Sebi's new stress testing methods to boost resilience in equity derivatives

The Securities and Exchange Board of India (Sebi) had first introduced new stress testing methodologies for determining credit exposure in CCs, including both hypothetical and historical scenarios to calculate potential losses when closing out client positions on October 16, 2023. CCs confirm, settle and ensure delivery of securities for trading on an exchange.

To strengthen risk management in the equity derivatives segment for CCs, Sebi on 1 October this year added new methods to determine the minimum required corpus (MRC) for the settlement guarantee fund (SGF), which covers losses from failed trades. Key methodologies include:

Stressed value at Risk (VaR): This method uses data from a stress period to calculate price movements in the underlying assets. The observed volatility is doubled, and simulations are carried out (with an assumption that daily returns follow a normal distribution). The final figure shows the expected price movement for each asset.

Filtered historic simulation: Adjusts historical returns based on current volatility.

Factor model: Considers extreme Nifty movements over a three-day period since 2000.

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For each of the stress testing models mentioned above, the data used to calculate the returns or price movements for each underlying asset will be based on stress periods set by the clearing corporations. In addition, a stress period of risk of three days (and non-overlapping price movements) will be considered for the analysis.

The new stress testing methodologies aim to better understand tail risks—rare but significant events that can impact the market, according to Puneet Sharma, chief executive officer and fund manager at Whitespace Alpha. “The enhanced framework for determining the MRC (minimum corpus) for the core SGF (settlement guarantee fund) will make the equity derivatives market more resilient to extreme conditions, which is a positive step toward ensuring systemic stability."

Challenges for hedge funds

Market participants, however, said these measures could pose challenges for long-short hedge funds trading in derivatives. During the initial phase, increased volatility and tighter liquidity may reduce trading volumes.

According to legal experts, while the measures are designed to strengthen long-term market stability, they come with both opportunities and challenges for participants.

“We see it impacting the value chain, including the exchanges and brokers," said Shravan Shetty, managing director at consulting firm Primus Partners. “While the steps may partially affect market sentiment, other expected regulatory changes could have a larger impact on pricing and participation."

Whitespace’s Sharma said in the short term, compliance with higher MRC levels for the SGF could lead to increased costs. "CCs must contribute more capital to ensure adequate risk buffers. Consequently, clearing members might pass on these higher costs to traders and investors, leading to increased transaction expenses," he said. “For participants relying on leveraged positions, such as long-short hedge funds, this could reduce profitability."

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In long term, he said, these changes are expected to provide substantial benefits. "Improved stress testing mechanisms will not only strengthen CCs' preparedness for market shocks but also boost investor confidence, potentially attracting more institutional investors," he said. “A market that can withstand periods of stress is more appealing to larger, risk-averse participants, leading to deeper liquidity and sustained growth."

To address the increased MRC in the equity derivatives segment due to the new stress testing methods, Sebi allowed a one-time transfer of funds between segments under the following framework:

Inter-segment fund transfer: CCs can transfer excess funds from the equity cash segment's SGF to the equity derivatives segment under certain conditions.

Penalty transfers: Penalties and accrued interest can be transferred from the equity cash segment to the derivatives segment.

Additional contributions: CCs must review MRC requirements monthly and make additional contributions to the core SGF.

Sharma from Whitespace termed the inter-segment fund transfer a crucial provision. “This flexibility helps alleviate immediate liquidity strains that CCs may face due to increased SGF requirements, minimizing short-term disruptions. It highlights Sebi's balanced approach of implementing higher safeguards while giving market players time to adjust," he said.

In its October 1 circular, Sebi clarified that stress testing methods will apply uniformly across CCs in the equity derivatives segment, with CCs categorized as follows:

Category A: CCs with 40% or more of the equity derivatives clearing volume.

Category B: CCs with less than 40% of the clearing volume.

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Sebi’s circular also specified that clearing volumes should be calculated based on the daily average value of cleared futures and options contracts. CCs must report their category to Sebi within 7 days of the circular and annually within 15 days after the financial year ends.

Credit exposure for category A: Calculated based on the default of at least 3 clearing members or ₹10,500 crore, whichever is higher.

Credit exposure for category B: Calculated based on the default of at least 2 clearing members.

While existing stress testing methods will continue alongside the new ones, CCs and stock exchanges must develop a standard operating procedure (SOP) within 30 days, covering stress period specifications, operational details, stress loss calculations, and staggered contributions.