New checks to ringfence markets from defaults, systemic risks

New mechanism aims to cut risks faced by markets due to defaults, will also have 'default waterfall' marks to limit liability of non-defaulting entities

To safeguard stock markets from any systemic risks arising out of trade and payment defaults, regulator Sebi is bringing in a new regulatory regime next week to ensure timely payment settlements and to keep the systems robust by way of daily 'stress tests'.

The new mechanism, which would come into force from December 1, is aimed at mitigating the risks faced by overall markets due to defaults by certain entities and would also include setting 'default waterfall' marks to limit the liability of non-defaulting entities.

The new stress testing norms would require that at least on a monthly basis, the Clearing Corporation perform a comprehensive and thorough analysis of stress testing scenarios, models, and underlying parameters and assumptions used to ensure necessary default protection measures in light the of current and evolving market conditions.

The stress testing norms will also capture the risk posed due to possible default in institutional trades, as per the new guidelines.

Besides, a daily stress test would need to be conducted to determine the Minimum Required Corpus of Core Settlement Guarantee fund, which would be needed to be set aside from the overall Settlement Guarantee Fund of a market infrastructure institution.

This new core fund would be created within the existing Settlement Guarantee Fund (SGF), against which no exposure is given and which is readily and unconditionally available to meet settlement obligations of clearing corporation in case of clearing members failing to honour settlement obligation.

The stress tests would need to be conducted for credit risk, liquidity, adequacy of liquidity arrangements and for back testing for adequacy of margins, among others.

The new regime is aimed at enhancing the robustness of the present risk management system of the clearing corporations to enable them to deal with defaults of the clearing members much more effectively.

Sebi has from time to time put in place various risk containment measures to address the risks involved in the securities market. One such measure prescribed was norms for Settlement Guarantee Fund (SGF) at stock exchanges including corpus, contribution, management, usage and recoupment of the fund corpus.

The new norms are aimed at further strengthening the system to deal with settlement defaults, although there have been very few such cases in recent times, as settlement commitments have mostly been met even in times of freak trades and temporary outages on stock exchange platforms.

Clearing corporations are required to maintain sufficient resources to cover losses due to major defaults in the market so as to avoid any systemic risk.