Part 4: NISM Series VII SORM - Risk Management

NISM Series VII SORM – Chapter 4: Risk Management (Margins, SPAN, Base Capital, Pre-Trade Controls)

This is Chapter 4 of the NISM Series VII Securities Operations and Risk Management (SORM) short notes. Risk Management is one of the highest-weightage topics in the NISM SORM certification exam. This chapter covers margins, liquid assets, SPAN computation, base minimum capital, pre-trade controls, and the F&O risk framework.

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What Is the Risk Management Framework?

The Risk Management Framework in securities operations is the structured system used by clearing corporations, exchanges, and broking firms to identify, measure, and manage financial risks. It consists of the following main components:

• Margins
• Liquid Assets
• Pre-trade Risk Controls
• Risk Reduction Mode
• Position Limits
• Core Settlement Guarantee Fund (CSGF)

Margining – How It Works

Margining is the process by which a clearing corporation computes the potential loss on open positions (both buy and sell) held by members. The clearing corporation collects margins to cover these potential losses.

Types of Margins in the Cash Market (Equity Segment)

Liquid Assets

Liquid assets (with applicable haircuts) are accepted as margin collateral. Examples include cash, government securities, bank guarantees, and approved equity shares.

Important rule: All institutional trades in the cash market are subject to the same margin requirements as other investors. Institutional trades are margined on a T+1 basis, with the margin collected from the custodian upon trade confirmation.

The Clearing Corporation provides a list of approved securities and collateral-related information on a monthly basis.

Calculation of Mean Impact Cost

Impact cost measures how much a trade of a given size moves the market price. The mean impact cost is calculated as follows:

• 4 snapshots per day are taken from the order book over the past 6 months
• These 4 snapshots are randomly chosen from within 4 fixed 10-minute windows spread through the trading day
• Impact cost = percentage price movement caused by an order of ₹1 lakh from the average of the best bid and offer price
• Calculated for both buy and sell sides in each order book snapshot

Shortfall of Margins / Pay-in of Funds

If a clearing member has a margin shortfall, the Clearing Corporation can advise the Exchange to:

• Withdraw all or some membership rights of the clearing member
• Suspend trading facilities of associated trading members
• Suspend clearing facilities of custodial participants

Additionally, there is a financial penalty for margin violations.

Base Minimum Capital (BMC) Requirements

Every broker is required to maintain a minimum capital deposit with the exchange. The BMC requirements are as follows:

Pre-Trade Risk Controls

Pre-trade risk controls are systems designed to prevent erroneous or uncontrolled trades before they reach the exchange. These include:

Order Level Checks

• Value/Quantity Limit per order: Maximum permissible value or quantity in a single order
• Cumulative limit on value of unexecuted orders of a stock broker
• Dynamic Price Bands: Price range within which orders are accepted; prevents extreme price movements

Risk Reduction Mode

When a stock broker's collateral utilised (adjusted against margins) reaches 90% of the total available collateral, the stock exchange must mandatorily put that broker in Risk Reduction Mode. In this mode, the broker can only place orders that reduce existing positions (cannot take new positions that increase risk).

Additional Margins

Exchanges and clearing corporations can impose additional risk containment measures over and above SEBI's mandated requirements. However, such additional measures must be based on objective criteria and must not discriminate between members.

Provision of Early Pay-In

Clearing corporations must have systems to enable early pay-in of funds by trading/clearing members. When a member makes an early pay-in, the corresponding open position is excluded from margin obligation computation to that extent.

Risk Management Framework for F&O Segment

The Risk Management framework for the Futures and Options (F&O) segment consists of:

• Margins
• Liquid Net Worth and Liquid Assets
• Pre-trade Risk Control
• Risk Reduction Mode
• Position Limits

Types of Margins in the F&O Segment 1. Initial Margin

Payable on all open positions of clearing members up to the client level. It is calculated using a portfolio-based approach via the SPAN (Standard Portfolio Analysis of Risk) software.

2. Computation of SPAN Margin

The clearing corporation uses the SPAN® system for real-time margin computation.

• Initial margin requirements are based on 99% Value at Risk (VaR) over a time horizon determined by the Margin Period of Risk (MPOR) for each product
• MPOR is set by SEBI's recommendations from time to time

3. Net Option Value (NOV)

NOV is the difference between long option positions and short option positions, valued at the last available closing price of the option contract. It is updated intraday at current market values at the time of risk parameter generation.

4. Delivery Margins

Delivery margins are levied on in-the-money long option positions or potential deliverable positions, starting 4 days before the expiry of the derivative contract.

Example: If expiry is on Thursday, delivery margins apply from the previous Friday EOD.

5. Extreme Loss Margin (ELM)

Clearing members are subject to ELM in addition to initial margins — to cover losses beyond VaR estimates.

6. Cross Margining

SEBI introduced cross margining to improve the efficiency of margin capital usage. The positions of clients in both the Capital Market (cash segment) and F&O segment, to the extent they offset each other, are considered for cross margining benefits. This facility is available to all categories of market participants.

Compliances and Regulatory Reporting

SEBI and stock exchanges have issued various directives that stock brokers must follow, covering:

• Client registration and dealing
• Issuance of contract notes
• Margin requirements
• Trading software guidelines
• Pay-in/pay-out operations
• Branch and authorised person management
• Maintenance and preservation of books of accounts
• Trading restrictions and base minimum capital

Key compliance obligations include:

• Failure to maintain or furnish required documents
• Failure to enter into agreements with clients
• Maintenance of different types of accounting books
• Submission of periodic regulatory reports
• Settlement of client accounts
• Sending periodic account statements to clients

Risk-Based Supervision of Market Intermediaries

SEBI has formalised a Risk-Based Supervision (RBS) approach for market intermediaries (including stock brokers), in alignment with global best practices. This systematic approach ensures more effective regulation of the marketplace.

Core Settlement Guarantee Fund (CSGF)

The Clearing Corporation (CC) of each stock exchange must create a Core Settlement Guarantee Fund (SGF) for each segment of the exchange. This fund provides settlement guarantees when a clearing member fails to meet their settlement commitments. The CSGF framework includes:

• Corpus: The total fund size
• Contribution to CSGF: From clearing members and the exchange
• Default Waterfall: The sequence in which losses are absorbed in case of default
• Stress Testing and Back Testing: Regular testing of the fund's adequacy

Quick Revision – Key Points for NISM VII Chapter 4

• VaR margin covers losses for 99% of trading days
• Impact cost is computed from 4 snapshots daily based on past 6 months of order book data
• Impact cost measures price movement for an order of ₹1 lakh
• BMC for brokers with Algo trading: ₹50 Lakhs
• Risk Reduction Mode triggers at 90% collateral utilisation
• SPAN system is used for F&O margin computation
• Initial margin in F&O is based on 99% VaR
• Delivery margins apply from 4 days before expiry
• Cross margining offsets positions across cash and F&O segments
• CSGF provides settlement guarantee if a clearing member defaults

📌 Next Chapter: NISM Series VII SORM – Chapter 5: The Clearing Process

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Related reads: NISM Risk Management Notes | SPAN Margin Explained | NISM Series VII SORM Mock Test