Need for Surveillance

Securities markets are essential for the growth and development of an economy as it offers individuals and large, small and medium-scale enterprises a broader menu of financial services and tailored financial instruments. Further, the forces of globalization, technology, changing investor demographics, and new forms of competition have dramatically transformed securities markets worldwide.

Since emerging middle class/retail investors are placing an increasing proportion of their money in securities markets and in-turn creating growing demand for property ownership, small-scale investment, and savings for retirement, securities markets have become central to individual wealth and retirement planning. This requires a sound and effective regulation which builds confidence of investors in the market as openness, fairness and sound regulation are cornerstone requirements to ensure efficiency and the fairest of practices in the integration of the securities markets.

On the other hand, in the wake of globalization and technological advancements, those have increased the cross-border activities and flow of money; organizations like World Federation of Exchanges (WFE) and International Organization of Securities Commissions (IOSCO) are stepping up their efforts to promote the immediate needs for real-time market surveillance, risk management and regulation of cross-border trading in order to harmonize the global activities at exchanges and maintain the integrity of the securities markets.

Market Surveillance System

Effective surveillance is the sine qua non for a well functioning capital market. As an integral part in the regulatory process, effective surveillance can achieve investor protection, market integrity and capital market development. According to IOSCO (International Organization of Securities Commissions), “the goal of surveillance is to spot adverse situations in the markets and to pursue appropriate preventive actions to avoid disruption to the markets.”

So, the question arises, what is a market surveillance system and how does it work?

And the answer can be summarized as:

As with most trading platforms, surveillance systems within exchanges around the world are automated. Real time computer surveillance systems alert surveillance staff of unusual trading activity based on orders and executed trades. Such alerts are not usually based on single trades but are generated based on patterns of trading to detect potential manipulative practices.

Different types of market manipulations can be the subject of both single and cross-market surveillance. Single-market manipulations can also be a cross-market manipulation (such as for a security that is listed on more than 1 exchange) or cross-product manipulations (such as a derivative and its associated stock). For example, wash trades may take place across markets (in fact, multiple transactions across markets could be used as a way to disguise wash trades). Front-running may also take place across markets where brokers place orders ahead of client orders for the same security traded on a different exchange.

Indian Experience

In India, the stock exchanges hitherto have been entrusted with the primary responsibility of undertaking market surveillance. Given the size, complexities and level of technical sophistication of the markets, the tasks of information gathering, collation and analysis of data/information are divided among the exchanges, depositories and SEBI.

Information relating to price and volume movements in the market, broker positions, risk management, settlement process and compliance pertaining to listing agreement are monitored by the exchanges on a real time basis as part of their self-regulatory function.

In addition to the measures taken by stock exchanges, the regulatory oversight, exercised by SEBI, extends over the stock exchanges through reporting and inspections. In exceptional circumstances, SEBI initiates special investigations on the basis of reports received from the stock exchanges or specific complaints received from stakeholders as regards market manipulation and insider trading.

Surveillance system provides facilities to comprehensively monitor the trading activity and analyze the trade data online and offline. To better understand the functioning of the system let’s consider the surveillance mechanism put in place by NSE:

On-Line Exposure Monitoring

Exchange has put in place an on-line monitoring and surveillance system whereby exposure of the members is monitored on a real time basis. A system of alerts has been built in so that both the member and the NSCCL are alerted as per pre-set levels (reaching 70%, 85%, 90%, 95% and 100%) when the members approach their allowable limits. The system enables NSSCL to further check the micro-details of members’ positions, if required and take pro-active action.

The on-line surveillance mechanism also generates various alerts/reports on any price/volume movement of securities not in line with past trends/patterns. For this purpose the exchange maintains various databases to generate alerts. Alerts are scrutinized and if necessary taken up for follow up action. Open positions of securities are also analyzed. Besides this, rumors in the print media are tracked and where they are price sensitive, companies are contacted for verification. Replies received are informed to the members and the public.

Off-line Monitoring

Off-line surveillance activity consists of inspections and investigations. As per regulatory requirement, a minimum of 20% of the active trading members are to be inspected every year to verify the level of compliance with various rules, byelaws and regulations of the Exchange. The inspection verifies if investor interests are being compromised in the conduct of business by the members.

The investigation is based on various alerts, which require further analysis. If further analysis reveals any suspicion of irregular activity which deviates from the past trends/patterns and/or concentration of trading at exchange at the member level, then a more detailed investigation is undertaken. If the detailed investigation establishes any irregular activity, then disciplinary action is initiated against the member. If the investigation suggests suspicions of possible irregular activity across exchanges and/or possible involvement of clients, then the same is informed to the market regulator, SEBI.

Any transaction or behaviour, whether it is buying, selling or instigating in a manner to willfully produce an abnormal effect on prices and/or volumes, goes against the very fundamental objective of the securities markets. Market integrity is the essence of any financial market. Here the risk management system plays a crucial role.

But risk taking is essential to an active market and regulation should not unnecessarily stifle legitimate risk taking. Rather, regulators should promote and allow for the effective management of risk and ensure that capital and other prudential requirements are sufficient to address appropriate risk taking, allow the absorption of some losses and check excessive risk taking. An efficient and accurate clearing and settlement process that is properly supervised and utilizes effective risk management tools is essential. An efficient risk management system is integral to an efficient settlement system.

The anonymous electronic order book ushered in by the exchanges did not permit members to assess credit risk of the counter-party necessitated some innovation in this area. To effectively address this issue, NSE introduced the concept of a novation, and set up the first clearing corporation, viz. National Securities Clearing Corporation Ltd. (NSCCL), which commenced operations in April 1996. The NSCCL assures the counterparty risk of each member and guarantees financial settlement.

Counterparty risk is guaranteed through a fine tuned risk management system and an innovative method of on-line position monitoring and automatic disablement. NSCCL established a Settlement Guarantee Fund (SGF). The SGF provides a cushion for any residual risk and operates like a self-insurance mechanism wherein the members contribute to the fund. In the event of failure of a trading member to meet his obligations, the fund is utilized to the extent required for successful completion of the settlement. This has eliminated counter-party risk of trading on the Exchange.

Systemic risk arises when failure of one of the parties to discharge his obligations leads to failure by other parties. The domino effect of successive failures can cause a failure of the settlement system. These risks have been contained by enforcement of an elaborate margining and capital adequacy standards to secure market integrity, settlement guarantee funds to provide counter-party guarantee, legal backing for settlement activities and business continuity plan, etc.

Reduction of Systemic Risk

Although regulators cannot be expected to prevent the financial failure of market intermediaries, regulation should aim to reduce the risk of failure (including through capital and internal control requirements). Where financial failure nonetheless does occur, regulation should seek to reduce the impact of that failure, and, in particular, attempt to isolate the risk to the failing institution.

Market intermediaries should, therefore, be subject to adequate and ongoing capital and other prudential requirements. If necessary, an intermediary should be able to wind down its business without loss to its customers and counterparties or systemic damage.

There must be effective and legally secure arrangements for default handling. This is a matter that extends beyond securities law to the insolvency provisions of a jurisdiction. Instability may result from events in another jurisdiction or occur across several jurisdictions, so regulators’ responses to market disruptions should seek to facilitate stability domestically and globally through cooperation and information sharing.

Risk Management Measures

To pre-empt market failures and protect investors, the regulator/exchanges have developed a comprehensive risk management system, which is constantly monitored and upgraded. It encompasses capital adequacy of members, adequate margin requirements, exposure and turnover limits, indemnity insurance, on-line position monitoring & automatic disablement, etc.

Apart from regulator/exchanges’ risk management system, a stock broking firm must identify factors that can trigger operational, market, credit and regulatory risks. It also needs to establish procedures so that risk management begins at the point nearest to the assumption of risks. This means adapting trade-entry procedures, customer documentation, client engagement methods, trading limits, and other normal activities to maintain management control, generate consistent data and eliminate needless exposure to risk.

Broker’s Risk Management System

The goal of a risk management system is to measure and manage a firm’s exposure to various risks identified as central to its operations. For each risk category, the firm must employ procedures to measure and manage firm-level exposure. These are:

1. Establish Standards and Reports: Every broker has a set of standards which they adhere to, and these are the standards against which a client is measured. In general and not only among brokers, certain standards must be met before rating a company or a client. These must be reported to the management for their perusal and action. .
2. Impose Position Limits and Rules: A key element of financial risk management is deciding which risks to bear and to what degree. A firm needs to impose limits to cover exposures to counter-parties, credit, and overall position concentrations relative to systematic risks. .
3. Set Investment Guidelines and Strategies: A firm should outline investment guidelines and strategies for risk taking in the immediate future in terms of commitments to a particular market area, extent of asset-liability mismatching, or the need to hedge against systematic risk at a particular time. Risk management involves determining what risks a firm’s financial activities generate and avoiding unprofitable risk positions. The board’s role is usually described as setting the risk appetite of the organization; however this is not possible if risks are understated or ill defined. Guidelines can advise on the appropriate level of active management, given the state of the market and senior management’s willingness to absorb the risks implied by the aggregate portfolio.

A broker’s risk management works on the following concepts:

• Broker should ensure that there is enough cash balance in the clients account to honor the trade. Should have sufficient margin else the trade cannot be entered into the system.
• In case a buy order is entered by the client, the broker’s system queries to find the available balance in the clients bank account and whether it is sufficient to meet the stipulated margin requirements. This is as per the agreed upon terms and conditions of risk management with the client. If the available balance satisfies the risk management parameters then the order is routed to the exchange. In cases where the balance is not sufficient the order gets rejected. A rejection message is shown in the system, which then is conveyed to client.
• In case there is no direct interface to a banking system, the client is asked to maintain cash and securities deposit in order to ensure adequacy of balance.
• In case a client gives a sell order, the broker ensures that the client’s custody/demat account has sufficient balance of securities to honor the sale transaction; this is possible only if the client has his/her demat account with the same broker. In all other cases, wherever the client has his demat account with an outside / third party DP, it’s the duty of the client to ensure that he has/ will have the required securities in the demat account, before selling the same.

Prologue

Last decade of 19th century will always be seen as the springboard for Indian economy. The Govt. of India after being stung by balance of payment crisis in late 80’s, undertook flurry of reforms which were envisaged in the financial sector regulation, foreign investments and Government control. In spate of these reforms, capital market remained one of the focal areas for overhauling.

Capital market was a marginal institution in the financial market for almost three decades after India’s independence. However, until the reforms the common man kept away from capital markets. Not many companies accessed the capital market and, thus, the quantum of funds mobilized through the market was meagre.

In 1994, National Stock Exchange (NSE) came into existence, which brought an end to the open out-cry system of trading securities which was in vogue for 150 years, and introduced Screen Based Trading System (SBTS). BSE’s On Line Trading System was launched on March 14, 1995. Now the trading in securities is done using screen based trading method on the stock exchange(s) and with this hundreds and thousands of trades started taking place every day.

A major problem, however, continued to plague the market. The Indian markets were literally weighed down by the need to deal with shares in the paper form. Till now, the system of transfer of ownership of securities was grossly inefficient as every transfer was required to be accomplished by the physical movement of paper securities to the issuer for registration and the ownership was evidenced by the endorsement on the security certificate. The process of transfer in many cases took much longer time than two months stipulated in the Companies Act, 1956 or the SCRA.

Problems with Physical Mode of Settlement

A significant proportion of transactions ended up as ‘bad delivery’ due to faulty compliance of paper work, mismatch of signatures on transfer deeds with the specimen records of the issuer or for other procedural reasons. The inherent right of the issuer to refuse the transfer of a security added to the misery of the investors.

The following are some of the major problems faced for physical certificates by the investors:

1. Inordinate delay in receiving securities after transfer by the companies.
2. Return of share certificates as bad deliveries on account of signature mismatch or forged signature of transferor or fake certificates.
3. Delay in receipt of securities after allotment by the companies.
4. Non receipt of securities.
5. Procedural delays in getting duplicate shares/ debenture certificates.
6. Storing physical certificates.

The cumbersome paraphernalia associated with the transfer of securities along with huge paper work, printing of stationary, safe custody of securities, transportation and dispatch added to the cost of servicing paper securities, delay in settlement and restricted liquidity in securities and made investor grievance redressal time consuming and at times intractable.

All these problems had not surfaced overnight but these were compounded by burgeoning trade volumes in secondary market and increasing dependence on securities market for financing trade and industry. The institutions and stock exchanges experienced that the paper certificates are the main cause of investor disputes and arbitration cases. This underscored the need for streamlining the transfer of ownership of securities which was sought to be accomplished by the Depositories Act, 1996.

The Depositories Act, 1996 and its Benefits

The Govt. of India promulgated the Depositories Ordinance in 1995 and both the Houses of the Parliament passed the Depositories Act in 1996. The Act provides a legal basis for establishment of depositories in securities with the objective of ensuring free transferability of securities with speed, accuracy and security by (a) making the securities of public limited companies freely transferable; (b) dematerializing the securities in the depository mode; and (c) providing for maintenance of ownership records in a book entry form.

The Depositories Act, 1996 ushered in an era of efficient capital market infrastructure, improved investor protection, reduced risks and increased transparency of transactions in the securities market. It also immensely benefited the issuer companies, in terms of reduced costs and the effort expended in managing their shareholder populace.

Due to the introduction of the depository system, the investors are able to enjoy many benefits like free and instant transferability in a secured manner at lower costs, free from the problems like bad deliveries, odd-lots etc. Today the tradable lot is reduced to “one unit” hence even a common man is able to invest money in one equity share or bond or debenture. Investors are also spared from the problems of preserving the securities held in physical form.

Investor is able to save a lot on account of stamp duty as government has exempted stamp duty on transfer of securities in dematerialized form at present. Other form of transaction costs also come down significantly. For instance, for users of physical paper, transaction costs were halved between 1994 and 1998 while for those using demat mode, transactions costs have come down to one-tenth of previous levels, comparable to those in overseas markets.

The unparalleled success of the introduction of the depository concept in the Indian capital markets is reflected in the on-going successful reduction in the period between trading and settlement, i.e. from T+5 to T+2 rolling settlement. Perhaps, no other single act other than the Depositories Act has had such profound all round impact on every single stakeholder in the Indian capital markets.

What is the concept of Dematerialization and Immobilization?

Conversion of securities from physical (paper) form to electronic form can be achieved by two methods dematerialization or immobilization.

Under the dematerialization method, the securities, issued in physical form are destroyed and exactly equal numbers of securities are created in the depository system, which are credited into the account of the investor. Unlike physical securities, the securities converted into electronic form do not have any distinctive numbers and they are treated as equal and replaceable in all ways i.e. securities in electronic form are fungible. All subsequent transactions (transfer of ownership) of such securities take place in book-entry form by debiting or crediting the respective buyer’s and seller’s demat account.

Under the immobilization method, securities in physical form are given credit and the physical certificates are stored or lodged with an organization, which acts as a custodian – a securities depository. Subsequent transactions in such immobilized securities take place through book-entries.

India has adopted dematerialization method where as immobilization has been adopted by some of the countries like Hong Kong and USA. Japan has adopted both, dematerialization as well as immobilization for achieving a paper-less securities market.

Whether a country has adopted immobilization or dematerialization, the investor has a right to get the securities converted back into physical form through a process called rematerialization, in case of need.