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.
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 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:
- 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. .
- 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. .
- 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.