On October 1, 2024, the Securities and Exchange Board of India (SEBI) released a crucial circular aimed at enhancing the stress testing framework for the equity derivatives segment. This initiative is part of SEBI’s ongoing efforts to ensure the robustness and reliability of the financial system, particularly in light of evolving market dynamics. The circular, numbered SEBI/HO/MRD/MRD-PoD-2/P/CIR/2024/131, outlines new methodologies and guidelines designed to improve the determination of the corpus for the Core Settlement Guarantee Fund (Core SGF).
Background and Objectives
The circular builds upon previous directives established in SEBI's Master Circular No. SEBI/HO/MRD2/PoD-2/CIR/P/2023/171, which provided initial guidelines on assessing credit exposure for Clearing Corporations (CCs). Recognizing the changing landscape of equity derivatives, SEBI consulted with market participants and its Risk Management Review Committee to develop a more comprehensive approach to stress testing.
The primary objective of this revised framework is to better quantify potential losses under extreme market conditions and ensure that adequate financial resources are available to manage these risks. The new methodologies are intended to enhance the accuracy of credit risk assessments, thereby safeguarding investor interests and promoting market stability.
Key Changes in Stress Testing Methodologies
The circular introduces several new hypothetical stress testing scenarios that complement existing methodologies. These include:
1. Stressed VaR (Value at Risk): This approach utilizes a variance-covariance matrix from a designated stress period, doubling the observed volatility and employing Monte Carlo simulations to predict price movements.
2. Filtered Historic Simulation: This method adjusts historical data to reflect current volatility conditions, applying an Exponentially Weighted Moving Average (EWMA) to calculate volatility.
3. Factor Model: This model focuses on the highest three-day movements of the NIFTY index since 2000, adjusted by the beta of individual stocks to project price movements.
These methodologies aim to provide a deeper insight into tail risks and ensure that the Core SGF adequately covers potential losses in equity derivatives.
Adjustments to Core Settlement Guarantee Fund (Core SGF)
To accommodate the increased Minimum Required Corpus (MRC) stemming from the new stress testing methodologies, the circular allows for a one-time inter-segment transfer of funds between the Core SGFs of equity cash and equity derivatives segments. Specific criteria govern these transfers, ensuring that CCs maintain sufficient reserves while optimizing fund allocation based on historical performance metrics.
Additional Contributions and Staggered Framework
SEBI has mandated that CCs review their MRC monthly and adjust contributions accordingly. Contributors are required to bring in additional funds based on the highest average stress loss observed since January 2024. Subsequent contributions can be made in a staggered manner, allowing for flexibility while ensuring that MRC requirements are met.
Uniform Application and Categorization of Clearing Corporations
The stress testing methodologies will apply uniformly across all CCs, which will be categorized into two groups based on their share of clearing volumes. This categorization will dictate the calculation of credit exposure in case of simultaneous defaults among clearing members, ensuring a tailored approach to risk management.
Conclusion
SEBI's latest circular represents a significant step forward in fortifying the equity derivatives segment against market volatility. By updating the stress testing framework and enhancing the Core SGF's operational guidelines, SEBI aims to bolster the resilience of the Indian financial system. As market dynamics continue to evolve, such proactive measures are crucial for maintaining investor confidence and ensuring sustainable market growth.
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