Interoperability of CCPs – Integrating the Securities Market

By Nikita Chawla and Smrithi Nair

The Securities and Exchange Board of India (SEBI) released a circular recently, dated 27th November 2018 (SEBI Circular), introducing the concept of ‘interoperability of clearing corporations’ in the Indian Securities markets.

Concept:

What is this concept and how does it work?

Interoperability of central counterparties (“CCPs”) is a mechanism by which financial market infrastructures (“FMI”), in this case, the CCPs, create and maintain a link with each other, such that the market participants will not be restricted to a particular CCP only because such a CCP is attached to an exchange on which the trades are executed or undertaken. This gives the market participants the option of clearing and settling their trades on a CCP of their choice instead of going through the CCP owned by the specific exchange.

There are primarily 2 ways of creating interoperability: Participant Link and Peer-to-Peer Link.

Current Structure in India:

In India, the current practice is that each stock exchange has its own CCP to handle trade settlements of the respective exchange. This results in participants having to take up memberships of multiple CCPs and making contributions (on account of margin, etc.) at multiple levels, which leads to concerns of suboptimal utilization of capital of such participants.

Trend being followed in other jurisdictions:

This principle of FMI links, was first set out in April 2012, under the Principles for Financial Market Infrastructures (“PFMI”) released by the Committee on Payment and Settlement System and Technical Committee of the International Organization of Securities Commissions. Principle 20 recommends that

“An FMI that establishes a link with one or more FMIs should identify, monitor, and manage link-related risks.”

Interoperability of CCPs is already being followed in other jurisdictions such as the European Union, Hong Kong, China. Some of these jurisdictions are even facilitating CCPs on a cross-jurisdiction basis as well.

Interoperability of CCPs in India:

With the ever-evolving and competitive markets where participants are offered better pricing with more options, there is a need for the Indian market to make efforts in the direction of making ‘interoperability of clearing corporations’ a reality in India. With this intent, the Indian securities market regulator, SEBI had constituted a committee chaired by Mr. K V Kamath, to inter alia examine the viability of introducing a single CCP or interoperability between different CCPs. The said committee submitted a report in the year 2015 (“Report”).

Under the Report, the committee while assessing the workings, pros and cons of each of these models, was ultimately of the view that moving to a single CCP approach may not be appropriate for the securities market at this juncture. The committee while acknowledging the fact that India has agreed to adoption of the PFMI principles, recommended that “SEBI can keep the interoperability option open and consider the proposal for implementation when ground conditions are met.”

While the concept of interoperability of CCPs is becoming globally popular, the need for introducing the same in India was fueled when instances of disruption of stock exchanges occurred in 2017.

Shortly afterwards, interoperability of CCPs formed a part of the agenda of the SEBI board meeting held on 18th September 2018, whereby the proposal of ‘Interoperability among clearing corporations’ as well as the proposed amendments to the Securities Contracts (Regulation) (Stock Exchanges and Clearing Corporations) Regulations, 2012 in order to enable the framework of interoperability was discussed.

SEBI Circular:

The SEBI Circular sets out the broad guidelines for operationalizing the interoperable framework among CCPs. The interoperable framework will allow participants to consolidate their clearing and settlement functions at a single CCP, irrespective of the stock exchange on which the trade is executed. The framework will be applicable to all the recognised CCPs excluding those operating in IFSC2, and all the products available for trading on the stock exchanges (except commodity derivatives).

The interoperability will be worked under the peer-to-peer model (unless otherwise required by SEBI in any specific cases), wherein the stock exchanges/ CCPs shall enter into multipartite agreements inter alia, to include system capability, inter-CCP links and CCP-trading venue link, risk management framework, monitoring of client margin/ position limits, obligation system, settlement process, surveillance systems, sharing of client data, sharing of product information, default handling process and dispute resolution process.

The interoperability framework will be under special arrangements and the CCPs will not be subjected to normal participation. The CCPs shall be required to undertake multilateral netting to create inter-CCP net obligations.

All stock exchanges and CCPs are required to operationalise interoperability by 1st June 2019.

To sum up…

While the discussions and deliberations on interoperability have been ongoing since a while, SEBI has finally agreed that interoperability is the need of the hour. The introduction of interoperability seems promising from securities market integration, to ensure, inter alia, inter-exchange risk management, rationalized margins across exchanges and products.

The interoperability framework was much needed in the Indian markets, and while there may be some teething problems for the CCPs now or post 1st June 2019, in terms of synchronized efforts on implementation, margin evaluations, dispute handling, it will ultimately be for the CCPs and SEBI to ensure that all creases are ironed out properly so that the market participants ultimately are able to actually benefit from this model.

In the meantime it will be interesting to watch the progress on this model and also wait for any further developments that pan out in this space, including any deliberations on linked issues such as clubbing of commodity derivatives under this interoperability model, consideration of a single CCP approach (with the market studies indicating that it may result in a monopoly in the market structure).

Nikita Chawla is a Principal Associate and Smrithi Nair is an Associate at the Mumbai office of Juris Corp.