Custody Overview Project

8/9/2019 Custody Overview Project

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Table of Contents

INTRODUCTION..........................................................................2

INTRODUCTIONOFCENTRAL SECURITIES DEPOSITORIES.........4

SUPPLYANDDEMANDOFCUSTODY SERVICES ....................... 7

Comprehending theCustody ScenarioinIndia 12

SECURITIES MARKETREGULATIONININDIA - ANOVERVIEW13

ROLEOFNSEANDCLEARING HOUSES.....................................27

RISKS INVOLVEDINCUSTODY .................................................33

OUTSOURCING ........................................................................35


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1. INTRODUCTIONThe securities market represents a large and growing part of financial markets. Custody as an

industry originated with investors needing to keep securities certificates in a safe place, usually a

bank with large vaults. The custody industry evolved, in step with the growth of sophisticated

financial markets, into a complex industry no longer characterized by physical safekeeping but

by a range of information and banking services.

THE DEVELOPMENT OF THE CUSTODY INDUSTRY

THE ORIGINS OF CUSTODY:

Custody in essence a service consisting in holding (and normally administering) securities on

behalf of third parties has its roots in physical safekeeping. In the days when securities existedonly in paper form, investors needed a safe place to keep these certificates of value. That safe

place could either be their own premises (which however then needed to be adequately

protected) or those of a safekeeping service provider (banks with their vaults were a natural

choice at that time).

Nowadays, custody is offered by a variety of institutions, primarily by brokers, commercial

banks and investment banks. These providers have developed specialized services that cater to

different customer segments.

CUSTODIAN BANKS

As just explained, banks were the natural providers of physical safekeeping services as they

would usually already have strong vaults for the holding of cash and other valuables taken for

deposit. Having the physical securities in safekeeping enabled the custodian bank to provide

additional services related to settlement and asset servicing. Although custodian banks main

function today is no longer safekeeping physical securities, the scope of their services in

settlement and asset servicing remains relatively unchanged:

a. When securities are bought or sold, the custodian takes care of the delivery and receipt ofsecurities against the agreed amount of cash. This process, i.e. the exchange of securities

against funds, is commonly called settlement

b. Holding securities in an investors portfolio attracts benefits, rights and obligations; theservices provided by the custodian to ensure the investor receives that to which he is

entitled are commonly called asset services. These services usually fall into several

broad categories:

y collection of dividends and interest

y corporate actions such as rights issues


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y re-denominations or corporate reorganizations

y payment and/or reclaim of tax

y voting at shareholders meetings by proxy

Much of the work done in asset servicing, therefore, involves a custodian acting as an

information intermediary, communicating between issuers and securities holders. While theinvesting customer could have performed the related work itself, it is more convenient for it to

entrust these activities to a specialist. Custodian banks have developed economies of scale to

provide services to their customers at a price that is less than what the customer would spend,

and probably faster and with less operational errors than if the customer were to do the same

work it.

In each market, there are usually a number of local custodian banks that provide custody

services, thus giving customers a choice of services and prices. When banks provide custody

services in multiple markets through one service agreement with customers, they are called

global custodianbanks.


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2. INTRODUCTION OF CENTRAL SECURITIES DEPOSITORIESWith high trading volumes, the movement of massive amounts of physical securities could cause

delays and errors that would result in more delays. Severely delayed settlement of securitiestransactions could give rise to liquidity problems in the financial markets.

Physical certificates could also increase the probability of fraud and forgeries. Therefore, at the

urging of national authorities and central banks, some markets set up Central Securities

Depositories (CSDs) many decades ago, to immobilize the securities certificates for the whole

market, so that physical movements would be eliminated. Advances in technology enabled other

markets to dematerialize, whereby securities would only exist in electronic form.

Whether by immobilization or dematerialization, securities are transferred from one holder to

another in CSDs by book entry settlement between securities account holders, which are

commonly called members or participants.

These institutions operate as central providers for the entire market and are expected to treat all

users equitably. Some markets set up CSDs only after having suffered through paper crises,

or after adopting best practice recommendations by important international organizations such as

the Group of Thirty.

In some markets, immobilization was not mandatory and investors were given the option to hold

physical certificates if they wished. In other markets dematerialization was mandatory, so that

the entire issue was held by the CSD in electronic form only. Markets that could not

dematerialize because of legal requirements for securities to be in physical form might have

opted to increase the efficiency of immobilization by adopting global certificates, where one

piece of paper represented an entire issue.

The establishment of CSDs generally took place at the urging of national authorities (Treasuries,

central banks) with broad market support, by brokers and banks alike, as the merits of their

efficiency were obvious. In some markets, the CSDs were set up by the exchange as a service to

their broker members. In other markets, the CSDs were set up with investments by custodian

banks, which shifted their focus from physical safekeeping to the provision of information on

customers transactions and securities holdings. Issuers and investors were usually not directly

involved in the founding of these central service providers, as it was typically their

intermediaries which had the vested interest in finding a solution to eliminate the inefficiencies

of moving physical paper.


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DIVERSITY:

Since the primary purpose of CSDs was to immobilize securities and to enable the transfer of

title by book-entry, most of them never went much beyond this basic function. However, because

of scale economies, it was recognized that services could be more efficiently delivered by a

central service provider. One of the most common of these services was that of central registrar,where the CSD holds the central record of ownership and provides the root of title. Some CSDs

developed a range of services such as income collection from issuers and distribution to

securities holders, notification of corporate actions and even tax reporting and collection services

for national authorities. Others offered a centralized securities lending service, as the CSD was

best placed to match demand with supply given that they have a view of the entire market in their

books. Usually, CSDs provide asset and securities lending services with little or no

customization by client, unlike those services offered by custodians.

The legal and historical context of a CSDs creation also affected what it did and how it did it.

For example, in national markets where dematerialization was implemented on a mandatorybasis, CSD activities were typically precisely defined and strongly regulated. In some markets,

CSDs have been granted banking licences, primarily for the purpose of holding a cash clearing

account at the central bank where payments among CSD members were effected with finality.

These CSDs typically are not allowed by regulation to extend credit to members. In some cases,

however, national banking law does not differentiate types of banking licences, so, in principle;

CSDs that have a banking licence in these jurisdictions are not prohibited from extending credit.

SERVICES PROVIDED BY CUSTODIAN BANKS

a. Safekeeping:Ensuring that a record of title to the customers securities is maintained on the books of a

higher-tier entity, and that the number of securities owned by the customer as recorded in

the custodian books can always be delivered to the customers order.

b. Settlement:Transmitting customers securities receipt and delivery orders to a higher-tier entity and

effecting or monitoring the associated payments.

c. Asset servicing:Processing the rights and obligations associated with securities in safekeeping. This

usually includes income and dividend collection, withholding tax processing and


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reclamation, proxy voting, corporate actions notifications, and statements of securities

holdings.

d. Fund servicesDelivering specialized services for investment portfolios (funds), usually involving

investment accounting, net asset valuation, performance measurement, compliance

monitoring, and regulatory record keeping. May also include fund holder registration,

subscription and redemption services.

e. BankingTaking deposits and providing services that involve credit exposure, usually intraday

liquidity, lending money, and lending securities as principal or as agent with a guarantee

to the lender. Collateral management is also usually provided. In markets with a centralcounterparty, some custodian banks provide an intermediary service to trading firms that

do not wish to access the central counterparty directly. This service, commonly called

General Clearing Member, involves assuming obligations of the customers vis--vis the

markets central counterparty and hence is a credit risk-taking service.

f. Paying agent:Distributing, on behalf of the issuer, dividends, interest or principal redemptions to the

securities holders or their financial intermediaries representatives.

1) Although the market terminology also attributes settlement and safekeeping

activities to CSDs, it is important to outline that the functions performed by CSDs differ

from those described above:

y Safekeeping by CSDs refers to the central deposit of an issue and the provision of

the root of title, placing CSDs at the highest level of the holding chain, with a

fiduciary responsibility to maintain at all times the balance of the issue and to

effect the transfer of securities positions on the central register;

y Settlement by CSDs refers to the transfer of securities within the books of the

central register. CSDs manage settlement systems and enact the regulationsgoverning such systems. Settlement systems are agreements between participants

with common rules and standardized arrangements for the execution of transfer

orders and the provision of finality.


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3. SUPPLY AND DEMAND OF CUSTODY SERVICESTHE SUPPLY OF CUSTODY SERVICES

MULTI-TIERED INTERMEDIATION:

Custody, as previously mentioned, is in essence the service of holding (and normally

administering) securities on behalf of others. The investment industry is characterized by

intermediation, and custody reflects this tiered structure: securities are ultimately held in their

national CSD but there are usually a number of intermediaries between the national CSD and the

investor. These intermediaries include brokers, investment firms, asset managers, global

custodians, local custodian banks, and CSDs that offer cross-border custody services. Each layer

of intermediary provides services that cater to its own customer base and that are associated with

the assets held under its custody.

For example, an individual investor

a) Could hold its entire portfolio of domestic and foreign securities investments with itsretail bank or broker.

b) The retail bank or the broker buys the custody services from its affiliatec) A major custodian bank in its home market. The custodian bank holds the home market

securities in the national CSD, but appoints a global custodian

d) As the single service provider for all foreign securities. The global custodian employs anetwork of sub-custodians (usually about 100) that in turn hold the securities in the

national CSDs of each foreign market.

MARKET SIZE:

Although there are no official figures on market size, it can be roughly expressed in three ways:

y The value of securities held by custodians

y Indirectly, by the total fee revenues custodians receive from safekeeping and settlement

of securities

y Indirectly, by the total fee revenues received from the full range of services provided by

custodian banks.

VALUE OF SECURITIES HELD:

Due to the multi-tiered structure of custody, the size of the market can be calculated at different

industry layers:

For example, the same securities held through a custody chain would be counted at the global

custodian level, at the sub-custodian level and at the level of the CSD where they were issued.


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THE DEMAND FOR CUSTODY SERVICES

A.INVESTORS:a) Retail investors: Retail investors typically use the same intermediaries that they use to

purchase and sell securities as their custodians. Retail customers needs tend to be morelimited (compared with those of institutional investors); confirmation of transactions,

monthly statements, and asset servicing. Usually, it is common for retail investors to keep

their securities with their retail bank. Over the past 20 years, in markets, retail banks have

acquired domestic brokerage businesses which enable them to offer retail clients a one-stop-

shop service for trade execution and custody services as part of their general banking

services. The large product range offered by retail banks enables them to attract clients and to

raise exit barriers. For the broker, whether it is independent or part of a retail bank, offering a

custody service to customers has multiple benefits: it eliminates the costs of transferring

securities to and from a custodian bank, ties the customer to using its brokerage services, and,

in cases where the broker is allowed to lend money to customers to buy securities (directly or

via its retail bank parent), the securities portfolio can be used as collateral for the loans that

generate additional income from the customer.

b) Private banking and wealth management customers: Custody is usually offered as oneelement in a comprehensive service which usually comprises investment advice, brokerage,

custody, and tax and estate planning advice. The exception is family offices managing very

significant assets that tend to use multiple, specialized providers.

c) Corporations: Companies with excess cash may invest it in liquid securities that yield morethan a bank deposit. They usually hold the securities with the financial institution they

purchased them from (bank or investment firm), but some do put them with a custodian bank.

Their specific requirement is usually efficient cash management that involves minimum

opportunity costs.

d) Investment Firms: These firms, also known as investment banks, engage in a variety ofactivities in the securities market. Their trading strategy is generally very short term to

medium term, and they turn around their securities portfolio very frequently. To ensure

maximum flexibility, this client segment generally tries to be as close as possible to the

market. Typically, they either participate directly in a CSD or use the services of a multi-

direct custodian or single-market custodian. One of their specific essential needs is liquidity:

the ability to conduct their securities activities in the most efficient way so as to minimize the

need to borrow funds, and when they do borrow to have access to funds at the lowest cost.

Investment firms invest or trade in securities for their own account, and their liquidity needs

are catered for by several services provided or intermediated by custodians: tri-party repo,


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collateral management, inventory financing, strategic securities borrowing and fails

coverage. In addition, they are heavy users of intraday credit extended by their custodian

banks, a liquidity service that involves payment of funds in the morning against receipt of

securities in anticipation of funds arriving on the customers account later in the day when

securities are delivered against payment.

e) Institutional investors: This is a diverse population that custodians typically view asconsisting of three distinct but similar sectors: collective investment funds, pension funds and

insurance companies. Institutional investors specific focus is return. They need services that

will increase the yield on their securities and cash portfolios. They also need information to

track and benchmark their investment performance. A third, though no less important

requirement, is compliance with regulations designed to protect investors whose money is

entrusted to them. Regulations vary by industry segment and jurisdiction, but commonly fall

into several areas: the type of investments allowed, the markets in which they can invest,

transparency of investment performance, proper segregation of and accountability forcustomers assets, and due diligence in the selection of service providers such as brokers and

custodians. There are usually many regulatory reporting requirements. The key business

activity of these investors is to maximize the return on investments within the confines of

regulations in general and their investment mandates in particular. Given their business

model, institutional investors are typically an asset-servicing-oriented group. They are hence

very sensitive to services, such as collection of dividends and interest, corporate actions and

tax processing, as well as to consolidated reporting and any type of information that analyses

their investment decisions or those of their asset managers, such as performance

measurement. Their managements attention is focused on investment and returns, and

typically they prefer to purchase non-investment-related services, relying on specialist providers with economies of scale. Institutional investors generally turn to third-party

providers, and often to their custodians (typically global custodians), for information

processing that requires heavy investment in technology. In some markets and for some

institutions, certain activities such as compliance monitoring are required by regulation to be

delegated to a third party that might need to be a specialized bank or trustee. The size and

reputation of the custodian is often a major factor in the selection process, and some criteria

may even be mandated by regulations. Institutional investors may also choose custodians

based on their ability to help enhance the return on their investment portfolio, via services in

securities lending, tri-party repo and cash management

B.INTERMEDIARIES TO INVESTORS:The custody business as a multi-tiered intermediation industry has customers that may

be investors in one market and intermediaries in another. Some customers of custodian

banks are not securities investors but their intermediaries. There are also providers that

compete in one market and have a supplier customer relationship in another.


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a) Brokers:When a brokers retail or institutional customers start investing in foreign markets,they generally use the brokers in their own markets, which speak the same language and are

in the same time zone, as an intermediary in the purchase or sale transaction. The broker will

relay the order to a broker in the destination market, who then executes the order on the

destination stock exchange. The introducing broker needs to set up settlement arrangements

in the destination market to receive and deliver securities between its customers custodian

and the executing broker. The introducing broker either becomes a direct but remote member

of the CSD in the destination market or appoints a local custodian bank as its settlement

agent. When the introducing broker also acts as custodian for its own customers for these

foreign securities, it is more likely to use a local custodian bank in the destination market

because of asset-servicing requirements that require local market expertise. Brokers are often

divisions within investment firms. An investment firms custodian would need to provide

services that cater to its customers proprietary trading, brokerage and prime brokerage

businesses, all with somewhat different service needs.

b) Global custodians: Single-market and multidirect custodians act as local custodians (alsonamed sub-custodians) for global custodians in markets where the latter lack a presence or a

membership in the CSD. Global custodians use local custodians for settlement and asset

servicing, but they provide fund administration, securities lending and tri-party repo services

to their own customers.

c) Asset managers: Some institutional investors may appoint third-party asset managers tomanage their investment portfolio. They may purchase the custody services for the

investment portfolio from these asset managers, who in turn appoint a custodian, usually a

bank. The asset manager may be able to provide its institutional investor customer with theinformation and reporting services that it needs. However, over time, many asset managers

decide to exit the custody business because the information technology investments needed

for reporting are very substantial and large global custodians are able to provide a

comprehensive service.


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4. Comprehending The Custody Scenario in IndiaThe Following are registered Custodians in India:

a. ABN Amro Bank N.V.b. Axis Bank Limitedc. BNP Paribasd. Citibank N. A.e. DBS Bank Ltd. Indiaf. Deutsche Bank AGg. HDFC Bank Ltd.h. HongKong and Shanghai Banking Corporation Limitedi. ICICI Bank Limited.j. IL&FS Securities Services Ltd.k. JPMorgan Chase Bank, N.A.l. Kotak Mahindra Bank Limitedm. Orbis Financial Corporation Ltd.n. SBI Custodial Services Pvt. Ltd.o. Standard Chartered Bank


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5. SECURITIES MARKET REGULATION IN INDIA - AN OVERVIEWINTRODUCTION:

A stable and efficient financial system provides the foundation for implementation of effective

stabilization policies, more accurate pricing of risk and more efficient use of capital. Efficiencyof the financial system is governed by the role of markets in mobilizing and allocating financial

resources, in providing liquidity and payment services and in gathering information on which to

base investment decisions. Stability, on the other hand, is concerned with safeguarding the value

of liabilities of financial intermediaries that serve as stores of wealth. This also involves

questions relating to prudential supervision, financial regulation and good governance. It needs

to be added here that as financial systems get increasingly globalized, capital moves not only in

response to competing monetary policies, but also to competing financial systems. Inefficient

and unstable financial systems are therefore likely to be increasingly penalized.

In India, as in other parts of the world, securities regulations have evolved in the face of twoapparently diverging trends. One relates to a move toward liberalization of financial markets,

which entails elimination of measures of financial repression such as direct controls on interest

rates, mandatory investment in government securities, administrative pricing of securities and so

on. The other force is toward stronger regulation. The need for stronger regulation comes to the

fore since financial markets are characterized by significant asymmetries of information, which

contribute to moral hazard and in extreme cases leads to market failure. In sum, an unregulated

market can entail high systemic risk. This section briefly discusses the problems faced by the

market prior to reforms and outlines the major reform initiatives of the 1990s with what results.

A) EQUITY MARKET:NATURE OF MARKET PRIOR TO REFORMS:

As compared to other developing countries, the Indian stock markets have a fairly long history.

However, the volume of transactions in these markets remained limited until the late 1970s, but

grew rapidly during the 1980s as the corporate sector turned increasingly to the equity market.

Although the volume of transactions increased, the market remained primitive, insulated from

foreign investment and continued to suffer from several problems. Most importantly, to access

capital markets, companies needed to have prior permission from the government, which had to

approve the price at which new equity could be raised. The aim was ostensibly to control flow of

funds to the private corporate sector in view of the requirements of public finance and also to

provide a fair value to investors. However, the practice effectively penalized firms raising

capital from the market: the Initial Public Offerings (IPOs) of equity were typically under-priced

in relation to the price upon listing, and the new issues by listed companies were at a substantial

discount to the prevailing price. While the new issue market was overly regulated, there were

inadequate regulations of secondary market activities. The domestic capital market had no global


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link. Information and transparency were limited, reflecting the individual, dealer-based trading

system. All these contributed to high transaction costs.

In addition, public sector financial institutions such as the Unit Trust of India (UTI), the

insurance companies and the Development Finance Institutions (DFIs) were dominant players in

the stock market. This had two significant effects. First, the government had major influence onthe domestic financial markets. Second, it allowed promoters of public companies to run their

companies with relatively small holdings of their own, because public sector financial

institutions generally supported the status quo ownership and management position, unless

something drastic happened.

EQUITY MARKET REFORMS SINCE 1992:

As part of a broad set of reforms, the Securities and Exchange Board of India (SEBI) was given

the legal powers in 1992 to regulate and reform the capital market, including new issues. The

equity market reforms since then can be divided into two broad categories: one that increases thelevel of competition in the market and the other that deals with problems of information and

transaction cost. The most important initiative to enhance competition was the free pricing of

IPO and formulation of guidelines concerning new issues. The new regulatory framework

sought to strengthen investor protection by ensuring disclosure and transparency rather than

through direct control. Secondly, the National Stock Exchange (NSE) was set up, which

competed with the Bombay Stock Exchange (BSE). The NSE introduced an automated screen-

based trading system, known as the National Exchange for Automated Trading (NEAT) system,

which allowed members from across the country to trade simultaneously with enormous ease and

efficiency. Faced with stiff competition, the BSE adopted similar technology. Competition was

also enhanced through an increased number of participantsforeign institutional investors (FIIs)were permitted to trade and private sector mutual funds came on the scene. To deal with market

imperfection such as information asymmetry and high transaction costs, a number of measures

were taken. At the trading level, transparency was facilitated by the new technology (NEAT

system), which operated on a strict price/time priority. At the investor level, transparency was

augmented by the regulation that required listed companies to increase the frequency of their

account announcements. To ensure transferability of securities with speed, accuracy and

security, the Depositories Act was passed in 1996, which provided for the establishment of

securities depositories and allowed securities to be dematerialized. Following the legislation,

National Securities Depository LimitedIndias first depository--was launched. Other measures

to reduce transaction costs included: a) a movement toward electronic trading and settlement,

and b) streamlining of procedures with respect to clearance of new issues.


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RESULTS

Following these measures, the Indian equity market has modernized rapidly and its ability to

serve investors has increased considerably. Competition among stock exchanges has intensified.

With all stock exchanges introducing screen-based trading, trading has become more transparent.

With the option of settling through depository now available to investors in case of most of theliquid stocks, it is possible to eliminate risks of bad delivery and counterfeit shares. The two

depositories that are in operation now ensure faster, cleaner and cheaper settlement.

Dematerialized settlement now accounts for about 90 percent of settlement settled by delivery.

Disclosure standards by companies and financial intermediaries are higher. Following the

introduction of prudential regulations, stock exchanges have become safer and more dependable.

One area where there has been only limited progress is in reducing the dominance of public

sector financial institutions.

A)DEBT MARKET:

The Indian debt market can be classified into three segments: (i) the government securities

market; (ii) the public sector units (PSU) bond market; and (iii) the corporate bond

market. Each segment has its own distinctive practices, procedures, institutional framework and

regulatory structure. The focus of debt market reforms has been on government securities

market, because not only does it dominate the debt market, but also plays an important role in

establishing benchmarks for the rest of the market.

NATURE OF MARKET PRIOR TO REFORMS:

Until the early 1990s, the debt market received very little attention. The government securities

market, which constituted the bulk of the debt market, remained dormant. The reason for this

was simple. Since the government could borrow at pre-announced coupon rates at below market

rates from a set of captive institutions, there was no need for the government to directly place its

securities on the market. The captive institutions largely held on to government paper until

maturity; whatever little trading existed, was aimed at adjusting the maturity structure of the

portfolio, rather than at profit making. As a result, the market did not develop.

REFORMS SINCE EARLY 1990s

Debt market reforms began with the establishment of a primary market for government

securities. It was followed by the strengthening of the legal, regulatory and paymentsinfrastructure which contributed to the development of a secondary market. Some of the

important reform initiatives undertaken since the early 1990s are given below.

There have been progressive restrictions on on-demand government borrowing from the RBI.

The earlier system of issuing ad hoc treasury bills has been replaced by a system of ways and

means advances, which are being made increasingly restrictive.


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y Auction for treasury bills of varying maturity14-day, 91-day, 182-day and 364-day

have been introduced. To encourage aggressive bidding, uniform price auctions have

been introduced for 91-day treasury bills. Also, to foster competition, non-competitive

bids are now kept outside the notified amount.

y To widen the investor base, foreign institutional investors have been allowed to invest in

government securities including treasury bills in both primary and secondary markets.

y The RBI has introduced a Delivery versus Payments (DVP) system, which ensures

settlement by synchronizing transfer of securities with cash payments, thereby

accelerating settlement, enhancing transparency and eliminating settlement risk. (Earlier,

settlements in securities transactions between any two parties were recorded without any

direct link with cash settlement between buyers and sellers, which entailed delays in

settlement and counterparty risk.)

y A primary dealer system has been developed to channel securities from primary auctions

to ultimate investors. Primary dealers facilitate debt trading through committed

participation in primary market auctions and by creating an active secondary market insecurities by giving two-way quotes.

y The RBI is actively promoting retailing of government securities by providing liquidity

support to satellite dealers and dedicated gilt funds to help them sustain their retail

activities. Gilt funds also benefit from special tax incentives.

y An active interbank repo market has been developed, which has helped to boost liquidity

in government securities. To provide depth to the interbank repo market, a number of

measures have been taken, including permission for all government securities to be

eligible for interbank repos.

RESULTS

These initiatives have resulted in a significant transformation of the debt market. The size of the

market has grown rapidly in the past four years. Activity in the secondary debt market has also

accelerated during recent years as reflected by the turnover of traded securities rising from 3.3

percent of GDP in 1996/97 to 6.7 percent in 1998/99. The market has not only grown in size, but

has become more efficient too. Prices for government securities are increasingly market-

determined. The government, like any other issuer, has to come to the market to raise its

resources. The ability of the market to signal changes in interest rate structure has been

augmented through regular auction of treasury bills of different maturity. The market has been

broadened through primary dealers and the FIIs. Introduction of DVP has enhancedtransparency. The move toward price discovery through a price-based auction system has

contributed to the development of bidding skills among market participants. Although reforms

have clearly achieved some success in the development of a modern, well-functioning market,

the overall progress toward modernization has been smoother and more substantial in the case of

the primary market in government securities than in the secondary market.


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A) REGULATORY ISSUES:a) THE REGULATOR

The regulatory responsibility of the securities market is vested in the SEBI, the RBI, and two

government departments--Department of Company Affairs and Department of EconomicAffairs. Investigative agencies such as Economic Offences Wing of the government and

consumer grievance redressal forums also play a role. The SEBI, established under the SEBI

Act, is the apex regulatory body for the securities market. Besides regulation, the SEBI's

mandate includes responsibilities for ensuring investor protection and promoting orderly growth

of the securities market. The RBI, on the other hand, is responsible for regulation of a certain

well-defined segment of the securities market. As the manager of public debt, the RBI is

responsible for primary issues of Government Securities. The RBI's mandate also includes the

regulation of all contracts in government securities, gold related securities, money market

securities and in securities derived from these securities. To foster consistency of the regulatory

processes, the SEBI is mandated to regulate the trading of these securities on recognized stock

exchanges in line with the guidelines issued by RBI. Although there is a clear division of

regulatory responsibilities between RBI and SEBI, and efforts have been made to make the

regulatory process consistent, the distribution of regulatory responsibilities among a number of

institutions can potentially create confusion among the regulated as to which body is responsible

for a particular area of regulation.

To ensure operational independence and accountability in the exercise of functions and powers

by the regulators, SEBI and RBI have been constituted as autonomous bodies and are established

under separate acts of the Parliament. Both regulators are accountable to the Parliament through

Central Government and the regulations framed by them are required to be laid before

Parliament by the Central Government. There is also a system of independent judicial review of

the decisions of SEBI and RBI. Although the SEBI and the RBI are operationally independent,

the government can issue directions to both in policy matters.

b) ENFORCEMENT OF SECURITIES REGULATIONThe SEBI has powers to carry out routine inspections of market intermediaries to ensure

compliance with prescribed standards. It also has investigation powers similar to that of a civil

court in terms of summoning persons and obtaining information relevant to its enquiry. Action is

taken on the basis of investigation. The enforcement powers of SEBI include issuance ofdirections, imposition of monetary penalties, cancellation of registration and even prosecution of

market intermediaries. To ensure effective and credible use of enforcement powers, the SEBI has

adopted measures such as development of a stock watch system, uniform price bands and

establishment of a Market Surveillance Division.


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While SEBI has powers of direct surveillance of the stock exchanges, members of stock

exchanges and other market intermediaries registered with it, SEBI has no powers over listed

companies. Further, the present penalty levels in many cases are not high enough to effectively

deter market players from regulatory violations. In particular, the amount of monetary penalty

for non-compliance with respect to disclosure, information requirements, insider trading and

market manipulation is very inadequate. To cite an example, a maximum monetary penalty of

only Rs.1, 000/- can be imposed in case of failure to comply with the provisions of listing

agreement. Similarly, under the SEBI Act the penalty for insider trading and non-disclosure of

acquisition of shares and takeovers is only Rs.5 lakh. The Group believes that there is a need to

allow SEBI enhanced authority and powers to impose penalty commensurate with the gravity of

the violation (i.e., disgorgement powers).

An additional problem relates to delays in taking action against those who commit frauds. A

number of companies, which had collected funds in the past through public issues, cannot even

be traced. To take action against such companies and bring their Directors to book, a number of

initiatives have been taken including the establishment of Central Coordination and Monitoring

Committee (CCMC), with Secretary, DCA and Chairman, SEBI as its co-chairmen. However,

only limited success has been achieved. Clearly, the enforcement procedures are cumbersome,

time-consuming and involve too many agencies. There is a need to streamline the procedures to

quickly detect frauds and take appropriate remedial measures.

In addition to the problem stated above, the slow response in case of frauds results from long

delays arising from the obligation to follow due process. As a regulatory body has to be

accountable for its action, by implication, it gives the alleged institution an opportunity to show

cause why action should not be taken. There is a need to streamline the procedures relating to

due process. Also, dealing with cases of suspected fraud often requires freezing the situation,

while the legal process is being pursued. This happens in India, but the decision to freeze the

situation often takes time.

c) COOPERATION IN REGULATIONVarious segments of the domestic financial market are getting increasingly integrated. There

have also been progressive linkages between the domestic and international capital markets. As a

result, the regulatory interventions or their absence in one market tend to have repercussions in

other markets that are more serious and more widespread than in the past. Further, with the

emergence of more and more financial supermarkets and growing complexity of financialtransactions, there are increasing instances of the same market intermediary coming under the

purview of multiple regulatory bodies. These factors have raised the potential for regulatory gaps

as well as overlaps, thereby underlining the need for greater cooperation among various

regulators.


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Currently, coordination among domestic regulators is occurring through the High Level Group

on Capital Markets (HLGCM) comprising the RBI, SEBI, the IRDA and Finance Ministry. The

HLGCM has set up two Standing Committees: one for regulatory coordination and the other for

coordination in matters relating to the development of debt markets. The Committee meets

periodically to exchange information and views. Besides, to address specific issues such as DvP

system or asset securitization, the RBI and SEBI have been coordinating through the institution

of working groups. The Group observes that there is scope to further strengthen the coordination

efforts. There may be merit in formalizing the HLGCM by giving it a legal status. Besides, the

HLGCM needs to meet more frequently and its functioning needs to be made more transparent.

Also, a system needs to be devised to allow designated functionaries (not necessarily only at the

top level) to share specified market information on a routine and automatic basis.

As regards coordination with regulators in other countries, the RBI has put in place a system of

exchange of need-based information in respect of international operations. However, the powers

of SEBI to assist foreign regulators or to enter into MOUs or other cooperation arrangements are

not explicitly provided by legislation, although SEBI has signed a MoU with the Securities

Exchange Commission of the USA. Hence, the Group is of view that necessary legislative

changes need to be made to enhance SEBI's scope in this regard.

d) SELF-REGULATIONThe SEBI Act provides for promotion and regulation of SROs (i.e., stock exchanges). The stock

exchanges are empowered to make rules and regulations for their members and for regulating the

conduct of respective members. However, self-regulation is not always effective, because the

current ownership and governance structures of many stock exchanges allow scope for conflict

of interest. These exchanges are owned and managed by members who enjoy exclusive tradingrights. In the broker-owned exchanges, brokers elect their representatives to regulate activities

of the exchange, including those of the brokers themselves. This raises fairness issues, because

the members of stock exchange governing boards have access to valuable information about

market participants. Elimination of such conflict of interest through demutualization, which

implies separation of ownership of exchange from the right to trade on it, can promote fairness

and reinforce investor protection.

Further, the slow evolution of the Association of Mutual Funds of India (AMFI) as a SRO has

meant continuation of substantial regulatory burden on SEBI. In this regard, the Group suggests

that SEBI assist the AMFI to develop into a full-fledged SRO. Similarly, in money andgovernment securities markets, Fixed Income Money Market and Derivatives Association of

India (FIMMDA) and Primary Dealers Association of India (PDAI) are operating as industry

level associations, who are gradually taking on the role of SROs. There is as yet no regulatory

oversight of the RBI over these emerging SROs. However, to facilitate these associations to

emerge as full-fledged SROs, the RBI is engaging them in a consultative process, which needs to

be further intensified. On their part, to promote integrity of the markets, FIMMDA and PDAI


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need to establish a comprehensive code of conduct and best practices in securities transactions

and also have a mechanism to enforce such codes. The RBI can play a supportive role here.

e) PRUDENTIAL ISSUESW

ith a view to contain risk, secure market integrity and protect the interest of investors, theregulators have prescribed elaborate margining and capital adequacy standards. In addition,

intra-day trading limit and exposure limits have been prescribed. Brokers are subject to various

types of margins, viz., daily margins, marked-to-market margin, ad hoc margin and volatility

margin. In case of excessive volatility or perceived higher risk, exchanges have been given the

flexibility of imposing higher margins. However, one lacuna that continues relates to the

absence of margin requirement for institutional trades. The Group recommends that this lacuna

be addressed.

A)LEGAL ISSUES:a) Institution-specific regulations

The legal framework constrains the RBI from exercising uniform powers vis-a-vis different

groups of players, even though the activity regulated is the same because of a peculiar legal

arrangement. The amended Securities Contract Regulation Act (SCRA) has conferred on the RBI

the responsibility of regulation of Government securities and money markets, but not the

necessary enforcement powers to regulate these markets. To regulate these markets, the RBI

therefore resorts to its regulatory authority over the major participants in these markets such as

banks, financial institutions and primary dealers through separate institution-specific legislation.

With respect to banks, the RBI has statutory powers of inspection, investigation, surveillance andenforcement under Banking Regulation Act, 1949. As regards financial institutions, the

regulatory powers are available to the RBI under the RBI Act 1934. The RBI's regulatory powers

over FIs are not as comprehensive as over banks. With regard to Primary Dealers, the RBI

exercises regulatory powers on the basis of guidelines issued by RBI and MOUs signed between

PDs and RBI on a contractual basis. This underlines the need for (a) the same legislation to

include both regulatory responsibilities and the authority to carry them out and (b) the focus to

shift from institution-specific regulation to market-specific regulation.

b) Multiplicity of ActsThe problem of multiplicity of regulators, as referred to earlier, emerges from the existence of

multiplicity of Acts governing securities market regulation. The legal framework comprises

inter alia the SEBI Act, Securities Contract Regulation Act (SCRA), Indian Contracts Act,

Companies Act, Public Debt Act, the RBI Act and the Banking Regulation Act. Some acts came

into being to create regulatory institutions (SEBI Act and RBI Act), some to regulate contracts

(SCRA and Indian Contracts Act) and yet others to regulate issue of government securities

(Public Debt Act). Although the scope of the Acts is well defined, problems of interpretation


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have led to confusion. There is therefore a need to simplify and streamline the legal framework.

In this context, the Group believes that consolidating the SCRA and the SEBI Act in line with

the recommendations of the Dhanuka Committee, will be very helpful.

A) MARKET ISSUES:

It is important to recognize the trade-off between over-regulation and high cost of compliance.

Over-regulation may minimize market friction, but can potentially kill a market. To dilute this

tradeoff, it is important to modernize the microstructure. (Microstructure relates to the manner in

which a market is organized and the trading and post-trading technology the market adopts.) As

regulations become more and more complex, certain regulatory objectives can be more easily

attained through changes in microstructure rather than further addition to regulatory law.

a) Market Infrastructure

Screen-Based Trading System: The equities market has witnessed a quantum

improvement in trading technology during the 1990s as it moved away from the open-outcry

system of trading to a computer screen-based trading. The new technology has not only

increased transparency in trading, but also facilitated the integration of different trading centers

into a single trading platform. Permitting of internet trading has enabled investors across the

globe to route orders through the internet for execution on the Indian stock exchanges. In

contrast to the equities market, the government securities market and the market for money

market instruments are largely negotiated markets. Although the NSE established a wholesale

debt market segment for exchange trading, members generally use this segment only for

reporting trades undertaken by them in the negotiated market, rather than trading on the

exchange.

b) Rolling SettlementThe stock exchanges in India have traditionally followed account period settlement system,

which tends to distort the price discovery process since it combines the features of cash as well

as futures markets. In contrast, the current international practice is predominantly rolling

settlement on a T+3 basis, which introduces certainty of trades and reduces risk and delay in

settlement. Beginning last year, compulsory rolling settlement has been introduced in a limited

number of scrips on a T+5 basis. The slow progress toward the introduction of rolling settlement

is on account of (a) lack of availability of electronic funds transfer across the country and (b) a

general apprehension that such a move will reduce liquidity in the market. Even though a more

effective payment and clearing system through a wider availability of EFT is important for

switch-over to rolling settlement , the Group is of the view that even the current payment

infrastructure can support a faster phasing-in. Further, the view that rolling settlement per se

will drain liquidity from the market is not borne out by international experience. The Group also

suggests that RBI and SEBI expedite their scrutiny of the recent recommendations made by the

joint task force of IOSCO and BIS on securities settlement systems, for early implementation.


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c) Depositories and dematerialization

To ensure transferability of securities with speed, accuracy and security, the Depositories Act

was passed in 1996, which provided for the establishment of securities depositories and allowed

securities to be dematerialized. Following the legislation, two depositories (NSDL and CDSL)

have so far been established. Further, the compulsory dematerialization of shares for tradingpurpose has been introduced in a phased manner with the aim of synchronizing the settlement of

trade and transfer of securities irrespective of geographical locations, and eliminating the ills

associated with paper-based securities system such as delay in transfer, bad delivery, theft and

forgery. Although the process of compulsory dematerialization is nearing completion, its full

benefits have not been reaped because of slow progress in introduction of rolling settlement.

With the appropriate infrastructure in place, there is now scope for taking further advantage of

depositories to promote retailing of government securities. The RBI has taken a step in the right

direction by allowing NSDL and CDSL to have a second SGL account for depository

participants who in turn can hold in custody government securities on behalf of the finalinvestors. This will facilitate holding of government securities in demat form.

d) Clearing CorporationsThe stock exchanges supervise the buying and selling activities of brokers, but financial

settlements are guaranteed by a clearing corporation, which creates a settlement guarantee fund

to ensure settlement of trades irrespective of default by trading members. This arrangement, by

nearly eliminating counterparty risk, has given a tremendous boost to investor confidence in

India.

Further, in contrast to the current Indian system of each stock exchange having its own clearing

corporation or clearing bank, it may be appropriate to have perhaps only two clearing

corporations in line with international practice, which would support many stock exchanges.

Such an arrangement would allow the clearing agency to have an overall view of gross exposures

of traders across the stock exchanges and would be much better geared to manage risks.

e) Delivery vs. PaymentIn the government securities market, DvP was introduced in 1994 for transactions put through

the SGL accounts maintained in RBIs Public Debt Office (PDO), which has greatly helped in

reducing the principal risk. The Special Fund Facility introduced last year has to a certain extentreduced risk of non-settlement due to gridlock. The Advisory Group on Payments and Settlement

Systems (Headed by Shri M.G. Bhide) has made some suggestions for improving the payments

and settlement systems and this Group would concur with these suggestions.

In the equity market there is currently no DvP. The Group notes that SEBI and RBI are jointly

trying to evolve a mechanism, which would seamlessly link the depositories with the payment


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system through the clearing corporation/ clearing agency to ensure DvP. The Group recommends

that establishment of such a mechanism is expedited.

f) Straight-through Processing:Straight-through Processing (STP) involves verification through Internet of (i) the selling client'sDP account for security balances following a sell order; and (ii) the buying clients' bank accounts

for cash balances following a buy order. This system can eliminate nearly all settlement and

payment risk. The significant changes taking place in technological and trading environment

worldwide are driving the global securities industry towards STP. However, at present, all the

pre-requisites for STP are not yet available in India. While automated trading and

dematerialization have been largely achieved, the limited availability of EFT and absence of

RTGS have constrained the introduction of STP. These constraints are likely to be eliminated in

the near future.

A)PRIMARY ISSUES AND TRANSPARENCY:

a) Private Placement MarketHigh costs of regulatory compliance associated with public issues of debt have made issuers

prefer the private placement market. The private placement market has registered tremendous

growth in the last few years. In 1999/2000, private placements accounted for 84 percent of total

resources mobilized by the corporate sector. Preponderance of private placement can potentially

strip the market of its ability to discipline issuers and thereby enhance systemic risk. Once

investors have used the private placement route, they cannot signal their changing evaluation of

the business prospects of the issuers, because there is no market in which they can sell. Thedominance of private placement in primary issue market possibly reflects an absence of

regulatory level playing field in the sense that public issues may be over-regulated while private

placements could be under-regulated. Some recent initiatives such as the amendment to the

Companies Act, making it mandatory for companies issuing debentures through private

placement route to set up debenture redemption reserves as in the case of public issues, can

partially restore the balance. These initiatives need to be complemented by simultaneous efforts

to ease some of the regulations governing public issues.

b) Corporate disclosureWith a view to enabling investors to take informed decisions as well as to promote transparency,

regulations have over the years become more stringent by requiring disclosure to be more

frequent and wider in scope. Currently, disclosure in India extends to material having a bearing

on the price of a security, and entities who either have significant interest in a company or seek

management control. A company offering securities is required to make a public disclosure of all

relevant information through its offer documents. After a security is issued to the public and


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subsequently listed on a stock exchange, the issuing company is required to make continuous

disclosures, including through publication of yearly audited balance sheets and quarterly un-

audited financial results. Moreover, the disclosure of material information, which could have a

bearing on the performance of the company, has to be made available to the public immediately.

Among the drawbacks, the timing and contents of disclosure of material events that impact prices are not unambiguously specified and followed. Recently, it has been decided that

companies would be required to make decisions regarding dividend bonus and rights

announcements or any other material event within 15 minutes of the conclusion of the board

meeting where the decisions are taken. In terms of contents of disclosure, the following

initiatives are necessary: (i) group company disclosures may be limited to top 5 companies by

market capitalization or turnover, to avoid cumbersome exercise of gathering information from

all companies falling under the definition of promoter group; and (ii) risk factors need to be

given in greater detail as per international practices, although management perceptions of risks

need not be given.

c) Transparency in the debt marketAs regards transparency in trading, the debt market is lagging behind the equity market. The cash

market in debt securities throughout the world prefers to operate through negotiated deals either

through telephone or an electronic dealing system like Bloomberg. This is because unlike the

equity market, the bond market participants are generally wholesale institutional investors who

put in large deals at a time, which may not always be possible through the screen based order

driven system. It is only in the futures market that the principles of anonymity, price time

priority, nationwide market and settlement guarantee are known to work. As stated earlier,

wholesale institutional investors have yet to show adequate inclination to use the anonymousorder matching system for executing their debt securities transactions. Under the circumstances,

SEBI has taken initiatives to foster transparency through regulatory fiat by prohibiting negotiated

deals on the exchanges in respect of listed corporate debt securities and prescribing that all such

trades would be executed on the basis of price and order matching mechanism of stock

exchanges as in the case of equities. However, negotiated deals are still continuing, albeit outside

the exchange, and there is no market dissemination of information on such transactions.

Since almost all deals in the government securities market are settled through the Subsidiary

General Ledger (SGL), the daily dissemination of such information (albeit with a one day lag)

has proved to be important in the price discovery process.) This, together with the data availablefrom the NSE's Wholesale Debt Market (WDM) segment has contributed to greater transparency

in the secondary market for government securities. Transparency will be further boosted by the

current initiative to put in place an electronic negotiated dealing system for the SGL participants,

which will disseminate information on a near real time basis.


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d) Mutual FundsSEBI is the principal regulator of the mutual fund industry. Mutual funds in India are constituted

in the form of trusts. The funds sponsor executes the trust deed, which outlines the liabilities and

obligations of the trustees in relation to the unit holders. The day-to-day operations of the fund

are carried out by the asset management company (AMC).The board of trustees oversees thefunds activities and enters into a management agreement with the AMC.

SEBI has put in place standards for the eligibility and the regulation of those who wish to market

or operate a collective investment scheme. Eligibility criteria have been set in terms of net worth,

track record and internal management procedure. The regulations lay down disclosure

requirements, procedures for calculating and declaring net asset values (NAV) of mutual fund

schemes, accounting standards and a code for advertisements. Regulations are also prescribed to

ensure arms-length relationship between the trustees and the AMC. SEBI is responsible not only

for registration and authorization of schemes, but also for inspection of registered mutual funds

and remedial action against any regulatory infraction.

Disclosure standards of mutual funds have been under regulatory focus. SEBI requires disclosure

to evaluate the suitability of a collective investment scheme for a particular investor and the

value of the investors interest in the scheme. Regulations have prescribed specified format for

offer documents as well as a disclosed basis for asset valuation and the pricing and the

redemption of units in a mutual fund. With a view to make unit holders aware of the securities in

which the funds have been invested by the mutual fund, it has been made mandatory for mutual

funds to send to all unit holders a complete statement of the scheme portfolio on a half-yearly

basis.

The mutual fund industry has played a significant role in mobilization of domestic savings.

Substantial progress has been made in strengthening regulation and improving transparency in

the mutual fund industry through the Mutual Funds Regulations of 1996 and subsequent

amendments. However, a number of challenges still remain, which are outlined below.

The UTI is the largest mutual fund in India, which was set up by an Act of the Parliament (the

UTI Act, 1963). As such it is bound by the UTI Act and not by mutual funds regulations,

although under a voluntary arrangement, SEBI oversees all the investment schemes launched by

UTI since 1994. The organizational structure of the UTI differs from other mutual funds in two

additional ways. First, there is no separate AMC with an independent Board of Directors.Second, there has been no separation of management groups managing schemes launched prior

to 1994; regulations apply only to schemes established after 1994. Currently, there are four UTI

schemes--US-64, ULIP-71, CRTS-81 and CCCF-93--which do not comply with SEBI

regulations. The US-64, the flagship scheme of the UTI and the largest scheme in India, does not

have a disclosed basis for asset valuation or pricing of units although it has plans to move

towards this. Bringing the UTI under SEBI's purview as well as the introduction and


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implementation of international accounting principles across the mutual fund industry will help

promote fairness and stability of the sector.

Currently, regulations appropriately require that the sale and redemption of funds should be

based on their NAVs, which have to be computed according to specified rules. However, there

is scope for further improvement in one significant area: AMCs still have considerable room fordiscretion in adopting valuation of thinly traded or non-traded securities, as regulations specify

only broad guidelines. There is a need to reduce the AMCs' discretion in this regard.

Finally, a couple of issues relating to prudential norms and corporate governance need to be

examined. Regulations provide that a fund's ownership in any single company should not exceed

10 percent of a company's voting shares, although there is no upper limit on the total holdings of

voting and non-voting shares of any single company. Further, there appears to be no restriction

on corporate investment in a mutual fund's units.


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6. ROLE OF NSE AND CLEARING HOUSESThe transactions in secondary market pass through three distinct phases, viz., trading, clearing

and settlement. While the stock exchanges provide the platform for trading, the clearing

corporation determines the funds and securities obligations of the trading members and ensures

that the trade is settled through exchange of obligations. The clearing banks and the depositoriesprovide the necessary interface between the custodians/clearing members for settlement of funds

and securities obligations of trading members.

Several entities, like the clearing corporation, clearing members, custodians, clearing banks,

depositories are involved in the process of clearing. The role of each of these entities is explained

below:

Clearing Corporation: The clearing corporation is responsible for post-trade activities such as

the risk management and the clearing and settlement of trades executed on a stock exchange.

Clearing Members: Clearing Members are responsible for settling their obligations as

determined by the NSCCL.

They do so by making available funds and/or securities in the designated accounts with clearing

bank/depositories on the date of settlement.

Custodians: Custodians are clearing members but not trading members. They settle trades on

behalf of trading members, when a particular trade is assigned to them for settlement. The

custodian is required to confirm whether he is going to settle that trade or not. If he confirms to

settle that trade, then clearing corporation assigns that particular obligation to him. As on date,

there are 11 custodians empanelled with NSCCL. They are Citibank N.A., Deutsche Bank A.G.,HDFC Bank Limited, HSBC Limited, ICICI Limited, IL&FS Limited, Standard Chartered Bank,

State Bank of India, SHCIL, Kotak Mahendra Bank Ltd., DBS Bank Ltd and Axis Bank.

Clearing Banks: Clearing banks are a key link between the clearing members and Clearing

Corporation to effect settlement of funds. Every clearing member is required to open a dedicated

clearing account with one of the designated clearing banks. Based on the clearing members

obligation as determined through clearing, the clearing member makes funds available in the

clearing account for the pay-in and receives funds in case of a pay-out. There are 13 clearing

banks of NSE, viz., Axis Bank Ltd., Bank of India Ltd., Canara Bank Ltd., Citibank N.A, HSBC

Ltd., HDFC Bank Ltd., ICICI Bank Ltd., IDBI Bank Ltd., Indusind Bank Ltd., Kotak MahindraBank, Standard Chartered Bank, State Bank of India and Union Bank of India

Depositories: Depository holds securities in dematerialized form for the investors in their

benefi ciary accounts.

Each clearing member is required to maintain a clearing pool account with the depositories. He

is required to make available the required securities in the designated account on settlement day.


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The depository runs an electronic file to transfer the securities from accounts of the

custodians/clearing member to that of NSCCL and visa-versa as per the schedule of allocation of

securities.

Professional Clearing Member: NSCCL admits special category of members known as

professional clearing members (PCMs). PCMs may clear and settle trades executed for theirclients (individuals, institutions etc.). In such cases, the functions and responsibilities of the PCM

are similar to that of the custodians. PCMs also undertake clearing and settlement responsibilities

of the trading members. The PCM in this case has no trading rights, but has clearing rights i.e. he

clears the trades of his associate trading members and institutional clients.

Clearing & Settlement Process

The clearing process involves determination of what counter-parties owe, and which counter-

parties are due to receive on the settlement date, thereafter the obligations are discharged by

settlement. The clearing and settlement process comprises of three main activities- Clearing,Settlement and Risk Management.

The clearing and settlement process for transaction in securities on NSE is presented in (Chart

5-1).


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Chart 5-1: Clearing and Settlement Process at NSE


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The core processes involved in clearing and settlement include:

(a) Trade Recording: The key details about the trades are recorded to provide basis for

settlement. These details are automatically recorded in the electronic trading system of the

exchanges.

(b) Trade Confirmation: The parties to a trade agree upon the terms of trade like security,

quantity, price, and settlement date, but not the counterparty which is the NSCCL. The electronic

system automatically generates confirmation by direct participants.

(c) Determination of Obligation: The next step is determination of what counter-parties owe,

and what counterparties are due to receive on the settlement date. The NSCCL interposes itself

as a central counterparty between the counterparties to trades and nets the positions so that a

member has security wise net obligation to receive or deliver a security and has to either pay or

receive funds.

The settlement process begins as soon as members obligations are determined through the

clearing process. The settlement process is carried out by the Clearing Corporation with the help

of clearing banks and depositories. The Clearing Corporation provides a major link between the

clearing banks and the depositories. This link ensures actual movement of funds as well as

securities on the prescribed pay-in and pay-out day.

(d) Pay-in of Funds and Securities: This requires members to bring in their funds/securities to

the clearing corporation.

The CMs make the securities available in designated accounts with the two depositories (CM

pool account in the case of NSDL and designated settlement accounts in the case of CDSL). Thedepositories move the securities available in the pool accounts to the pool account of the clearing

corporation. Likewise CMs with funds obligations make funds available in the designated

accounts with clearing banks. The clearing corporation sends electronic instructions to the

clearing banks to debit designated CMs accounts to the extent of payment obligations. The

banks process these instructions, debit accounts of CMs and credit accounts of the clearing

corporation. This constitutes pay-in of funds and of securities.

(e) Pay-out of Funds and Securities: After processing for shortages of funds/securities and

arranging for movement of funds from surplus banks to deficit banks through RBI clearing, the

clearing corporation sends electronic instructions to the depositories/clearing banks to releasepay-out of securities/funds. The depositories and clearing banks debit accounts of the Clearing

Corporation and credit accounts of CMs. This constitutes pay-out of funds and securities.

Settlement is deemed to be complete upon declaration and release of pay-out of funds and

securities.


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Settlement Cycle

NSCCL clears and settles trades as per the well-defined settlement cycles (Table 5-1). All the

securities are being traded and settled under T+2 rolling settlement. The NSCCL notifies the

relevant trade details to clearing members/custodians on the trade day (T), which are affirmed on

T+1 to NSCCL. Based on it, NSCCL nets the positions of counterparties to determine theirobligations. A clearing member has to pay-in/pay-out funds and/or securities. The obligations are

netted for a member across all securities to determine his fund obligations and he has to either

pay or receive funds. Members pay-in/pay-out obligations are determined latest by T+1 and are

forwarded to them on the same day, so that they can settle their obligations on T+2. The

securities/funds are paid-in/paid-out on T+2 day to the members clients and the settlement is

complete in 2 days from the end of the trading day. The settlement cycle for the CM segment are

presented in Table 5-1.


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Dematerialised Settlement

NSE along with leading financial institutions established the National Securities Depository Ltd.

(NSDL), the first depository in the country, with the objective to reduce the menace of

fake/forged and stolen securities and thereby enhance the efficiency of the settlement systems.

This has ushered in an era of dematerialized trading and settlement. SEBI, too, has beenprogressively promoting dematerialisation by mandating settlement only through dematerialized

form for more and more securities. The share of demats delivery in total delivery at NSE touched

100% in terms of value during 2007-08.


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7. RISKS INVOLVED IN CUSTODYA growing number of market participants venture into markets which are new to them. There is

an obvious danger that some of the associated risks are ignored or underestimated.

The main types of risks are related to the nature of the business, the country invested in, the

counterparties involved, credit, liquidity, the market conditions, operational hazards, settlement,

systemic and transfer risks.

Major Types Of Risks

Business Risk

Also referred to as Competitive Risk, means risk

of losing clients' business(and subsequently

critical mass of asset value or transaction

volume)

e.g. due to pressure on margins, innovation,

new laws. If the income erosion happensfaster than costs can be reduced, business

may become unprofitable and will have to be

abandoned.

Counterparty Risk

Risk of non-fulfillment of a trade contract due to

inability or unwillingness.

It is mainly a credit risk and can also include

market risk. In certain markets, counterparty risk

in broker-to-broker deals is assumed by a third

party.

Country Risk

Risk connected with holding assets in a foreign

country, e.g. political, economic, fiscal and legalchanges, or gaps in supervisory coverage. (See

also Transfer Risk).

Credit RiskRisk that a counterparty will fail to deliver or

pay in full on due date (or with accrued interest

if delayed) or be liquidated or go bankrupt.

Liquidity RiskRisk that settlement of an obligation will not be

made on due date, but on some unspecified date

thereafter.

Market Risk

Risk arising from market price fluctuation

(volatility) of securities and currencies from

the time of trade execution to eventual

settlement. Also called Market Price Risk (or

Position Risk,if related to a given long or short

position).

Operational risk

Risk of loss due to clerical errors, organizational

deficiency, delays, fraud, system failure,

misperformance, non-performance by third

party service providers, and similar incidents.


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Settlement RiskRisk that a party will default on one or

more delivery or payment obligations to its

counterparties or to a settlement agent.

Systemic Risk

Risk that the inability of one institution to

meet its obligations when due will cause other

participants or financial firms to be unable tomeet their obligations when due (chain reaction).

Transfer Risk

Risk that a country will introduce exchange

controls which will not allow for conversion of

local into foreign currency and transfer of the

proceeds abroad (e.g. for the settlement

of outstanding foreign exchange obligation).


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8. OUTSOURCINGWhile the safe-keeping of assets and trade settlement remain the core focus of custody banks

worldwide, such tasks are now considered plain vanilla services and are not enough to sustain a

viable business. Custody banks are under constant threat of tighter margins on traditional

products and consolidation of industry players. And banks in Asia are not immune to suchthreats. Banking liberalization in Japan, for example, has seen 20 or so big banks, insurance

companies and trust banks reduced to five major groups. The Australian market too has seen a

number of players bow out (most recently CBA), though there is still fierce competition in this

market with between five and seven banks bidding for each piece of custody business. These

competitive factors have led many banks to offer new value-added services such as cash

management, securities lending, compliance monitoring, risk management, proxy voting and

corporate actions. So far, the diversification strategy has worked and the increased profitability

of banks in recent years is some indication that these higher- margin services are paying off. The

latest value-added offering is back and middle office outsourcing which custodians have

identified as a business with substantial growth prospects (see table showing outsourcing

revenue)

The outsourcing trend started in the US and Europe about three years ago when four large

contracts were signed including: BoNYs contract with Julius Baer, the Swiss private bank; State


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Streets contracts with PIMCO and Scottish Widows Investment Management; and J P Morgans

contract with Schroders, the UK fund manager. The successful implementation of these

relationships has encouraged others to sign deals.

Just what functions are being outsourced depends on the perceived or real benefits to the client

and their familiarity with using third party providers. It also depends on external factors like therelative maturity of the market and trading conditions such as settlement cycles and market

automation. There is still some confusion, however, about what services are categorized as back

office and what services are characterized as middle office. (Most agree that proxy voting and

corporate action services are now considered mainstream custody products, as are transfer

agency services and member record keeping at the retail end of the market.)

In its simplest form, back office outsourcing includes fund accounting and fund administration

services.

Fund accounting covers security pricing, general ledger bookkeeping, NAV calculation, datadistribution, reconciliation, and daily, monthly and ad hoc reporting. Fund administration covers

statutory reporting, tax, compliance and performance measurement. Back office outsourcing

contracts vary by degrees based on a clients willingness to let go of the accounting process. It

starts with basic NAV calculations followed by monthly accounting and then on to full-blown

annual auditing. Ultimately all record keeping and accounting for individual fund vehicles is

handled externally, meaning that a fund manager has no need to employ any accounting staff,

other than one or two people to look after the management of the company as a corporate entity.

Back office services in Australia have recently extended to include multi-class pricing across the

different categories of units within a fund. In most cases, back office outsourcing contracts are

signed with the bank that also has custody of a funds assets. Middle office outsourcing isdifferent in that the third party provider does not necessarily retain custody of the assets. Broadly

defined, middle office outsourcing covers trade matching and confirmation which involves

establishing interfaces and maintaining links between brokers and custodians. It can also cover

cash flow forecasting and cash position reporting. There are also certain performance services

which can be defined as middle office. These functions occur pre-trade and involve providing

fund managers with immediate feedback on whether a trade that they want to make is in

compliance and analyzing what sort of impact it will have on a portfolio.

In many countries, middle office outsourcing has been driven by the shift to shorter settlement

cycles. Unwilling to invest in new technology that will improve straight through processing, fundmanagers choose to outsource trade matching and confirmation to a third party.

According to a research report compiled by Omgeo in October 2003, 89% of fund managers in

Asia that operating in a manual environment are considering adopting STP solutions in the near

future. When questioned, however, few are prepared to spend a lot of money on the process. This

raises questions about whether market participants are really committed to increasing same day


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affirmation rates (SDA), a simple measure which reduces a funds risks and lowers operational

costs. While SDA rates are relatively high in markets like Singapore and Hong Kong - due to the

number of block trades conducted - most other Asian markets need improvement.

Custody Overview Project

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