bank could offer its own bank guarantee to meet the margin requirements on its own position. This problem would arise if a bank itself became a member of the futures exchange or if it gave a bank guarantee for a broker through whom it has originated a large open position on its own account.

The group concluded that given the Indian realities, it is necessary to accept bank guarantees as part of the liquid net worth of the broker. It is also of the view that a requirement that a bank cannot give its own bank guarantee on its own behalf would be neither conceptually sound nor easy to enforce (For example, two banks could give guarantees to each other).

The group is also of the view that all banks cannot be treated alike by the clearing corporation without regard to their net worth, capital adequacy, credit rating and other characteristics. Considering all the above, the group decided that the clearing corporation would set an exposure limit for each bank taking into account all relevant factors. Specifically, the group recommends:

The Board of Directors or other equivalent organ of the clearing corporation shall lay down exposure limits either in rupee terms or as percentage of the trade guarantee fund that can be exposed to a single bank directly or indirectly. The total exposure would include guarantees provided by the bank for itself or for others as well as debt or equity securities of the bank which have been deposited by members as liquid assets for margins or net worth requirement.

Not more than 5% of the trade guarantee fund or 1% of the total liquid assets deposited with the clearing house whichever is lower shall be exposed to any single bank which is not rated P1 (or P1+) or equivalent by a RBI recognised credit rating agency and not more than 50% of the trade guarantee fund or 10% of the total liquid assets deposited with the clearing house whichever is lower shall be exposed to all such banks put together.

The exposure limits and any changes thereto shall be promptly communicated to SEBI. The clearing corporation shall also periodically disclose to SEBI its actual exposure to various banks.

The group recommends that the Board of Directors or other equivalent organ of the clearing corporation shall approve the list of acceptable securities, the hair-cuts applicable to various classes of securities, and the method of periodic revaluation (marking-to-market). The clearing corporation is free to adopt more stringent conditions than those described below. These policies shall be promptly disclosed to SEBI.

1. The marking to market of securities shall be carried out at least weekly for all securities.

2. Debt securities shall be acceptable only if they are investment grade. Haircuts shall be at least 10% with weekly mark to market.

3. The total exposure of the clearing corporation to the debt or equity securities of any company shall not exceed 75% of the trade guarantee fund or 15% of the total liquid assets of the clearing corporation / house whichever is lower. Exposure for this purpose means the mark to market value of the securities less the applicable haircuts.

4. Equity securities shall be in dematerialised form. The acceptable securities shall be the top 100 securities by market capitalisation out of the top 200 securities by market capitalisation and also by trading value. This list shall be updated on the basis of the average market capitalisation over the previous six months. When a security is dropped from the list of acceptable securities, existing deposits of that security will continue to be counted for liquid assets for a period of one month. Haircuts on equity shall be at least 15% with weekly mark to market. The clearing corporation may charge a higher haircut on concentrated portfolios of equity securities deposited by a member.

5. All securities deposited for liquid assets shall be pledged in favour of the clearing corporation.

At least 50% of the total liquid assets shall be in the form of cash equivalents viz. cash, bank guarantee, fixed deposits, T-bills and dated government securities.

The SEBI requirement of segregation of client funds could, in the futures market, lead to a situation where a large amount of customer funds lie in a current account which earns no interest. This is ultimately a matter to be negotiated between the broker/exchange and the banks. The group recommends however that the segregation rules themselves should not bar the deployment of customer funds in liquid interest earning instruments of equivalent safety.

Suppose that the position at the beginning of day one is as follows:

The margin and capital adequacy calculations will be as follows:

• Initial margin = 5% * 200 * 1,00,000 = 10,00,000

• Total open position = 2,00,00,000

• Total liquid assets will be treated as 70,00,000 only since at least 50% of total liquid assets must be in cash equivalents (see 5.3).

• Liquid net worth = 70,00,000 - 10,00,000 = 60,00,0000

Both conditions in 4.2 above are satisfied as shown below:

• Condition 1. 60,00,000 > 50,00,000

• 2. 60,00,000 * 33^1/3 = (20,00,00,000) > 2,00,00,000.

Suppose that the member does a calendar spread trade by buying 300 contracts of 3 months futures and selling 300 contracts of 1 month futures.

Since the near month contract of the spread is five days to expiry, the member will have the full benefit of spread margining:

• Margin on spread = 1% * 300 * 1,00,000 = 3,00,000

• Spread open position 300 * 1,00,000 * 1/ 3 = 1,00,00,000

Adding the figures for the earlier long position we get:

• Total open position = 2,00,00,000 + 1,00,00,000 = 3,00,00,000

• Liquid net worth = 70,00,000 - 10,00,000 - 3,00,000 = 57,00,000

Both conditions in 5.2 above are satisfied as shown below:

• Condition 1. 57,00,000 > 50,00,000

• 2. 57,00,000 * 331/3 = 19,00,00,000 > 300,00,000

Suppose that on day two, the member does not initiate any new trades, but prices move up so that the situation is as follows:

The margins and exposures for the 200 contract long position would be:

• Open position = 200 * 1,01,000 = 2,02,00,000

• Initial Margin = 5% * 200 * 1,01,000 = 10,10,000

The spread open position for exposure purposes would be 1,41,4

• 20% of far month = 20% * 300 * 1,01,000 = 60,60,000 PLUS

• 80% of far month = 80% * 1/3 * 300 * 1,01,000 = 80,80,000

The initial margin on spread would be 5,45,000 as shown below:

• 20% of far month = 20% * 5% * 300 * 1,01,000 = 3,03,000

• 80% of spread = 80% * 1% * 300 * 1,01,000 = 2,42,000

The margin, exposure and liquid networth of the member would be as follows:

• Total open position = 2,02,00,000 + 1,41,40,000 = 3,43,40,000

• Total initial margin = 10,10,000 + 5,45,400 = 15,55,400

• Liquid net worth = 70,00,000 - 15,55,400 = 54,44,600

Both conditions in 4.2 above are satisfied as shown below:

• Condition 1. 54,44,600 > 50,00,000

• 2. 54,44,600 * 331/3 (18,14,86,667) > 3,43,40,000

The group considered the issue of position limits at the customer level, trading member level, clearing member level, and market level.

• Customer Level
  The group agreed that though position limits make most sense conceptually when imposed at the customer level, it is not practical to enforce such a requirement unless

• The aggregate position of a customer who operates through several brokers can be determined by the use of a single customer code (for example the Income Tax permanent account number). Currently, each broker assigns a code to a customer independently so the customer has as many codes as the number of brokers through whom he operates.

• A customer operating under multiple names and through multiple shell companies can be identified as a single customer using an operationalizable definition of "acting in concert".

Instead of recommending position limits at the client level, the group recommends a self-disclosure requirement similar to that in the take-over regulations:

1. Any person or persons acting in concert who together own 15% or more of the open interest shall be required to report this fact to the exchange and failure to do so shall attract a penalty as laid down by the exchange / clearing corporation / SEBI.

2. This requirement may not be monitored by the exchange on a real time basis, but if during any investigation or otherwise, any violation is proved, penalties can be levied.

3. This would not mean a ban on large open positions but only a disclosure requirement.

The group recommends:

1. There shall be a position limit at the trading member level of 15% of the open interest or Rs 100 crore whichever is higher.

2. This is to be reviewed after six months of index futures trading.

No separate position limit should be imposed at this level on aggregate trades cleared by a member. However, the clearing member shall ensure that his own positions and the positions of members clearing through him are within the limits specified in 6.2 above.

The group recommends:

1. No limits should be imposed at this stage on the total market wide open interest (as a percentage of the underlying market capitalisation).

2. This should be reviewed at the end of six months of index futures trading to determine whether position limits are required at this level to guard against situations where a very large open interest leads to attempts to manipulate the underlying market.

The clearing corporation may specify:

1. the minimum margins to be collected from customers which may be more than the margins charged to members;

2. the minimum capital requirements for trading members in the form of deposits with the clearing member or the clearing corporation.

The group recommends that at the end of six months of futures trading, SEBI should review the risk containment measures with specific reference to the following:

1. Removal of the transitional provisions in 3.2 (g) and (h)

2. Review of the margins for calendar spreads as mentioned in 3.4 (b)

3. Review of position limits as mentioned in 6.2 (b) and 6.4 (b)

4. Cross margining between cash and futures markets (see 6.9 of LCGC report)

The group recognises that it is easier to introduce stringent risk containment measures in the derivatives market which are being set up from scratch. However, it does not make sense to have lesser risk containment measures in the cash market than in the derivatives market. The group recommends that the basic ideas enshrined in this report be extended to the cash market. In particular:

1. the margins in the cash market should be based on a 99% VaR. As an interim measure, the margins could be twice that in the index futures market since individual securities are roughly twice as volatile as the index. Exposure limits could also be commensurately lower than in the derivatives market.

2. the recommendations on the computation of liquid net worth and the up front margins could be readily applied to the cash market.