11

The Clearing Corporation of

India
R. H. Patil

As the economy of a country develops, its financial markets expand and

get diversified. New and innovative products get introduced and new mar-
ket players having diverse interests and outlooks join in large numbers to
widen and deepen the financial markets. Growth in the volume of transac-
tions in financial markets is invariably accompanied by an increase in the
complexity of operations. For protecting integrity of rapidly growing fi-
nancial markets a sound institutional structure to support and facilitate the
clearing and settlement of financial transactions becomes essential.
Recognising the need for upgrading the country’s financial infrastruc-
ture in respect of Clearing and Settlement of debt instruments and forex
transactions, Reserve Bank of India initiated the move to set up The Clear-
ing Corporation of India Ltd. (CCIL). The country’s largest bank, State
Bank of India, took the lead in setting up of the CCIL. The other core pro-
moters of CCIL are LIC, IDBI, ICICI Bank, HDFC Bank, and Bank of
Baroda. Subsequently, CCIL invited all the important commercial banks
and primary dealers to take up shareholding so that CCIL truly becomes a
venture of the major players in the Indian financial system. CCIL was in-
corporated on the April 30, 2001. It commenced its operations on February
15, 2002 along with the commencement of operations of RBI’s Negotiated
Dealing System (NDS).
CCIL is the country’s first clearing house for Government Securities,
Repos, Forex and other related market segments. The primary objective
222 The Clearing Corporation of India

in setting up CCIL has been to provide a safe institutional structure for the
clearing and settlement of trades in the Government Securities, Forex (FX),
Money and Debt Markets, to significantly improve efficiency in the trans-
action settlement process, and insulate the financial system from shocks
emanating from the counterparty risks and market deficiencies of various
types that currently plague the Indian financial markets. Operations at the
CCIL currently encompass settlement of trades in Government securities,
Treasury bills and Repos concluded and/or reported on NDS. CCIL ex-
tended the facility of guaranteed settlement of trade to its members with
effect from April 10, 2002.
The facility of centralized clearing and settlement offered by CCIL is a
great advantage to the players in this market. Moreover, CCIL’s assurance
that trades entrusted to it will get settled on the settlement day has been
providing the much-needed comfort to the market. For participants in the
forex market, CCIL’s intermediation provides a structure to mitigate, and
manage risks associated with settlement of these high-value transactions.
Since the foreign currency leg has necessarily to be settled overseas while
the rupee leg gets settled locally, time-zone differences come into the pic-
ture adding to the settlement risk. Besides bringing tangible benefits in
the form of improved efficiency and easier reconciliation of accounts with
their correspondent banks, CCIL’s intermediation in the settlement process
will lead to lower transaction costs to the participating banks, institutions,
and primary dealers.
Important Milestones
O Date of Incorporation: 30 April, 2001



O Date of Commencement of Securities Settlement: 10 February,



2002
O Commencement of Guaranteed Settlement: 10 April, 2002



O Settlement of Forex Trades: Early November 2002

O Launching of CBLO: Mid–November 2002

Expected Events
O Launching of Forex Trading Platform: Before the end of 2003
 Derivatives Markets in India: 2003 223

1 Risks and Their Mitigation

Since one of the major contributions of CCIL to market development will

be risk mitigation for its members it is worthwhile to discuss the aspect
of market risks that members normally face. As a settlement organisation,
CCIL is uniquely placed in the market in the sense that most of its members
are banks, financial institutions, and mutual funds which are all closely reg-
ulated entities and hence relatively less risky entities to deal with. Further,
CCIL will not be facing the usual risks that most of the clearing corpora-
tions face when they rely one of the banks through which the settlement
transactions are routed. Since RBI, the central bank of the country itself
acts as the clearing bank for the transactions handled by CCIL, it does face
the usual “settlement bank risk” which most of the clearing entities face
when they have to rely on the commercial banks however strong they may
be.
The second advantage CCIL enjoys is that most of its members are
banks which maintain sizeable unencumbered balances with RBI in the
form of the cash reserve ratio (CRR) balances. Hence CCIL would rarely
face problem of funds default from its member banks in respect of their
transactions in securities or the foreign exchange. When CCIL admits
corporates and NBFCs as its members at a later stage, it will stipulate a
condition that they will have to choose one of the member banks as its
clearing agent be fully responsible for all the risks posed by the entities
whose trades it will be handling as a clearing member of CCIL.
The major risks that CCIL faces as the central clearing agency guar-
anteeing settlement are: Credit risk, Liquidity risk and Operational risk.
Credit risks are of two types: Principal risk and pre-settlement (or replace-
ment) risk. Principal risk gets crystallized when one of the parties to set-
tlement fails and is unable to meet its full obligations under the contract on
the settlement date. Pre-settlement or replacement risk is the risk of loss
resulting from replacement costs that may have to be incurred by CCIL as
the clearing entity in case one of the counter-parties to settlement becomes
insolvent before settlement.
Foreign exchange contracts are a good example to explain these risks.
Let us say, a party enters into a contract with another party for purchase
of US dollars, but the counter-party fails in the pre-settlement period it-
self. The former will then have to enter into a contract with another party
224 The Clearing Corporation of India

for purchase of the dollar amount. The party will then have to book a no-
tional loss on account of the adverse movement, if any, in the rupee-dollar
exchange rate between the day it had first contracted for purchase of US
dollars and the day it replaces that contract with the second counter-party.
Liquidity risk refers to a party’s inability to make payment (or deliver
security) to its counter-party on account of shortage of funds (or securi-
ties), and as far as the counter-party is concerned, it is as good as a credit
failure. The risk can, however, be managed much better if settlement is
done through a settlement agency that has suitable mechanisms, such as a
standby line of credit and/or a security borrowing/lending arrangement, in
place. This is where the framework of settlement through CCIL will help.
Operational risk refers to risk arising from deficiencies in systems
and/or management control, or due to human failure. Again, a centralized
settlement system can tackle operational risk much better than individual
players can.
For settling trades in both the government securities and the inter-bank
forex spot/forward transactions, CCIL employs the mechanism of multilat-
eral netting and novation, becoming the central counter-party to both the
contracting entities, and guaranteeing settlement of trade on the settlement
date. For meeting the challenges posed by technical or other defaults and
completing settlement on time, CCIL makes use of a settlement guaran-
tee fund (SGF) composed of different types of collaterals contributed by
its members. Members are also required to provide additional collateral
by way of margins as and when there are variations in prices of govern-
ment securities etc., or foreign exchange rates. By employing a system
of multilateral netting, CCIL ensures that, regardless of the number of
trades/transactions entered into by a member on any given day, there is
only one net funds obligation, either payable or receivable, that is needed
to be put through the member’s account.
Since CCIL becomes the central counterparty for all trades/transactions
members of CCIL do not have to worry about the risks they face while
dealing with any other market player as soon as their trades/transactions
are accepted by CCIL for settlement. Once the members are freed from
the worries of counterparty risks each of them is able to devise its own
optimum trading and portfolio strategy and maximise returns. The most
important role that the CCIL thus plays through its settlement guarantee
mechanism is to upgrade the credit rating of all its members’ irrespective
of their own/inherent credit rating.
 Derivatives Markets in India: 2003 225

Market players will attach high value to the settlement guarantee of

CCIL only if it is able to generate high level of confidence in its abil-
ity to contain settlement risks by easily absorbing any possible loss that
weak members will inflict on the resources at the command of CCIL. The
skill and efficiency of CCIL therefore lies in its competence to quantify
with a high degree of accuracy the risks involved in accepting member’s
trades/transactions for guaranteed settlement. Once CCIL is able to quan-
tify risks that it will have to shoulder in different market situations, it
should price this risk to each member by way of its contribution to set-
tlement guarantee fund. CCIL would have to impose exposure limits on
a real time basis on each member depending on the contribution that the
member makes towards the settlement guarantee fund and pays margins
and other charges that CCIL demands from time to time. CCIL will have
to charge margins of different types to protect itself against the possible
loss it may incur when market situation/prices change.

2 Clearing and Settlement of Securities

Presently banks, financial institutions, primary dealers and mutual funds
who are allowed to trade on, or participate in, the RBI’s Negotiated Deal-
ing System (NDS) platform can become members of CCIL for Govern-
ment Securities Settlement. CCIL accepts both outright and repo trades
in government securities for settlement. Outright trades involve one-time
settlement of securities and funds.
Repo trades involve an immediate sale/purchase of securities, followed
by a re-purchase/re-sale of the same securities in the same quantity at a
future date, with the repo rate being decided on the trade date itself.
RBI has developed the Negotiated Dealing System (NDS) platform for
Screen-based trading in Government Securities and Money Market instru-
ments. Members are connected to RBI through the INFINET network, a
secure closed user group (CUG) hybrid network (consisting of both VSAT
and leased lines) developed by RBI exclusively for use by the Indian banks
and financial institutions. Trading among members, and reporting of trades
to the RBI, happens on-line and in real time.
After trades are concluded/reported on the NDS, details thereof are sent
to CCIL by RBI–PDO for processing and settlement, in two batches. The
first batch consists of trades with settlement on
 day. The second batch
226 The Clearing Corporation of India

consists of trades with settlement on
  and beyond. The cut off timings
for the batches are 14.30 hrs for batch I and 17.30 hrs for batch II. How-
ever, depending on the exigencies and requirements of market participants,
the cut off timings are extended by RBI.
CCIL’s system computes the margin requirement on the trades and com-
pares the same against available margin of the concerned members in his
Settlement Guarantee Fund (SGF), a fund maintained by CCIL comprising
of member’s contribution (partly in cash and partly in acceptable securities)
as per policy laid down by CCIL in this behalf. This process of checking
adequacy of margin is known as “exposure check.” For trades where mar-
gin requirement are met, CCIL generates member-wise report of “Trades
Accepted for Guaranteed Settlement.”
In case of insufficiency of margins for a member, a “Trades Exceeding
the Exposure Limit” report is generated for the member. Such trades are
eligible for guaranteed settlement upon putting up the necessary additional
margin by the concerned members. Presently, CCIL follows the DVP–II
method of settlement, where securities are settled on a gross basis, i.e. trade
by trade, and funds are netted, member-wise. Current RBI stipulations do
not permit short selling of securities. Hence as per RBI’s requirements
CCIL has adopted DVP–II mode of settlement for securities.
Both the securities as well as funds settlement takes place through the
settlement accounts of CCIL maintained at RBI. The settlement process
is complete in case no shortage in securities and funds is encountered. In
case of funds shortage, CCIL completes settlement by utilizing the cash
component of the Settlement Guarantee Fund or/and the Line(s) of credit
available to CCIL from banks. The securities deliverable to the defaulting
member is withheld. The funds utilized to meet the shortage are replen-
ished on the next day by the defaulting member, to secure the release of
withheld securities.
The current size of the settlement guarantee fund is around
Rs.1300 crores of which the cash component is around Rs.225 crores.
CCIL has arrangements with major five commercial banks for lines of
credit. CCIL has already entered into agreement for credit lines for Rs.400
crores. For the balance amount of Rs.400 crores documentation is in
progress with the concerned banks. The experience so far indicates that the
lines of credit obtained from the banks would be highly comfortable since
on very rare occasions the institutional players are ever short on cash.
 Derivatives Markets in India: 2003 227

In case of securities shortage, CCIL arranges to complete settlement by

transferring the security/securities concerned, either from the Settlement
Guarantee Fund SGL account or from its own Proprietary SGL account.
CCIL has also entered into an arrangement with LIC and SBI whereby
it can borrow securities from them for completing the settlement in case
of delivery shortages. Since both these institutions are very large hold-
ers of almost the whole range of government securities it should not at
all be difficult for CCIL to complete the settlement whenever it faces de-
livery shortages in respect of government securities. The funds/securities
payable/deliverable to the defaulting member is withheld. The securities
utilized in completing settlement are replenished by the defaulting mem-
ber on the next day, to secure the release of withheld securities/funds. The
defaulting member is required to pay a penalty and bear all the costs in-
curred by CCIL in connection with the default.

2.1 Risk Management Tools

CCIL has in place a comprehensive risk management system in place in re-
spect of the government securities segment which has gone live recently. It
has also devised a similarly tight risk management system for the forex seg-
ment that is expected to become operational in the immediate future. The
risk management system comprises strict admission norms for member-
ship, measures for risk mitigation in the form of robust margining process,
setting up of exposure limits, settlement guarantee fund (SGF), liquidity
arrangements, continuous position monitoring and loss allocation proce-
dure (in respect of the forex clearing where the market is still not ready for
a DVP type of settlement mechanism) and penalties in the case of default
and/or violation of settlement rules.

2.2 Margins for Securities Segment

CCIL charges two types of margins for the securities segment. They are the
initial margin and the mark-to-market (MTM) margin. Initial margin is col-
lected to cover against the likely risk from future adverse price movements
of the concerned security and is computed trade-wise by multiplying the
total value of consideration for the trade with the applicable margin factor
for each security calculated with the help of a value at risk model (VAR).
Off-set for the initial margin is allowed only in the case of counter trade in
228 The Clearing Corporation of India

the same security with the same settlement date. In other words the initial
margin is calculated on the basis of net exposure in the concerned security
vis-à-vis the CCIL. The margin factor (VAR) is normally computed using
historical simulation method and it covers risk over a 3-day holding pe-
riod at 99 percent confidence level on past 1000 days zero coupon yield
curve (ZCYC) based on the Nelson & Siegel equation. Since CCIL allows
a day’s period for replenishment by a defaulter members in case of pay-in
default a 3-day holding period is used for calculating the level of initial
margin.
Members are encouraged to maintain sufficient balances in their contri-
bution to settlement guarantee fund (SGF) to cover both initial margin and
the mark-to-market margin requirement at any point of time. With a view
to keeping opportunity costs of contributions to SGF low, CCIL has given
an option to members of paying 90 percent of the required contribution to
the SGF meant for securities segment in the form of liquid GoI securities.
To protect itself from the erosion in the value of the collateral contributes
by the members to the SGF meant for securities segment CCIL revalues
the collateral at regular short intervals to reflect price changes in securities
and applies a suitable hair-cut to the value thus obtained.
Mark-to-market (MTM) margin is collected to cover notional loss that
may have been incurred by the member (i.e. the difference between the
MTM price and the contract price of a trade). It is computed on the basis
of movement in market prices in the case of outstanding position of the
members in all forward leg of the repo and outright transaction to be settled
beyond
 
 day in case of securities transaction. In the case of a buyer,
MTM margin would be payable if the MTM price is lower than the trade
price. Similarly, in the case of a seller, MTM margin would be payable in
case the MTM price is higher than the trade price.
CCIL computes MTM price of a security based on the weighted average
price (WAP) of the last five outright transactions1 reported on the RBI’s
NDS. In case no deals are reported, the previously available WAP is used
unless this WAP is more than 6-days old. In all other cases, model prices
are computed using ZCYC.
CCIL is in the process of finding a reasonably satisfactory solution to
the problem that illiquid stocks pose in its risk management strategy. The
1
If there were less than 5 trades, prices of all trades are used in the weighted average
price calculation.
 Derivatives Markets in India: 2003 229

present margining system is based on the assumption that CCIL would be

able to square off positions within a day. But this assumption does not
hold good in particularly in respect of stocks that are relatively illiquid.
There are a number of GOI stocks which are not very liquid and less fre-
quently traded. Most of the state government stocks are highly illiquid.
Prices at which deals in such illiquid stocks can be squared off may be far
away from the price calculated by the current procedure adopted in CCIL.
One possible solution would be to attach a variable illiquidity premium for
such illiquid stocks depending on the level of their perceived illiquidity and
charge higher initial margin to cover the potential risks of CCIL.
Apart from the inherent problem of illiquidity of several stocks, there is
also the problem of strange behaviour of some of the market players often
trading in stocks at prices which are at considerable variance with the going
market prices. This strange behaviour is noticed often in respect of trading
in stocks that are relatively liquid or not so much illiquid. It is likely that
this behaviour may be partly due to the current imperfections of the market
which is not transparent and transaction details are not disclosed on near
real–time basis to the market. There is no strict regulatory compulsion to
report trades on the NDS soon after they are concluded through the brokers.
NDS is currently used only to report trades and not for actual negotiation of
trades on the NDS screen itself. This state of affairs is also indicative of the
strong hold that the broker community on the market. Broker community
is particularly not in favour of real time transparency of all the deals in
securities in regard to the deal quantities and their respective prices.

3 Clearing And Settlement of Forex

Membership to the forex segment of CCIL is currently restricted to the Au-
thorized Dealers (ADs) in Foreign Exchange. Both Spot and Forward forex
transactions will be covered. Initially, CCIL will settle spot and forward
inter-bank US Dollar-INR forex trades which account for approximately
85 percent of the total inter-bank forex trades concluded in the country.
Since the RBI’s INFINET network forms the communication back bone
for our operations, connectivity to the network will be a pre-requisite for
members availing of CCIL’s services. Members will be provided with the
software necessary for linking up their existing back-office systems at the
designated offices with CCIL’s systems. The settlement process involves
230 The Clearing Corporation of India

mandatory transfer of deal confirmation files, over INFINET, by the mem-

bers to CCIL, in format IFN 300.
Once the structured financial messaging system of RBI’s INFINET sys-
tem becomes operational, such trades will get reported by members direct
over this network. Further, CCIL also intends to launch its own trading
platform for inter-bank forex transactions shortly. Trades concluded over
the trading platform will form a direct input to CCIL’s settlement systems
and no separate confirmation need be sent by the banks for such trades. No
settlement (of US$/INR forex transactions) will take place on Saturdays,
Sundays and such other days as are not business days in either Mumbai
or New York. There will be at least one settlement per business day of
Mumbai.
As in the case of government securities clearing and settlement, the
original contracts for buying and selling foreign exchange, entered into be-
tween the parties concerned, will be novated and replaced by a new one,
for the same value date, between CCIL and each of them. The deal con-
firmation data currently exchanged among members will be validated and
matched at CCIL and processed for exposure check. Each member is as-
signed a “Net Debit Cap” (NDC) which is the maximum exposure to be
taken by CCIL on such member (in terms of US$ sold by the member for a
particular value date). CCIL will not normally accept any deal which vio-
lates the member’s NDC/Exposure limit for settlement, unless such excess
is fully pre-funded. All deals which thus the exposure check are netted.
While the rupee funds will be settled through the members’ current ac-
counts with RBI, the US$ funds will be settled through CCIL’s account
maintained with the Settlement Bank at New York.

3.1 Default in Payment of US$ Obligation

A member with a net payable position is said to have defaulted when it fails
to credit part or the whole payable amount (in US$) to CCIL’s account
maintained with the Settlement Agent before the stipulated cut-off time
on the value date. In such a case, CCIL will complete the US$ leg of
the settlement by drawing under the dollar line of credit facility from the
Settlement Bank. The settlement bank has extended credit lines to the
tune of US$ 275 million, which is expected to be more than adequate for
the purpose. The settlement guarantee fund of CCIL would be around
 Derivatives Markets in India: 2003 231

US$ 120 million. The defaulting bank’s rupee account with RBI will be
debited next morning with the amount paid into it by CCIL (CCIL would be
appropriately pre-authorized by every member for posting a debit into the
member’s account in such an eventuality), in connection with settlement of
trades, the previous day.
If the defaulting member repays the US$ amount to CCIL before expiry
of the deadline (12.00 noon IST) on the business day after the day of the
default, the default will stand cured and the debit raised in the member’s
current account with RBI will be reversed. However, if the default is not
cured by the deadline set by CCIL, then CCIL will utilize the INR funds,
withdrawn earlier by debiting the member’s current account with RBI, to
purchase US$ in order to pay off the Line of Credit (LOC) outstanding,
incurred earlier for completing settlement. In case adequate INR funds
are not available in the current account of the defaulting member, the loss
allocation procedure will be invoked. The cost of recovering the shortfall
in US$, including exchange loss if any, along with out-of-pocket expenses
and handling charges, will be recovered from the defaulting member. A
penalty will also be levied on the defaulting member on the outstanding
amount, from the day of the default till all obligations arising out of such
default is extinguished.

3.2 Default on INR Obligation

If a member defaults on its INR obligation, CCIL will withhold the dollar
funds payable to the member. CCIL will, however, complete the Rupee
settlement by availing of the line of credit facility. Subsequently, if the
defaulting member repays its obligation before expiry of the deadline set
by CCIL, the default will stand cured. However, if it fails to do so and
the default continues beyond the deadline (12.00 p.m. IST on the business
day after the day of the default), the US$ funds payable to the default-
ing member and withheld by CCIL will be converted into rupees in order
to extinguish its outstanding obligation. In case of shortfall, the loss al-
location procedure will be invoked. As in the case of the US$ default, a
penalty calculated on the outstanding amount from the day of default till
extinguishment of all obligations, as well as the cost of funding the INR
shortfall, exchange loss, if incurred, and out-of-pocket expenses and han-
dling charges, if any, will be recovered from the defaulting member.
232 The Clearing Corporation of India

3.3 Loss Allocation Procedure

It is worth noting the basic difference in the modes of settlement of the
securities transactions from that of the rupee-dollar settlement handled by
CCIL. In the case of securities settlement, CCIL adopts the DVP method
whereby securities are not transferred in the buyer unless the buyer has paid
for the securities fully. However, in the case of rupee-dollar settlement,
CCIL has to fall in line with the current market practice whereby rupees
are first paid in India to the net sellers of US$ and these sellers deliver the
US$ to CCIL in its account with the settlement banker viz., ABN Amro’s
New York office subsequently. In case there is a default in the delivery of
US$ by a seller, CCIL will have to first recover the rupees already paid to
the defaulting member and use the rupee proceeds to buy US percent so as
to reimburse ABN Amro Bank to the extent of the credit lines used.
If CCIL incurs expenditure in excess of the rupees recovered from the
defaulting member in the whole process it will have to absorb this loss.
Secondly, if CCIL does not succeed in recovering the rupee proceeds from
the defaulting member it will have to invoke the loss allocation procedure.
Thus the rupee-dollar settlement procedure being adopted is more risky
involving credit risk mainly because the market players are still not willing
to adopt DVP-like method which is also commonly referred to as Payment-
Versus-Payment (PVP) method.
As per the procedure devised by CCIL, in case default remains out-
standing for more than one business day, the loss allocation procedure will
get automatically invoked. In such a case, the settlement loss will be first
met out of the defaulting member’s contribution to the SGF. If the collat-
eral contributed by the member is insufficient for this purpose, the amount
of shortfall will be apportioned to the surviving members in proportion to
their exposure to the defaulting member on the value date.

3.4 Risk Management

The risk management mechanism for forex segment includes tools for man-
aging credit risk by way of membership norms, member-wise NDCs. The
tools for managing liquidity risks include both fully collateralised lines of
credit as also non-collateralised lines of credit form the settlement bank.
Based on certain performance parameters, CCIL will fix suitable net expo-
sure limits or NDC for all its members. NDC is calculated as the maximum
 Derivatives Markets in India: 2003 233

exposure, in terms of net payable amount, that CCIL will take on a member
by accepting its trades for settlement.

3.5 Collateral Requirements

For mitigating CCIL’s risk, members are required to contribute collateral
to the SGF in accordance with the policy laid down by CCIL from time to
time. Currently the contribution amount is a factor of the member’s NDC.
A member’s margin factor is arrived at on the basis of its credit rating as
determined by an independent rating agency, and the volatility factor in
respect of US$ – INR exchange rate. The contribution to SGF of CCIL’s
forex segment is payable in US$ funds. CCIL will invest the corpus in US
Government Securities and deposits, and distribute earnings arising out
of such investments (excluding revaluation gains/loss, net of costs/taxes
if any, on the basis of each member’s average daily cash balances to the
members at half-yearly rests). The SGF corpus is used to collateralise the
lines of credit availed by CCIL to facilitate settlement.
CCIL has made necessary arrangements for availing of lines of credit
from its overseas Settlement Bank, as also banks in India, in order to ensure
that settlement of both the forex and the INR legs of the transactions, goes
through even if a member(s) fail to deliver its/their currency obligation to
CCIL on the value date.

4 Future Plans
CCIL will constantly endeavour to assess market needs and come out with
products to satisfy the same. The Corporation will also strive to contribute
its bit to facilitate a deepening of the secondary debt market, particularly
the repo market in government securities. New services to be launched in
future will touch the forex (including settlement of the inter-bank US$/INR
Cash/TOM deals), derivatives and money markets and will include devel-
opment of a dealing platform for forex and collateralised borrowing and
lending obligation (CBLO) deals. CCIL would gradually extend its geo-
graphical coverage to other parts of the country. CCIL is also planning to
introduce clearing and settlement facilities in Interest Rates Swaps (IRS).
234 The Clearing Corporation of India

4.1 Collateralised Borrowing & Lending

CCIL has developed a new money market product called “Collateralised
Borrowing and Lending Obligation” (CBLO), to meet the needs of banks,
financial institutions, primary dealers, mutual funds, NBFCs and corpo-
rates for borrowing and lending of funds. CBLO is a new type of deriva-
tive instrument that incorporates the basic features of the standard tripar-
tite repo, the call/notice money market, and tradable securitised debt in-
strument of short maturity. In the standard tripartite repo instrument the
borrower deposits the repo-able securities with a third party like bank or a
clearing corporation that is acceptable to the lender of funds. When funds
are lent to the borrower the third party holding custody of repoable securi-
ties acts as a trustee and guarantees the return of funds from the borrower
to the lender. In case the borrower does return borrowed funds on the due
date the third party holding custody of securities sells them in the market
and repays the funds to lender.
In all repo transactions, including the tripartite repo deals both the
lender and the borrower are obliged to unwind the deal only on the due
date. Assume the repo is for a period of say, 15 days; even though the bor-
rower’s liquidity position improves before the stipulated 15
 day borrower
cannot unwind the repo either in part or the whole of the transaction. In
such situations the borrower has no choice other than entering into a fresh
repo transactions to lend the surplus funds. In the same way the lender of
funds is has also no flexibility of getting his funds back either in part or
the whole of it until the maturity date of the repo deal. If the lender of
the funds needs liquidity he will also have to enter into a repo to borrow
funds for the balance maturity. Thus both the lender and the borrower do
not have enough flexibility in the case of a repo transaction.
To resolve this problem satisfactorily both for the borrowers and lenders
of funds, CCIL has designed the tradable CBLO instrument to lend liquid-
ity to the tripartite repo instrument. CCIL proposes to provide a dealing
platform through which market participants will borrow and lend funds by
trading in the CBLO instruments of various maturities which will be issued
at discount to their face values. CBLOs will be denominated in multiples
of Rs.5 million so that there is a facility to unwind lending/borrowing po-
sitions in part at attractive prices depending on the market situation.
 Derivatives Markets in India: 2003 235

Since holders of CBLO (or lenders of funds) have the freedom to exit
the market at their choice they may be willing to bear the risk of buying
CBLOs with longer maturities. Over a period of time it should be possible
for the borrowers of funds to float CBLOs with maturities up to 90 days or
more. In the early phase CCIL proposes to encourage the market to float
CBLOs with maturities up 90 days. Thus CBLO instrument will help in
developing an active term money market.
Since both the borrowers and lenders of funds are afraid to take posi-
tion on interest rates for different durations the Indian market has failed
to develop an active term money market. Currently, the National Stock
Exchange (NSE) has been publishing its MIBID/MIBOR for various du-
rations up to 90 days. These rates are based on a polling method and
not on the willingness of the market players to lend/borrow even modest
amount of funds at the rates indicated by them in the polls. Hence NSE’s
MIBID/MIBOR rates for different durations have failed to develop confi-
dence in the market players to actually lend/borrow funds at these rates.
Today market participants consider that these rates are as purely indica-
tive in nature. Despite the availability of MIBID/MIBOR for periods up
to 90 days for about two years the market has not witnessed a term money
market at which funds are actually lent on even a modest scale. The main
reason is that market does not consider these rates as not being dependable
for entering into actual transactions but more speculative/indicative in na-
ture. But once CBLOs of varying maturities start getting traded actively
the market in CBLOs would effectively help in the discovery of bid/offer
rates for different maturities. This will help in the development of a real
term money market.

4.1.1 What is a CBLO?

An obligation by the borrower to return the money borrowed at a specified

future date; an authority to the lender to receive money lent at a specified
future date with an option/privilege to transfer the authority to another per-
son for value received; An underlying charge on securities held in custody
(with CCIL) for the amount borrowed/lent.

4.1.2 Eligibility

The membership of CBLO segment will be initially extended to NDS

members. The membership will be subsequently extended to non-NDS
236 The Clearing Corporation of India

members like NBFCs and Corporates once the internet platform that CCIL
is developing gets ready. The CCIL internet platform will help in expand-
ing the geographical reach of the market to all those cities where inter-
net connectivity is available. All the NDS and non-NDS borrowing mem-
bers will be required to open their Constituent SGL (CSGL) Accounts with
CCIL to lodge securities which can be used by them as collateral for bor-
rowing.

4.1.3 Borrowing Limits

Borrowing limits for the members will be fixed at the beginning of the day
taking into account the securities deposited in the constituent SGL (CSGL)
account. The securities will be subjected to necessary haircut after marking
them to market. The limits in effect will denote the drawing power up
to which members can borrow funds. Lenders will deposit cash to meet
initial margin requirements that are designed to take care of the settlement
risks. Since the borrowing limits of the borrowers are based on the value
of sovereign securities held in CCIL’s custody through its CSGL account
the tradable CBLO is essentially a derivative instrument that can be freely
traded on the screen to be provided by CCIL.

4.1.4 Creation and Issue of CBLO

Members will have the flexibility to access the auction market and also
normal market for borrowing funds based on the borrowing limits fixed by
CCIL. The CBLOs could be offered on an outright basis and also for vary-
ing periods maturing on the reporting Fridays not exceeding 90 days. The
members desirous of borrowing from the auction market will be required
to indicate their borrowing requirements clearly mentioning the amount,
maturity date of CBLO and the range for the rates before commencement
of the trading session of the day. The range could be specified by the bor-
rower one of the following:
(a) with cap at MIBOR.
(b) with a cap at MIBOR+50 bps.
(c) with a cap at MIBOR-50 bps.
(d) without any cap.
 Derivatives Markets in India: 2003 237

CCIL will convey its acceptance of the request to the respective mem-
bers and place their offer on the auction screen. In the case of borrowing
through normal market, members can directly place their offers for bor-
rowing on the normal market screen, subject to availability of eligible bor-
rowing limit.

4.1.5 Auction Market

Based on the borrower’s requirement, CCIL will place the offer indicat-
ing the amount and maturity date of borrowing on the auction screen. The
lenders will submit their bids for the amount to be lent and the yield ex-
pected. The lenders will have flexibility to modify/cancel their bids during
the auction process. However, borrowers will not be permitted to revise the
amounts or the terms of their offers during the auction period. The auction
matching will be initiated based on uniform yield method which will be
applicable to all the borrowers and lenders. Auction session will be kept
open between 9.45 am to 11.30 am every day. The CBLOs allotted to the
lenders in the auction market will be available for trading in the normal
market from the subsequent day onwards.

4.1.6 Normal Market

The normal market is available to the members for borrowing funds and
also for trading in CBLOs. The members can simultaneously borrow in the
auction and normal market to the extent of the limit allocated initially by
CCIL based on their request for each market. In case the members are not
successful in meeting their borrowing requirements in the auction market,
they can access the normal market to the extent of their available borrowing
limit for which CBLOs have already been created for respective maturities
and made available in the members account. Besides, the members can
use the normal market for trading in the CBLOs which they had acquired
by lending in the auction market or normal market. In effect, the normal
market provides a facility to offload the CBLOs in their possession to meet
requirement of funds.
In the normal market operations, members willing to lend or borrow
funds can do so by placing their buy/sell orders for CBLOs on the screen.
The members willing to sell CBLO will place their offers indicating the
CBLO of relevant maturity for matching with the best bids for the same
238 The Clearing Corporation of India

CBLO. Like-wise members willing to buy CBLOs will submit their bids
which will match with the best offer on the screen. The matching of bids
and offers will be on the basis of Best Yield – Time Priority. Normal market
trading session will be kept open between 9.30 a.m. and 3.30 p.m. every
day.

4.1.7 Clearing and Settlement

After the trading session, all the matched deals in both the auction and nor-
mal markets will be taken up for processing and settlement. The settlement
will be on
 basis. The CBLO obligation is generated by netting trades
in the same CBLO for the normal market and the obligation for CBLOs for
the auction market is worked out on gross basis. The funds obligation for
each member will be netted across all the matched deals of the concerned
member in the auction and normal markets. Funds pay-in and pay-out files
will be generated by the CCIL system and will be sent electronically to RBI
for effecting debits and credits in the members’ current accounts through
the settlement account of CCIL with RBI.
CCIL will have the mandate from its members for posting debit and
credit entries into their current accounts with RBI. After effecting funds
transfer between members’ current accounts, the RBI will be sending back
settlement confirmation file electronically to CCIL. After receiving confir-
mation of funds settlement from RBI, CCIL will effect CBLO pay-out to
respective buyer member’s account.

4.1.8 Risk Management

CCIL will address risk relating to trading and settlement by adopting strict
membership norms and restricting the membership only to those entities
that meet the minimum eligibility criteria. Members will be allowed to
borrow to the extent of the limit fixed on the basis of the securities de-
posited after necessary valuation and haircut. The securities in the CSGL
account will be subjected to daily valuation and any deficit in the value of
the securities vis-à-vis the face value of CBLO will be collected from the
concerned members. Besides, CCIL will stipulate initial margin for the
lenders in the auction market and for each bid and offer in the normal mar-
ket to address the interest rate risk, in case the lenders do not honour their
commitments and CCIL has to step in as guarantor. CCIL has also framed
procedures for handling shortfall in funds and in CBLOs.
 Derivatives Markets in India: 2003 239

4.2 Forex Dealing Platform

CCIL is proposing to launch a Forex Dealing platform to meet the require-
ments of the Inter Bank Foreign exchange transactions. The proposed deal-
ing platform will offer two modes of dealing– “Negotiation” and an “Order
Matching.” Together, they will offer the facility of obtaining quotes, in real
time, from banks, posting two-way quotes on the screen for order match-
ing.
Initially the proposed dealing system will cover the inter-bank US$–
Indian Rupee (US$–INR) Spot and Swap forex transactions. This segment
constitutes about 85 percent of the transactions of the total Forex transac-
tions in terms of value. Through the launch of this dealing platform, CCIL
hopes to bring in wide ranging benefits to the market participant such as
price competitiveness, an institutional frame-work, price discovery mech-
anism etc.

4.2.1 Eligibility

The membership of the Forex dealing segment will be initially extended

only to those entities that have taken up membership of the Forex Clearing
segment. This membership may be subsequently extended to entities who
are not necessarily members of Forex clearing segment.

4.2.2 Order Matching Mode

The order matching mode will be a neutral, anonymous on a truly order

driven dealing platform. It will work on the principle of ‘full price discov-
ery’. In this mode, orders (both bids and offer) with valid inputs will be
accepted for dealing and the system will endeavour to match these with the
counter-orders available in the order book, based on price and time priority.
The counter-party’s identity will not be disclosed to either party until after
the matching has resulted in a trade. Initially, CCIL proposes to provide
this mode for only US$–INR currency pair. Subsequently other currency
pairs may be made available in this mode.

4.2.3 Quote–Driven/Negotiation Mode

In this mode, a dealer will be able to initiate a ‘chat’ or conversation with

all other dealers that use the Dealing platform. The Deals negotiated will
240 The Clearing Corporation of India

be captured as confirmed trades once acknowledged by both the parties.

This mode will be available for other currency pairs besides US$–INR.

4.2.4 Clearing and Settlement

CCIL will provide STP (Straight Through processing) for all trades in
US$–INR done on CCIL forex dealing platform. All deals concluded in
US$–INR currency pair on CCIL’s dealing platform will be taken up for
settlement by CCIL’s forex clearing segment. This will include deals on
both the order matching mode as well as the negotiation mode.

4.2.5 Risk Management

As stipulated for its existing forex clearing and settlement product, CCIL
will use the Net Exposure Limits (or NDCs) and the Loss Allocation Pro-
cedure as its risk management tools. While the system will freely allow
members to negotiate and complete trades, it will accept a trade for settle-
ment only if the net payables position resulting from the concerned mem-
ber’s trades up to that point in time (inclusive of the trade in question) is
within the NDC limit. If acceptance of a trade were to result in a viola-
tion of the NDC limit, the same will be kept in the queue until the cut-off
time for accepting trades for settlement by CCIL. Members will thus have
the benefit of straight-through processing without having to send deal con-
firmation files to their counter-parties or to CCIL, as they are currently
required to do, and all trades accepted on the dealing platform will have
CCIL’s guarantee for settlement.
Members can also set up bilateral limits for trading against its counter
members on the Dealing platform. If the orders match, trade will take place
for the quantity indicated, provided it is within the Bilateral Limit set by
the member on the counter-party and by the counter-party on the concerned
member.

4.3 Interest Rate Swaps

An Interest Rate Swap (IRS) is a financial contract between two parties
for exchanging streams of interest payments for a “Notional Principal
Amount” on multiple occasions during a specified period. A notional prin-
cipal amount is necessary in order to compute the two parties’ respective
 Derivatives Markets in India: 2003 241

interest payment obligations. (In single currency transactions, no exchange

of principal amount is needed.) Generally, IRS contracts involve exchang-
ing fixed-rate interest payments for floating-rate interest payments (on the
notional principal amounts), or vice–versa. On the designated payment
dates during the swap period, each party has to make the contracted cash
payments to the other. Although fixed-to-floating swap contracts with the
two interest streams being tied to two different benchmark rates (LIBOR
and CP/T-Bill rate, for instance, are also concluded.
Since issue of the RBI guidelines on FRA/IRS in July, 1999, activ-
ity and volume in one variant of the IRS, called Overnight Indexed Swap
(OIS), has gone up steadily. Although authoritative data are not available,
estimates provided by some market participants place the daily volume of
such swaps at between Rs.250 and Rs.300 crore. There are some 10-12
active participants in the market; these include both Indian and Foreign
banks.
In terms of the RBI guidelines, Scheduled Commercial Banks, Pri-
mary Dealers and All-India Financial Institutions, are allowed to under-
take FRAs/IRS for their own balance-sheet management and for market
making purposes. The guidelines allow banks/PDs/FIs to undertake only
plain vanilla FRA’s/IRS and place no restriction either on the size of “no-
tional principal” or the tenor of the contract. They may use any domestic
money or debt market rate as the benchmark rate, but must conform to cap-
ital adequacy norms and stipulate suitable prudential limits on their swaps
positions.
The guidelines stipulate different accounting norms for Hedge Swaps
and Trading Positions. Trading swaps are required to be marked to mar-
ket with changes recorded in the income statement. Income and expenses
relating to these swaps is to be recognized on the settlement date. The
fee earned or paid, and gains or losses on the termination of swaps, are
required to be recorded as immediate income or expenses.

5 Overnight Indexed Swaps (OIS)

In an OIS contact, the floating rate payment/receipt is linked to a bench-

mark, or index, rate such as NSE-MIBOR. There are several reasons why
participants would like to enter into such a contract, such as:
242 The Clearing Corporation of India

(a) Interest Rate Hedging – Undertaken with a view to reducing or elim-

inating interest rate risk in a portfolio.
(b) Management of Asset – Liability Mismatches: This is achieved by
transforming the interest payment liability from fixed rate to floating
rate or vice-versa.
(c) As a Cash Management Tool – It allows a market player to keep
deploying surplus funds in the liquid overnight market, even as the
interest rate risk is mitigated by locking into a term rate through OIS.
And
(d) Trading/Position Taking – based on one’s view of the future move-
ment of interest rates, a trader may, for instance, choose to borrow
overnight and invest longer term, with and OIS swap to transform
the payment liability form floating rate to fixed rate.
Feedback received from the market participant is that OIS market has
been steadily growing during the recent past. CCIL would take up at a later
date the clearing and settlement of OIS trades and developing a trading
platform for use by the members.
Currently, the deals are negotiated, as also settled, bilaterally between
the two contacting parties. There is very little role for brokers, since market
custom does not permit any brokerage to be paid. Yet, in the absence of any
trading platform, it is a telephone market. Interestingly, deals on account
of market making are the dominant variety in the OIS deals market, today.
That is to say, a large majority of the deals arise from position taking by
the players on their own account. The expectation in the marketplace is
that, as and when public sector banks join the fray, the trading volumes
will multiply manifold. FRA deals are few and far between.
It is obvious that the market will benefit from the proposed new prod-
ucts if CCIL takes up clearing and settlement of such transactions. These
advantages will be of two types:
O From the time a deal has been accepted for settlement, all procedures

leading up to final clearing and settlement will be CCIL’s responsi-

bility.
O With CCIL giving its guarantee for settlement of the trade on the due

date, members concerned will be able to free from the counter-party

exposure limit.
Intermediation