Regulatory Uncertainty Clouds NSE IPO, Calls For Rule Clarity

Ongoing uncertainty around regulatory decisions on the ownership and economic structure of clearing corporations—following SEBI’s consultation paper from November 2024—has sparked concerns regarding the National Stock Exchange of India’s planned Initial Public Offering. Given the Payment and Settlement Systems Act overseen by the Reserve Bank of India, a regulatory synchronisation to future ownership structures is needed. 

Amid the rising profile of the Indian securities markets, the improved structural capabilities and agile resiliency posture of clearing corporations require critical attention to ensure market stability. Having grown at an accelerated pace in recent years, some of the fundamental issues relating to clearing corporations' operational capabilities and risk resilience reveal underlying structural constraints and demand for a forward-looking regulatory strategy.

A highly concentrated clearing market signifying a monopolistic structure is a key issue. NSE’s NSE Clearing Ltd dominates the clearing services, controlling capital market and equity/currency/interest rate derivatives segments. BSE’s subsidiary Indian Clearing Corporation Ltd occupies an also-ran position across segments. Multi Commodity Exchange Clearing Corporation Ltd holds a dominant position in commodity derivatives. 

This concentrated market position poses systemic risks, including unexpected credit losses and liquidity shortages arising from the inadequacy of a clearing corporation’s resources and risk management safeguards. The situation can also trigger the ‘Too Big to Fail’ dilemma for the regulator.

Regulatory concern about clearing corporations’ financial resources and risk resiliency is another important issues. In recent times, exceptional growth in investor accounts and trading in equity derivatives have raised regulatory concerns. In May 2024, SEBI advised NSE/NCL to raise the Core Settlement Guarantee Fund in equity derivatives to almost 2.5 times from ₹43.34 billion as of March 31, 2024. In October 2024, SEBI further advised exchanges and clearing corporations to adopt new stress testing methodologies and bring additional contributions to the core SGF for the equity derivatives segment.

Recent disclosures of clearing corporations and SEBI orders indicate irregularities in operations and risk management functions, including deficits in minimum liquid assets, insufficient inter-CCP collateral, and non-compliance with cybersecurity and cybersecurity frameworks. The lack of targeted remedial measures by clearing corporations to strengthen governance oversight and prevent recurrences could potentially imperil their safety and market resilience.

It is time for a holistic relook at systemic issues to improve the agility and resilience of clearing corporations, a comprehensive review of their business structure, risk framework, and processing model is crucial.

Financial & Functional Autonomy
Currently, clearing corporations operate as wholly-owned subsidiaries of exchanges. Thus, exchanges significantly influence their business affairs, governance structure, and oversight, including pricing and infrastructure investment decisions. Also, exchange-determined fees or cost reimbursements impact the profitability of clearing corporations and restrict a user-aligned cost structure. With financial and functional autonomy, an independent clearing corporation can truly operate a horizontal model, catering to a wide segment of products and trading venues.

The current commercial bank money settlement processing model poses significant interdependencies and concentration risk due to the handling of large settlement flows, cash collateral, and custody of assets of multiple clearing corporations by a few clearing banks. 

In the backdrop of drastic evolution of payment infrastructure, the central bank money settlement model can significantly enhance the efficiency and resilience of clearing corporations by eliminating systemic risk from the concentration of credit and liquidity exposures from clearing banks.

It may also be appropriate to reframe the core SGF and financial resources requirements. The core SGF, Minimum Required Corpus, and net worth of clearing corporations need a review reckoning contemporary contexts of volumes, volatility, intra-segmental risk correlation, and interoperability arrangements. Given the highly unpredictable market patterns, a realistic evaluation of the stress testing framework can boost the risk resiliency of clearing corporations by setting comprehensive norms on default waterfalls, including clearing corporations’ skin-in-the-game component.

A clearing corporation’s skin-in-the-game is a portion of its capital reserved to absorb losses if a clearing member defaults. When a default occurs, the process typically starts with liquidating the defaulting member’s portfolio, then using their collateral and default fund contributions. If losses persist, the clearing corporation’s capital is used, followed by contributions from non-defaulting members and, if necessary, the corporation’s remaining or emergency funds. For instance, at NSE Clearing, the amount of the first tranche is set at 5% of the segment’s minimum required corpus, ensuring the clearing corporation shares the risk. 

Clearing corporations’ legacy technology adds costs and complexities to keep pace with the demands of changing market structure and regulatory changes. It necessitates significant investment to maintain an agile and scalable infrastructure for adapting to market changes and processing model innovations. Importantly, rising cyber incidents in the securities markets demand proactive cyber-resilience strategies to prevent clearing corporations as a single point of failure affected by intensified cyber-attacks, vandalism, and ransomware raids.

Aligning with International Organization of Securities Commissions’ guidelines, adoption of a credible recovery plan, outlining recovery tool options and emergency funding resources, is critical for restoring financial soundness and operations of clearing corporations during a crisis. Also, market-wide stress tests for interconnected CCs can help in identifying risks and potential loss breaches in stressed conditions. Likewise, suitable regulatory formulation based on the recent IOSCO policy proposal on margining practices can enhance the resilience of centrally cleared markets.