On May 10, 2021, SEBI issued a Consultation Paper seeking public comments on a proposed framework for the segregation and monitoring of collateral at client level (“the Consultation Paper”). The main objective of the proposed framework is to enable identification and protection of client collateral from misuse/mismanagement by the trading member (“TM”) or clearing member (“CM”).
Under the extant framework, the clearing corporation (“CC”) of a stock exchange (“Exchange”) identifies all the margin collected by the TM/CM and reported to the Exchange, as that of the TM/CM. The Consultation Paper now proposes to segregate the funds collected by TMs and identify them in the name of each client. It must be noted that the Consultation Paper does not propose changes to the collateral management framework with regard to pledged and re-pledged securities under the depository system, as the CC has visibility of the client to whom such securities belong to. Some of the key proposals from the Consultation Paper are mentioned below:
Reporting mechanism by TMs and CMs
Under the proposed framework, the CC will be required to specify a reporting mechanism for both cash and non-cash collaterals (not securities). The reporting is proposed to take place in two phases to ensure visibility of client’s collateral: first, the TM will report to the CM the information on the collateral received, retained and placed by it with the CM; and second, the CM will report to the CC and the Exchange, the collateral it retains and that which it places with the CC as well as the information which TM has reported to it. Additionally, it is proposed that this information will be provided in a disaggregated manner i.e., in an asset wise break up, and will be reported on a daily basis
Collateral Deposit and Allocation
For collateral other than securities, it is proposed that the CM shall allocate these collaterals upfront into its proprietary account and/or proprietary account of the TM clearing through them, and/or account of any of the clients clearing either through the CM, or through the TM who in turn is clearing through such CM. It is proposed that the CC must, by the use of such collateral allocation information, ensure that the collateral allocated to a client is used towards the margin obligation of that client only.It is proposed that no collateral shall be accepted by the CM or the CC if the TM or the CM, as the case may be, fails to provide a break-up of such collateral into its proprietary account and the uniquely identified client account.To eliminate chances of any misappropriation of client’s collateral, the proposal accentuates on the total value of client’s collateral to ensure that the break-ups and further allocations do not exceed this value. The following must be kept in mind for the allocations to be lawful:
- The CM shall ensure that the sum of break-up of collateral provided by the TM is equal to the total value of the collateral provided by the TM and that the allocation reported to the CC does not exceed the allocation of collateral reported by the TM for that entity.
- When the TM/CM allocate their proprietary collateral as client collateral, the value of such proprietary allocation must not exceed the value of client collateral received by them (excluding demat securities).
- Allocation of collateral to individual client accounts must not exceed the collateral individually provided by them.
- On exceptional basis, there shall be a deemed allocation of TM/CM’s proprietary collateral towards client margins in case the client margin exceeds the collateral allocated to the client plus the securities collateral re-pledged to CC.
CMs are required to maintain at least 50% of the total collateral in the form of cash or cash equivalents. The Consultation Paper proposes that the 50% cash equivalent collateral rule shall not be applied at the client level. While monitoring the 50% requirement at the CM level, the excess cash-equivalent collateral of a client shall not be considered for other client or for the proprietary account of TM/CM. However, excess cash-equivalent collateral of proprietary account of TM/CM can be considered for offsetting excess non-cash collaterals of their clients.
Blocking of Margins
Under the extant framework, the procedure for blocking of margins only specifies the order of blocking of collateral available with the CC. It is proposed that in case of a trade from a client account, the margin shall first be blocked from the value of client collateral. If the client collateral is not sufficient, the residual margin shall be blocked from the TM proprietary collateral first and then from the CM proprietary collateral. Similarly, for a trade from the TM’s proprietary account, the margin shall be blocked from proprietary collateral of TM first followed by the CM proprietary collateral; whereas for trades of CM’s proprietary account, the margin shall be blocked from the proprietary collateral of the CM only.
Default and Default Management Process
The Consultation Paper proposes a four-stage default management process in case of default of a CM. At the first stage, the CC shall finish the pay-outs to non-defaulting members. At the second stage, the CC shall identify and offer non-defaulting members, the choice of porting their positions and collateral to another CM or immediate return of such collateral. At the third stage, the CC shall close out all open positions of the defaulting CM including the positions of the entities cleared by it by first utilizing their respective collaterals for meeting any losses in close-out of respective positions. Here, after provisional appropriation of collateral by adjusting any shortfall in collateral of any entity under the CM, the remaining obligations will be attributed pro-rata among TM/ clients having funds payable.
At the fourth and final stage, the Member and Core Settlement Guarantee Fund Committee (“MCSGFC”) of the Exchange would identify the actual defaulting clients/ constituents and attribute the actual shortages replacing the pro-rata attribution conducted at the third stage. The Exchange or the CC shall initiate appropriate proceedings for liquidation of defaulting TM/CM if any client collateral is retained by them without it being allocated to the client’s account. Similar default management process shall be followed by the CM in case of default by TM to CM.
The proposals discussed above not only strengthen reporting requirements between TM, CM and CC, but also improve transparency at every level, which in turn, will bring efficiency to the risk and default management processes.