Study Of Risk Management In Stock Broking Firm 11u2x

A Project Report On

“Study of Risk Management in Stock Broking Firm” For

“Pune Stock Exchange Securities Limited, Pune” By

“Mr. Prasad Dipak Deshmukh”

Under the guidance of

“Dr. Yashwant Vaishampayan”

Submitted to

“University of Pune” In partial fulfillment of the requirement for the award of the degree of Master of Business istration (MBA) 2007-2009

Through

Vishwakarma Institute of Management Pune-48.

1

ACKNOWLEDGEMENT

It gives me great pleasure to express my sincere gratitude towards all the individuals who have directly or indirectly helped me in completing the project. First of all I am extremely grateful to Mrs. Nihali Mitra, M.D. Pune Stock Exchange Ltd. for providing me an opportunity to work with such an esteemed organization. I feel immense pleasure to thank Mrs. Archana Gorhe, Officiating C.E.O., PSE Securities Ltd. and Ms. Darshana Deshpande, Senior Manager, PSE Securities Ltd.

.

I would also like to express my sincere thanks to Dr. Sharad L. Joshi,

Director, Vishwakarma Institute of Management, Prof. Shailesh Kasande, Executive Director, Vishwakarma Institute of Management and my project guide Dr. Yashwant Vaishampayan for providing valuable guidance and inputs which helped a lot for the completion of project in a true sense.

I would also like to thank the whole staff of PSE Securities Ltd., my parents and all my friends for their kind co-operation and .

Prasad Dipak Deshmukh

2

CERTIFICATE

This is to certify that Mr. Prasad Dipak Deshmukh has completed the Summer Project Titled “Study of Risk Management in Stock Broking Firm” to my satisfaction and as per the requirements of the two year full-time MBA programme.

Project Guide

Director

Date:

3

INDEX

Sr. No.

Title

Page Number

I

Executive Summary

1

II

Company Profile

3

III

Objectives of the Study

7

IV

Research Methodology

8

V

Data Analysis

9

VI

Findings

60

VII

Suggestions and Conclusion

62

VIII

Limitations

65

Bibliography

66

IX

4

EXECUTIVE SUMMARY

Title of the Project: Study of Risk Management in Stock Broking Firm. Duration of the Project: 2nd June 2008 to 2nd August 2008.

The capital market in India is an emerging market with a great potential. Indian capital market has got a strong foundation and therefore has gained a confidence of Indian investors as well as Foreign Institutional Investors. In India there are two Stock Exchanges (National Stock Exchange and Bombay Stock Exchange) through which securities are traded. Stock exchange is a body formed for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities.

An investor has to trade in stock market through a ed stock broker. A stock broker is a member of a recognized stock exchange who is permitted to do trades on the floor of the exchange. „Study of Risk Management in Stock Broking Firm‟ the title, shows that the project revolves around the risks managed by Stock Brokers while handling their Sub brokers, branches, franchisees and investors. The study was carried out in PSE Securities Ltd., Pune during the period of 2nd June 2008 to 2nd August 2008. Risk can be defined as„Risk is the possibility of happening uncertain events.‟ Risk is the chance of happening of something that may affect the desired results. Therefore, the concept of Risk Management comes into picture.

5

Risk Management can be defined as„Risk Management is the structured approach towards managing the uncertainties.‟ Risk Management involves risk identification and risk assessment. Further to avoid the unpredictable outcomes arising out of risk, the risk can be avoided, reduced or transferred. However, best possible solution has to be chosen to tackle the risk.

Risk can be broadly categorized as Systematic Risks and Unsystematic Risks. Risk and uncertainty go together. However, risk and return have a direct relationship, higher the risk, higher the chances of good return and vice versa. In stock broking industry risks are high due to the volatility of the market. The risk may cause due to its sub brokers, branches, investor clients etc. There are uncertainties about payments from clients or from clients to sub brokers and then sub brokers to the broker. The high volatility of the market may cause the clients or sub brokers not to make payments in specified time. Thus brokers are always exposed to market risks, financial risks, credit risks, liquidity risk and operational risks. To cope up with such events brokers have to collect certain amount of margins and maintain the same with the exchange.

To manage such risks Value at Risk margin, Mark to Market margin and extreme loss margin is maintained. Also, the brokers are allowed intra day turnover and gross exposure limits. Brokers have to maintain minimum base capital and additional base capital with the exchange. Exchanges, SEBI and NSCCL have taken steps like KYC, continuous surveillance, mandatory audit etc. Thus, every

6

broking firm has Risk Management department. In PSE Securities Ltd., there is a surveillance department to deal with the risk management activities.

COMPANY PROFILE

PSE Securities Limited History Pune Stock Exchange Securities Ltd. is located at Shivleela Chambers, 752, Sadashiv Peth, R.B. Kumthekar Road, Pune-411030. It was founded in the year 1999 and is a subsidiary company of Pune Stock Exchange Ltd. PSE Securities Ltd. is a leading Stock Broking Firm, member of NSE and BSE and also a Depository Participant of CDSL. It commenced Live Trading in the BSE Cash Segment from 15th March 2004 and commenced depository operations with Central Depository Services (I) LTD. from 16th Dec. 2003.

The company is also a CDSL Depository Participant and it witnessed an increase in the handling of approximately 5600 Beneficiary s in the previous year to 8400+ s this year.

PSE Securities Ltd. has the largest turnover in the cash market segment in Pune. However the management still feels the need to generate more operational income through Brokerage.

Founders and Promoters The founders and promoters of PSE Securities Ltd. are the of Pune Stock Exchange Ltd. All the of Pune Stock Exchange Ltd. came 7

together and formed PSE Securities Ltd. According to the Articles of Association of company and SEBI, only the of the Pune Stock Exchange Ltd. which is the parent company can as sub broker of PSE Securities Ltd. Hence all the present sub brokers of PSE Securities Ltd. are the of Pune Stock Exchange Ltd. There are total 152 sub brokers of PSE Securities Ltd.

Board of Directors Dr. Sharad L. Joshi

-

Chairman & PR Director

Mr. Mahesh Athavale

-

PR Director

Me. Shaukat Merchant

-

PR Director

Mr. Shailendra Shah

-

Broker/Member Director

Mr. Arvind R. Shah

-

Broker/Member Director

Mr. Rajendra Nahar

-

Nominee Director-Pune Stock Exchange Ltd.

Products The main business of the company is to provide a platform for trading in securities market with the help of Stock Broking and Depository Services. PSE Securities Ltd. has cash segment hip of the Bombay Stock Exchange and National Stock Exchange and also is a depository participant of Central Depository Services Limited.

Competitors Though the company deals in the cash segment only, it has to face competition from following organizations. 

Motilal Oswal

8



India Infoline



Sharekhan



Anand Rathi



Indiabulls



Religare



Angel Broking



Karvy Consultancy

Financial Data The Authorized Capital of the company is Rs.7,80,00,000 divided into 390 equity shares or Rs. 2,00,000 each. The paid up capital is Rs.7,06,00,000 divided into 353 equity shares or Rs. 2,00,000 each.

During the Financial Year 2007 – 2008, the total turnover of dealings through BSE and NSE was Rs. 7451 Crores (Rs. 2885 Crores was delivery turnover and Rs. 4556 was non delivery turnover).

The Profit before Taxes of PSE Securities Ltd. during the year was Rs. 494.80 Lacs of which Rs. 401.32 Lacs has been earned by way of Brokerage and Rs. 67.52 Lacs by way of interest on fixed deposits and short term deployment of funds. The Net profit for the year was Rs. 367.04 Lacs.

9

Organization Chart

New Projects This year the company proposes to issue 25 equity shares to persons other than existing share holders thus increase the number of sub brokers from 152 to 177.

10

OBJECTIVES OF THE STUDY

Background The stock prices in Indian capital market change very rapidly. It results into high volatility in the market. Therefore, the brokers are always at a risk that investors may not pay in the securities or funds due to increase or decrease in the prices of shares. In the securities market the liquidity risks, financial risks and operational risks also create hurdles in the smooth running of broking firm.

Need Therefore, to tackle these situations need for risk management in stock broking firm arises. To reduce such risks broking firms have risk management or surveillance departments, which monitors the day to day activities of its sub brokers and investors. Thus, this study is carried out to understand the measures taken to reduce the risks at brokers‟ end and the objectives of the study are as follows. 

Introduction to Capital Market.



To get familiar with the working of broking firm.



To understand the concept and types of risk.



To find out the risks involved in stock broking firm.



To study the measures to reduce the risk.

11

RESEARCH METHODOLOGY

During the project, the necessary inputs taken were primary as well as secondary. The primary data collection and secondary data collection form an integral part of the study. They are explained as below. 

Primary Data Primary data is the one which is collected specifically for the purpose

of the project, and can be obtained from various people working in the organization. For this study the primary data was collected from following sources.



»

Discussion with Surveillance department officers.

»

Discussion with manager.

»

Discussion with sub brokers.

»

Discussion with employees of the organization.

Secondary Data Secondary data is the one which is not specifically collected for a

certain work. It is a data collected by somebody else for their own purposes. However, it plays a significant role in the project. For this study the secondary data was collected from the following sources. »

Books related to risk management and capital market.

»

Magazines related to the stock market.

»

Websites related to risk management and stock market.

12

DATA ANALYSIS Capital Markets The capital markets deal in financial assets, which comprise shares, debentures, mutual funds, insurance policies, bank s, pension funds, provident funds and other securities. A capital market deals in financial assets, excluding coins and currency. Capital market is a market for long-term debt and equity shares. In this market, the capital funds comprising of both equity and debt are issued and traded.

Transfer of resources from those with idle resources to others who have a productive need for them is perhaps most efficiently achieved through the Capital Markets. They provide channels for reallocation of savings to investments and entrepreneurship and thereby decouple these two activities. As a result, the savers and investors are not constrained by their individual abilities, but by the economy‟s abilities to invest and save respectively, which inevitably enhances savings and investment in the economy. It is not that the s and suppliers of funds meet each other and exchange funds for securities. It is difficult to accomplish such double coincidence of wants. The amount of funds supplied by the supplier may not be the amount needed by the . Thus, there are intermediaries who may act as agents to match the needs of s and suppliers of funds for a commission. In this way, the Capital market moves the money of investors who have a surplus to the entrepreneurs who needs it with the help of intermediaries.

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The capital market in a country is very valuable indicator of its soundness. Capital markets are evaluated while judging the performance of any economy. Every decision or event related to economy of the country is reflected and influenced by the capital market thus; it carries a huge weightage for the economic development of any country.

Indian Capital Market – An Overview Indian Stock Markets are one of the oldest in Asia. Its history dates back to nearly 200 years ago. The East India Company was perhaps the most dominant and powerful institution in those days and business in its loan securities used to be transacted in an unorganized for at Bombay and Calcutta in early Nineteenth century. Later on the business on corporate stocks and shares in bank and cotton presses took place in Bombay and gradually the number of companies listed increased from 1125 in 1946 to 8593 in 1995.

The tail of Twentieth Century made the Indian Capital Market change drastically. During 1990‟s with the introduction of computers, Indian Market started prospering. On line trading, transparency, strict surveillance, depository system, investor protection and regulations were some of the key activities which reflected the growth of the Indian Capital Market. With the Dematerialization of shares and introduction of SEBI (Securities and Exchange Board of India) Indian Capital market provided protection to its investors.

With the liberal policy of India and investments of Foreign Institutional Investors, the confidence of investors is increased to a great extent. In

14

January 2008 the BSE Sensex touched the 21000 points, which is the highest up till now.

SEBI Act (Securities and Exchange Board of India Act), 1992 The Act had its origin during the war in 1943 when the objective was to channel resources to the war effort. It was retained with some changes as a means of controlling the raising of capital by companies and to ensure that national resources were channeled into proper lines, i.e., for desirable purposes to serve goals and priorities of the government, and to protect the interests of investors. Under the Act, any firm wishing to issue securities had to obtain approval from the Central Government, which also determined the amount, type and price of the issue.

As a part of the liberalization process, the Act was repealed in May 1992 paving way for market determined allocation of resources. To ensure effective regulation of the market, SEBI Act, 1992 was enacted in establish SEBI with statutory powers for (a) protecting the interests of investors in securities, (b) promoting the development of the securities market, and (c) regulating the securities market. It can conduct enquiries, audits and inspection of all concerned and adjudicate offences under the Act. It has powers to and regulate all market intermediaries and also to penalize them in case of violations of the provisions of the Act. SEBI has full autonomy and authority to regulate and develop and orderly securities market.

Market Segments A) Primary Market

15

The primary market provides the channel for sale of new securities. Primary market provides opportunity to issuers of securities, Government as well as corporates, to raise resources to meet their requirements of investment and/or discharge some obligation. In this market the securities are offered for subscription for the purpose of raising capital or fund. The investors and the company come into direct in the primary market. The entrepreneurs or corporates as well as Government may issue the securities at face value, or at as discount / and these securities may take a variety of forms such as equity, debt etc. They may issue the securities in domestic and/or international market.

(B) Secondary Market Secondary Market refers to a market where securities are traded after being initially offered to public in the primary market and/or listed on the Stock Exchange. Majority of the trading is done in the secondary market. This market comprises of equity markets and the debt markets.

For the general investor, the secondary market provides an efficient platform for trading of securities. For the management of the company, secondary equity markets serve as a monitoring and control conduit-by facilitating valueenhancing control activities, enabling implementation of incentive-based management contracts, and aggregating information (via price discovery) that guides management decisions.

Stock Exchange

16

As seen earlier, securities are traded or exchanged in secondary market. A Stock Exchange is an organized platform where securities are traded or exchanged. Securities are defined as any monetary claims and include stock, shares, debentures, bonds etc. Under the Securities Contract Regulation Act, 1956, securities trading are regulated by the Central Govt. and such trading can take place only in Stock Exchanges recognized by the Govt. under this Act. At present there are 23 such recognized Stock Exchanges in India. Of these, major Stock Exchanges are Bombay, Kolkata, Delhi, Chennai etc. As per the Act, trading in securities permitted to be traded would be in normal trading hours (09:55 A.M. to 03:30 P.M on working days). National Stock Exchange (NSE) The National Stock Exchange (NSE) is India‟s leading stock exchange covering various cities and towns across the country. NSE was set up in November 1992 with an equity capital of Rs. 25 crores by leading institutions to provide a modern, fully automated screen-based trading system with national reach. The Exchange has brought about unparalleled transparency, speed & efficiency, safety and market integrity and its index NIFTY has got worldwide recognition.

NSE has played a catalytic role in reforming the Indian securities market in of microstructure, market practices and trading volumes. The market today uses state-of-art information technology to provide an efficient and transparent trading, clearing and settlement mechanism, and has witnessed several innovations in products & services viz. demutualization of stock exchange governance, screen based trading, professionalism of trading , fine-tuned risk management systems, emergence of clearing corporations to assume counter party risks, market of debt and derivative instruments and intensive use of information technology. IDBI & other

17

financial institution with paid equity capital of Rs. 25 cores set up NSE. It started operation in Wholesale debt market in June 1994 & in equity, in Nov 1994. Bombay Stock Exchange (BSE) Bombay Stock Exchange Limited is the oldest stock exchange in Asia with a rich heritage. Popularly known as „BSE‟, it was established as „The Native Share & Stock Brokers Association‟ in 1875. It is the first stock exchange in country to obtain permanent recognition in 1956 from the Government of India under the Securities Contracts (Regulation) Act, 1956. The Exchange‟s pivotal and pre-eminent role in the development of the Indian capital market is widely recognized and its index, SENSEX, is tracked worldwide. The Exchange has a nation-wide reach with a presence in 417 cities and towns of India. The systems and processes of the Exchange are designed to safeguard market integrity and enhance transparency in operations. The Exchange provides an efficient and transparent market for trading in equity, debt instruments and derivatives. The BSE On Line Trading System (BOLT) is a proprietary system of the Exchange and is BS 7799-2-2002 certified. The surveillance and clearing and settlement functions of the Exchange are ISO 9001:2000 certified. Regional Stock Exchanges (RSEs) There are 23 stock exchanges in India. Among them two are national level stock exchanges namely Bombay Stock Exchange (BSE) and National Stock Exchange of India (NSE). The rest 21 are Regional Stock Exchanges (RSE). The Regional Stock Exchanges started clustering from the year 1894, when the first RSE, the Ahmedabad Stock Exchange (ASE) was established. In the year 1908, the second in

the

series,

Calcutta

Stock

Exchange

(CSE)

came

into

existence.

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During the early sixties, there were only few recognized RSEs in India namely Calcutta, Madras, Ahmedabad, Delhi, Hyderabad and Indore. The number remained unchanged for the next two decades. 1980s was the turning point and many RSEs were incorporated. The latest is Coimbatore Stock Exchange and Meerut Stock Exchange.

Stock Broker The Stock Broker is a member of a recognized stock exchange, who is permitted to do trades on the floor of the exchange. A broker is an intermediary who arranges to buy and sell securities on behalf of clients (the buyer and the seller). According to Rule 2 (e) of SEBI (Stock Brokers and Sub brokers) Rules, 1992, a stock broker means a member of a recognized stock exchange. No stockbroker is allowed to buy, sell or deal in securities, unless he or she holds a certificate of registration granted by SEBI.

No investor can invest in the stock market directly, they have to themselves with a ed broker of recognized stock exchange. The broker then trades in securities on behalf of its investors.

Sub broker A Sub broker is a person who intermediates between investors and stock brokers. He acts on behalf of a stock broker as an agent or otherwise for assisting the investors for buying, selling or dealing in securities through such stock broker. No sub broker is allowed to buy, sell or deal in securities, unless he or she holds a certificate of registration granted by SEBI. A sub broker may take the form of

19

a sole proprietorship, a partnership firm or a company. Stock brokers of the recognized stock exchange are permitted to transact with sub brokers.

Depository A depository is an organization which holds securities of investor in electronic form at the request of the investor through a ed Depository Participant. It also provides services related to transactions in securities. Depository transfers securities between s on the instructions given by the holder. The fear of loosing of securities is removed through depository as it facilitates safekeeping of shares. It transfers the ownership of the securities without having to handle the securities.

Depositories in India There are two depositories in India. 1. National Securities Depository Limited (NSDL) 2. Central Depository Services Limited (CDSL)

Depository Participant A Depository Participant (DP) is an agent of the depository through which it interfaces with the investor. A DP can offer depository services only after it gets proper registration from SEBI. A Depository can be compared with a bank, like wise a DP may be compared with a branch of a bank. Presently there are approximately 390 DPs are ed with SEBI. To avail the services of a depository an investor has to open an with any of the depository participant of any depository.

Dematerialization 20

Dematerialization is the process by which physical certificates of an investor are converted to an equivalent number of securities in electronic form and credited to the investor‟s with his Depository Participant (DP).

Working of Stock Broking Firm

Stock Broker As seen earlier, According to Rule 2 (e) of SEBI (Stock Brokers and Sub brokers) Rules, 1992, a Stock Broker means a ed member of a recognized stock exchange. A broker is an intermediary who arranges to buy and sell securities on behalf of clients (the buyer and the seller). No stockbroker is allowed to buy, sell or deal in securities, unless he or she holds a certificate of registration granted by SEBI. The constitution of a broking firm may be a Proprietary Concern, a Partnership firm or a Corporate.

Departments in Stock Broking Firm (A) Central Depository Services Ltd (CDSL) Department

CDSL Department

Demat Opening

Dematerialization &

Transmission

Settlement

Rematerialization

& Nomination

of Trade

21

The CDSL department performs the above stated functions. An investor has to first open an with the DP in order to hold the securities in a dematerialized form. An investor can open an with any DP of CDSL or NSDL. The CDSL department also converts the physical shares into demat form and also shares in demat form into physical share certificate. The activities like transmission and nomination and trade settlement are also done at CDSL department. Importance of Demat 

Demat is a safe and convenient way to hold the securities as compared to holding them in physical form.



No stamp duty is levied on transfer of securities held in demat form.



Change of name, address, registration of power of attorney, deletion of deceased name etc. can be effected across companies by one single instruction to the DP.



It eliminates thefts, deface, delays, and subsequent misuse of the certificates.



Any number of securities can be transferred and delivered with one delivery order. Therefore heavy paperwork and headache of g multiple transfer forms is eliminated.

(1) Demat Opening The CDSL department performs the basic function of demat opening. To hold the securities an investor has to open the demat with any of the DP of either Central Depository Services Ltd. or National Securities Depository Limited. It is mandatory of open a demat with any of the DP in order to hold the securities in an electronic form.

22

To open a demat client has to submit identity proof, address proof, PAN Card, statement of bank , cheque and two latest photographs. Absence of any of the above document create hurdles in the procedure of demat opening. (2) Dematerialization and Rematerialization

(a) Dematerialization Dematerialization is the process in which the physical form of holding securities is replaced with electronic (book-entry) form of holding. Shares in demat form do not bear any distinguishable feature like distinctive number, certificate number. Each security is identified in depository system by ISIN (International Securities Identification number).

To convert the physical shares certificates in the dematerialized form, an investor has to submit the DRF (Dematerialization Request Form) along with the shares certificate. DP enters the DRF in its system and dispatches the Physical certificates along with the DRF to the R&T agent. R&T agent, on receiving the physical documents and the electronic request verifies them. Once the R&T agent is satisfied, dematerialization of the concerned securities is electronically confirmed to the Depository. Depository credits the dematerialized securities to the beneficiary of the investor and intimates the DP electronically. The DP issues a statement of transaction to the client.

(b) Rematerialization

23

Rematerialization is exactly opposite of dematerialization. It refers to the process of converting the shares held in electronic form with a DP into the physical shares certificate. Under this process the depository of a beneficial owner is debited for the securities sought to be rematerialized and physical share certificates for the equivalent number of securities issued. To convert the shares in dematerialized form into physical form, a client has to submit the RRF (Rematerialization Request Form) with its DP. DP checks all the details of RRF and also verifies that client has a sufficient balance of shares in his . RRF is then entered in the system. DP sends it to the R & T agent for further procedure. R & T agent scrutinizes of shares and after being satisfied a certificate is issued to respective DP which is later ed on to the client.

(3) Transmission and Nomination

(a) Transmission The Companies Act 1956 distinguishes Transmission of shares from transfer of shares. Transfer of shares relates to a voluntary act of the shareholder while Transmission is brought about by the operation of law. The word “Transmission” means devolution of title to shares. Such kind of transmission takes place due to devolution by death, succession, inheritance, bankruptcy, and marriage etc. The person on whom the shares devolve has to prove his entitlement by submitting appropriate documents and seek transmission. If the securities are held in the depository system, documents have to be submitted to the DP. If the securities are held in physical form, the documents have to be sent to the company for effective transmission of shares.

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(b) Nomination The Companies (Amendment) Act 1999 has introduced provisions for nomination in respect of shares, Debentures, Fixed Deposits etc. Under the provision the security holder can nominate a person in whom the shares, debentures, bonds or deposits would vest, in the event of original investor‟s death. If the shares are held tly, all the t holders are required to sign the nomination form. A holder can even nominate a minor, represented by one of the parents or guardian. However, Trusts, Societies, Body Corporate, Partnership Firms, Kartas‟ of Hindu Undivided Family, or Power of Attorney holder cannot be appointed as nominee.

(4) Settlement of Trade One of the basic services provided by the Depository is to facilitate transfer of securities from one to another on the instruction of the holder. Transfer of securities from one to another may be done for any of the following purposes. 

Transfer due to a transaction done on a person-to-person basis.



Transfer arising out of transaction done on a stock exchange.



Transfer arising out of transmission and closure.

(B) Compliance Department Compliance Department

25

Reg. Of Client

Individual

Reg. of Sub Broker

Non-individual

t Stock Co.

Partnership firm

Sole Proprietor

The main function of the compliance department is to open a trading of clients and registration of sub brokers and franchisees. As a client has to open demat to hold the securities, a trading is opened to trade into securities. Such enables the client to trade in the securities held in the demat . Such is opened with the ed member broker.

The compliance department has to comply with the rules and regulations of SEBI while opening of clients and ing the sub brokers. An individual client has to submit identity proof, address proof, PAN card, broker client agreement on stamp paper along with application form. In case of non individuals t Stock Company, Partnership Firm or Sole Proprietor the documents required are application form, broker client agreement, certified copy of Articles and Memorandum of Association, certified copy of resolution to open , bank certifying letter whichever is applicable.

While ing for sub broker compliance department has to comply with the criteria laid down by the SEBI. The applicant should not be less than 21 years of age, he should have at least ed HSC exam, he should not be convicted to any offence involving fraud or dishonesty etc. An application for the grant of certificate shall be made in form B, application shall be accompanied by a

26

recommendation letter from a stock broker of recognized stock exchange with whom he is d to along with two references including one from his banker. The stock exchange on receipt of application shall the information contained and then shall also certify that the applicant is eligible for registration.

(C) Dealing Department Dealing Department

Buying Securities

Selling Securities

Entering

Order

Order

Order

Orders

Modification

Cancellation

Matching

The most basic and important function of stock broking firm i.e. buying and selling of securities on behalf of its clients is performed by the Dealing Department. The employees who carry out this function are known as dealers. Dealer is the person who performs the function of buying and selling of securities of securities for clients. The clients have to inform the dealer to buy or sell securities who then enters the order in the system. Generally, the ODIN software is used for such purposes. The functions carried out at dealing department are explained below in detail.

27

Entering Order The trading member can enter orders in the normal market during the trading hours. When an order enters the trading system it is an active order, it tries to find out on the other side of the books if it finds the match, trade is generated. If it does not find a match, the order becomes ive order and appears in the order book.

Order Modification All orders can be modified in the system till the time they do not get executed and only during the market hours. Once an order is modified, the branch order values limit for the branch and get adjusted automatically. Order Cancellation Order cancellation functionality can be performed only for orders which have not been fully or partially executed (for the unexecuted part of partially traded orders only) and only during the market hours. Order Matching The buy and sell orders are matched on book type, symbol, series, quantity and price. The best sell order is the order with lowest price and best buy order is the order with highest price. The unmatched orders are queued in the system by the following priority.

(D) Settlement Department Settlement Department

28

Pay In Of

Pay Out Of

Pay In

Pay Out

Securities

Securities

Of Funds

Of Funds

Settlement department performs the back office function i.e. settling of trades that takes place every day. This settling is done under „T+2‟ rolling settlement system. NSE/BSE provides a platform for trading to its trading ; the National Securities Clearing Corporation LTD (NSCCL) determines the funds/securities obligation of the trading and ensures that trading meet their obligations. The clearing banks and depositories provide the necessary interface between the custodians and clearing (who clear for trading or their own transactions) for settlement of funds/securities obligation of trading . Rolling Settlement Under Rolling settlement all the trades executed on a trading day are settled X days later this is called „T+X‟ rolling settlement where „T‟ is the trade date and „X‟ is the number of working days after trade date in which settlement takes place. The rolling settlement has started in T+5 bases in India, now it is T+2. Pay In Of Securities and Funds The bring in their securities/funds to the NSCCL; they make available required securities in designated s with the depositories by the prescribed pay in time. If they fail to do so the securities go for auction. Pay Out Of Securities and Funds NSCCL sends electronic instructions to the depositories/clearing banks to release pay out of securities/funds. These securities/funds reach to the respective . This settlement is based on rolling system which is T+2 days.

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(E) Risk Management Department / Surveillance Department Risk Management Department

Capital

On Line

Off Line

Margin

Circuit

Adequacy

Monitoring

Monitoring

Requirements

Filters

A sound risk management system is integral to an efficient clearing and settlement system. The NSCCL ensures that trading ‟ obligations are commensurate with their net worth. It monitors the track record and performance of and their net worth, undertakes on-line monitoring of ‟ positions and exposure with the market collects margins from and automatically disables if the limits are breached. Thus, in order to keep a continuous check on market risk management department performs the following functions. Capital Adequacy The stock exchanges mention their own capital adequacy requirements. The have to pay Base Minimum Capital and Additional Base Capital. Base minimum capital of the member is taken to determine the member‟s intra-day trading limit and/or gross exposure limit only whereas the amount provided as additional capital is allowed to be utilized towards margin payment if not used up for taking exposure/turnover. On-line Monitoring NSCCL has put in place an online monitoring and surveillance system whereby exposure of the is monitored on a real time basis. A system of alerts has been built in so that both the member and NSCCL are alerted as per pre-set levels (reaching 70%, 85%, 90%, and 100%) when the approach their

30

allowable limits. It enables to further check the micro-details of ‟ positions, if required and take pro-active action. Off-line Monitoring Off-Line surveillance activity Consists of inspection and investigations as per regulatory requirement a minimum of 10% of the active trading are to be inspected every year to the level of compliance with various rules, bye laws and regulations of the exchange. Generally, inspection of more than the regulatory requirement is undertaken every year. It also verifies if investor interests are being compromised in the conduct of business by the . Margin Requirements As per SEBI directive, in T+2 rolling settlement, all stock exchanges have imposed stringent margin requirements as a part of their risk containment measures. The daily margin in rolling settlement comprises of Value at Risk - based Margin (VaR Margin) and Mark to Market margin (MTM Margin). Margins are computed at client level. A member entering an order needs to enter the client code. Based on this information margin is computed at the client level which will be payable by the trading member on T+1 basis. Circuit Filters An index based market wide circuit breakers system applies at three stages of the index movement either way at 10%, 15%, and 20%. These circuit breakers bring about a coordinated trading halt in all equity derivatives market nationwide. These breakers are triggered by movement of either S&P CNX Nifty or Sensex whichever is breached earlier. As an additional measure of safety, individual scrip – wise price bands of 20% for all scrips and 10% for scrips for which derivative

31

products are available or those included in indices on which derivative are available, have been imposed.

Risk Risk has been known to man ever since he first faced adversity. It is an integral part of the evolution of man. Risk has been encountered primarily in his physical environment, later on in his social environment. With time, risk has evolved along with man. The main risk man faced was an attack by animals. This risk was mitigated by the discovery of fire. Here also risk is mitigated not eliminated. From that time to the twenty first century man has faced n number of risks. Whether it is walking on the road or flying in the plane, buying the video game or a bunglow every person is exposed to the risk involved in the situation. Risk can be defined as„Risk is the possibility of happening uncertain events.‟ Risk is the chance of happening of something that may affect the desired results.

Risk exists if there is something you don‟t want to happen – having a chance to happen. The risk can also be explained as a probability that some event will cause an undesirable outcome on the financial health of your business and/or other business/family goals. In the same way risk is involved in the investments also. All investments are risky, whether in stock, capital market, banking, financial sector, real

32

estate, bullion, gold etc. The degree of risk however varies on the basis of the features of the assets, investments instrument, the mode of investment, time frame or the issuer of the security etc. However, the risk and return goes hand in hand. Higher the risk, higher is the possibility of better returns and vice versa. Thus, the degree of risk plays a vital role in any kind of investment.

Types of Risk Risks are broadly divided into 2 categories. Risk

Systematic Risk

Unsystematic Risk

(1) Systematic Risk Systematic risks are out of external and uncontrollable factors, arising out of the market, nature of the industry and the state of the economy and a host of other factors. The examples of systematic risk are as follows. (a) Market Risk This arises out of changes in demand and supply pressures in the markets, following the changing flow of information or expectations. The market risks also arise due to ups and downs in the prices of securities. The economic changes affect the prices of securities to go up or down, and make the market more volatile. The totality of investor perception and subjective factors influence the events in the market which are unpredictable and give rise to risk, which is not controllable.

33

(b) Interest Rate Risk The return on an investment depends on the interest rate promised on it and changes in market rates of interest from time to time. The cost of funds borrowed by companies or stockbrokers depends on interest rates. These interest rates depend on nature of instruments, stocks, bonds, loans etc., maturity of the periods and the creditworthiness of the issuer of securities.

(c) Purchasing Power Risk Inflation or rise in prices lead to rise in costs of production, lower margins, wage rises and profit squeezing etc. The return expected by investors will change due to change in real value of return. The element of purchasing power risk is inherent in all investments and cannot be controlled.

(2) Unsystematic Risk Unsystematic risks emerge out of the known and controllable factors, internal to the issuer of the securities or companies. The examples of unsystematic risk are as follows. (a) Business Risk Business risk relates to the variability of the business, sales, income, profits etc., while in turn depend on the market conditions for the product mix, input supplies, and strength of competitors. It is sometimes external to company due to changes in Govt. policy or strategies of competitors etc. It may internal due to labour problems, raw material problems, fall in production etc. (b) Financial Risk

34

Financial risk relates to the method of financing, adopted by the company, high leverage leading to larger debt servicing problems or short-term liquidity problems due to bad debts, delayed receivables and fall in current assets or rise in current liabilities. Proper financial planning and other financial adjustments can be used to correct this risk and as such it is controllable. (c) Default or Insolvency Risk The borrower or issuer of securities may become insolvent or may default, or delay the payments due, such as interest installments or principal repayments. The borrower, in extreme cases, may get bankrupt in short span of time, may be due to mistakes of management. In such cases, the investor may get no return or negative returns. Risk vs. Return The risk and return go hand in hand. They have a direct relationship. Higher the risk, higher is the possibility of better returns and lower the risk, lower is the possibility of better returns. Investors‟ personality, lifestyle, and their financial position play a big role on how much risk they can comfortably bear. The risk/return tradeoff is the balance, an investor must decide on between the desires for the lowest possible risk for the highest possible returns. It is important to keep in mind that low levels of uncertainty (low risks) are associated with low potential return and high levels of uncertainty (high risks) are associated with high potential returns.

The diagram given below explains the relationship between the risk and return. As the risk increases the probability of getting higher returns also increases and vice versa.

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RISK/ RETURN TRADEOFF

Returns

Low Risk

Higher Risk

Low Return

High Return

Risk Different securities have different degrees of risk. Insurance is the safest mode of investment, whereas there is very high risk in equity. The below diagram shows the degree of risk contained in various investments.

* Equity * Mutual Funds Rewards

* Debentures * Fixed Deposits * Post Office Certificates * Bank Deposits * Insurance Schemes Risk Taken By Investor

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Risks involved in a Stock Broking Firm A stock broker has to deal with various risks while dealing with its sub brokers, clients etc. Due to the high volatility of the market broker is always exposed to the risks. The various risks borne by a broker can be classified as under.

Risks in broking firms

Market

Financial

Credit

Liquidity

Operational

Risks

Risks

Risks

Risks

Risks

(1) Market Risks Market risks are the risks which cause due to the high volatility of market and value of scrips. These risks arise due to adverse market rate movements i.e. foreign exchange rate, interest rates, commodity prices and equity prices. The value of investments may decline over a given time period simply because of

37

economic changes or other events that impact large portions of the market. Proper asset allocation and diversification can protect against market risk.

(2) Financial Risks Financial risk is the risk that a company will not have adequate cash flow to meet the financial obligations. Financial risk means fear of loss of money, which is the biggest risk faced by a broking firm. Financial risk in respect of broking firm can be of two types firstly loss of income i.e. brokerage secondly loss of capital. It has a risk that it will go out of funds because of non payment by the clients, sub brokers etc.

(3) Credit Risks Credit risk is the risk that the counter party of financial transaction will fail to perform according to the and conditions of the contract, thus causing the other party to suffer a financial loss. Credit risk is the risk of loss due to a debtor's non-payment of a loan or non fulfillment of and conditions of contract. Credit risk is often due to bankruptcy or insolvency of the counter party which results in non payment of dues.

(4) Liquidity Risk Liquidity risk is a risk which arises from the difficulty of selling an asset and realizing the money of it. Market liquidity is the risk that a financial instrument cannot be sold quickly at a price, which equates to their market value. An investment may sometimes need to be sold quickly. Unfortunately, an insufficient secondary market may prevent the liquidation or limit the funds that can be generated from the asset. Some assets are highly liquid and have low liquidity risk (such as stock of a publicly traded company), while other assets are highly illiquid and have high liquidity risk (such as a house).

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(5) Operational Risks Operational risks are explained as Risk of loss arising due to procedure errors, omission or failure of internal control system. These risks are defined as „The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.‟ An operational risk is a risk arising from execution of a company's business functions. As such, it is a very broad concept including fraud risks, legal risks, physical or environmental risks, etc. Operational risks are very common risks, which are found almost in every organization. All the organizations face the risks that their activities and processes may be disrupted unexpectedly or fail and this will stop the functioning of organization. Such events may cause an organization certain problems like

Direct financial losses, which arise from failing to meet an obligation (e.g. penalty interest payments or restitution loss).



Direct financial losses, attributable to an absence of income (e.g. loss of sales, transaction fees, direct fees or commission)



Statutory or regulatory penalties resulting to revocation of licenses.



Opportunity costs, arising from adverse publicity, being unable to trade or because of processing delays, backlogs, and poor customer service delivery or poor product or service quality.

In stock broking firms the operational risks are found at various levels of departments. They are as follows. Operational Risks

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CDSL

Compliance

Dealing

Department

Department

Department

Settlement

Risk Management

Department

Department

(a) CDSL Department Following are the risks involved in CDSL department. 

Failure in receipt of transaction slip.



Wrong entry of DRF and RRF.



Punching error.



Networking problem with the exchange.



Failures in maintaining records for demat and remat .

Effects CDSL department directly deals with the clients. If services are not provided properly to the clients, it may mar the reputation of the broker. If transaction slip is not received, it will result in the problems with recording the transaction. The errors in entering the details of DRF and RRF will cause problems to security holder. Errors in CDSL department will directly affect the clients and this may cause a bad client broker relationship. (b) Compliance Department Following are the risks involved in compliance department. 

Non-eligibility of the applicant.



Non-compliance of various agreements and forms.



Absence of bank certification.



Absence of identity proof.



Absence of reference letter from chartered ant.

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

Absence of undertaking from sub broker that he/she has not been involved in any criminal offence and no trail is pending against him/her.

Effects Compliance department is responsible for the acceptance to the new clients and sub brokers. Therefore compliance department must all the documents while opening the trading s of investors and approving to new sub brokers. On the event of non compliance of documents a broker can be penalized or terminated. This will result in the bad publicity and loss of clients. Also the compliance department has to all the details about person applying for the sub broker ship. If a wrong person is appointed as sub broker it may mar the reputation of the broker. (c) Dealing Department Following are the risks involved in dealing department. 

Placing of wrong order i.e. instead of buy order sell order is given.



Placing of wrong quantity.



Trading done from wrong i.e. buying and selling from wrong clients .



Trading in wrong scrip i.e. instead of trading in L & T, trading is done in ABB

Effects In all the above cases mentioned a broker has to face financial loss. If the trading is done from wrong client i.e. if buy order is put from Mr. A in place of Mr. B and Mr. B does not give a cheque a broker has to face the loss from is own pocket. Thus, such kinds of events result in loss of money as well as loss of reputation for a broker. If such things happen on regular basis the client may change the broker and it will create problems for broker in the long term.

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(d) Settlement Department Following are the risks involved in settlement department. 

Failure of client in Pay in of shares or funds.



Payout of shares to wrong .



Failure in deciding brokerage slab for a client.



Wrong preparation of statement of funds.



Failure in sending confirmation of opening to the client.



Failure in sending contracts.



Failure in preparing bills.



Failures in preparing pay in and pay out slips.

Effects The work of settlement department is of utmost importance and full of responsibility. All the good work done by different departments can be nullified by an incompetent or casual work of settlement department. Wrong payout of shares, wrong payout of funds, failure in preparing bills in time, failure in preparing pay in and pay out of slips can not only create chaos in a broking firm, it can result in huge financial losses to the broker and a bad image in the minds of clients. (e) Risk Management Department Following are the risks involved in risk management department. 

Failure in calculating the limits and margins.



Giving wrong limits to the client.



Failure in collecting margins.



Failure in sending daily reports to franchisee and sub broker.



Failure in sending daily reports to management.

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Effects The risk management department directly comes into with sub brokers and franchisees. If risk management department does not give enough limits where it is due and is required it can result in loss to investor or a sub broker leading to dispute and financial loss. On the contrary giving wrong limits have the same effect. Failure in collecting margins attracts two types of risks regulatory and financial. If the margins are not collected according to SEBI guidelines it can result in financial penalty, suspension or termination of broker ship.

Risk Management Risk management is a structured approach to managing uncertainty related to a threat, a sequence of human activities including: risk assessment, strategies development to manage it, and mitigation of risk using managerial resources. The complexity of our modern lives and the numerous decisions we are able to take are only made possible by our ability to manage risks - the risk of house fire; the risk of losing a job; the risk to the entrepreneur who invests in a business; the risk to the farmer who plants a crop that will have an uncertain yield and be sold at an uncertain price in several months time; the risk to the investor in the stock market; and so on. Ways to deal with Risk Ways to deal with Risk

Avoid

Retain

Reduce

Transfer

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(a) Avoid the Risk Avoidance of risk Includes not performing an activity that could carry risk. Avoidance may seem the answer to all risks, but avoiding risks also means losing out on the potential gain that accepting the risk may have allowed. Not entering a business to avoid the risk of loss also avoids the possibility of earning profits.

(b) Retain the Risk Retention of risk involves accepting the loss when it occurs. Risk retention is a viable strategy for small risks where the cost of insuring against the risk would be greater over time than the total losses sustained. All risks that are not avoided or transferred are retained by default. This includes risks that are so large that they either cannot be insured against or the s would be infeasible.

(c) Reduce the Risk Reduction in risk involves methods that reduce the severity of the loss or the likelihood of the loss from occurring. Outsourcing could be an example of risk reduction. For example, a company may outsource its manufacturing of hard goods to another company, while handling the business management itself. This way, the company can concentrate more on business development without worrying much about the manufacturing process.

(d) Transfer the Risk Risk transference causes another party to accept the risk, typically by contract or hedging. Insurance is one type of risk transfer which uses contracts.

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Liability among construction or other contractors is very often transferred this way. Such transference of risk may include certain cost like insurance .

Process of Risk Management 

Identify the areas of risk Search for and locate the areas where there can be risk before they

become the actual problems for the organization. 

Analyze the risk Transform the risks data into decision-making information. Evaluate

impact, probability and time frame of it and classify the risks, and prioritize them. 

Plan On the basis of the data evaluated, plan for the management of risk

Planning is done according to whether the risk is to be avoided, retained, reduced or transferred. 

Control Find out any deviations or variance and correct for the same during the

execution of risk mitigation plan. 

Communicate Communicate the internal and external information and to

the project on the risk activities, current risks, and emerging risks.

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Measures to reduce the risk Stock broking firm is highly exposed to the financial risks. Since it poses maximum risk in the financial markets, risk management in stock broking firms was felt most essential by the exchanges and its regulatory bodies. National Stock Exchange introduced for the first time in India, risk containment measures that were common internationally but were absent from the Indian Securities Market. NSCCL has also put in place a comprehensive risk management system, which is constantly upgraded to pre-empt market failures. These measures were taken to reduce the risks at brokers‟ end. SEBI has also suggested certain measures to manage the risks borne by the brokers.

Margins There is a lot of uncertainty in the movement of share prices. This uncertainty leading to risk is sought to be addressed by margining systems by stock markets.

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Suppose an investor, purchases 1000 shares of „ABC‟ company at Rs.100 on July 1, 2008. Investor has to give the purchase amount of Rs.1,00,000 (1000 x 100) to his broker on or before July 2, 2008. Broker, in turn, has to give this money to stock exchange on July 3, 2008. There is always a small chance that the investor may not be able to bring the required money by required date. As an advance for buying the shares, investor is required to pay a certain portion (margin) of the total amount of Rs.1,00,000 to the broker at the time of placing the buy order. Stock exchange in turn collects similar amount from the broker upon execution of the order. This initial token payment is called margin. For every buyer there is a seller and if the buyer does not bring the money, seller may not get the money. Margin is levied on the seller also to ensure that he gives the shares sold to the broker who in turn gives it to the stock exchange.

Volatility Volatility essentially refers to uncertainty arising out of price changes of shares. It is important to understand the meaning of volatility a little more closely because it has a major bearing on how margins are computed. Volatility has different definitions and therefore different people compute it differently. For the margin purposes, let us compute volatility based on close prices of a share over last 6 months. Since it is based on historical data let us call it „historical volatility‟.

The historical volatility can be easily calculated using an excel sheet. First put down close prices of a share for the last six months in a column of the excel sheet. Calculate the daily returns, that is, use „LN‟ (natural log) function in excel. Use the formula LN (today‟s close price / yesterday‟s close price) in the next column for

47

calculating daily returns for all the days. Go to the end of the second column (after the last value) and use the excel function „STDEV‟ (available under statistical formulas) to calculate the Standard Deviation of returns computed as above. The calculated standard deviation expressed as percentage is the „historical volatility‟ of the share for the six months period.

Higher volatility means the price of the security may change dramatically over a short time period in either direction. Lower volatility means that a security‟s value may not change as dramatically.

Date

Closing price of shares of X

Daily LN returns

Closing Daily price of LN shares Returns of Y

Closing Daily price of LN share Returns of Z

2420

2510

1-July-08

2800

2-July-08

2850

1.77%

2480

2.45%

2515

0.20%

3-July-08

2700

-5.41%

2515

1.40%

2520

0.20%

4-July-08

2750

1.83%

2550

1.38%

2512

-0.32%

5-July-08

2900

5.31%

2565

0.59%

2508

-0.16%

6- July-08

2800

-3.51%

2592

1.05%

2514

0.24%

7-July-08

2650

-5.51%

2614

0.85%

2523

0.36%

8- July-08

2700

1.87%

2635

0.80%

2510

-0.52%

9-July-08

2750

1.83%

2667

1.21%

2505

-0.20%

10-July-08

2650

-3.70%

2686

0.71%

2515

0.40%

11-July-08

2640

-0.38%

2708

0.82%

2502

-0.52%

12-July-08

2520

-4.65%

2725

0.63%

2510

0.32%

13-July-08

2670

5.78%

2742

0.62%

2515

0.20%

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14-July-08

2720

1.86%

2758

0.58%

2511

-0.16%

15-July-08

2790

2.54%

2825

2.40%

2514

0.12%

Volatility

3.85%

0.62%

0.32%

Value at Risk Margin (VaR Margin) The most popular and traditional measure of uncertainty/risk is Volatility, while historical volatility tells us how the security price moved in the past, VaR answers the question, „How much is it likely to move over next one day?‟ VaR is computed using exponentially weighted moving average (EWMA) methodology. Based on statistical analysis, 94% weight is given to volatility on „T-1‟ day and 6% weight is given to „T‟ day returns.

To compute, volatility for Trading Day (T), first we need to compute day‟s return for T by using LN (close price on T / close price on T-1). Following formula is used to calculate volatility T. Square root of [0.94*(T-1 volatility)*(T-1 volatility) + 0.06*(T LN return)*(T LN return)]

To arrive at VaR margin rate, companies are divided into 3 categories based on how regularly their shares trade and on the basis of liquidity (that is, by how much a large buy or sell order changes the price of the scrip, what is technically called as impact cost. Group I consists of shares that are regularly traded (that is, on more than 80% of the trading days in the previous six months) and have high liquidity (that is, impact cost less than 1%). Group II consists of shares that are regularly traded

49

(again, more than 80% of the trading days in the previous six months) but with higher impact cost (that is, more than 1 %). All other shares are classified under Group III.

For Group I shares, the VaR margin rate would be higher of  3.5 times volatility or  7.5% of value For Group II shares, the VaR margin rate would be higher of  3.5 times volatility or  3.0 times volatility of index The volatility of index is taken as the higher of the daily Index volatility based on S&P CNX NIFTY or BSE SENSEX. At any point in time, minimum value of volatility of index is taken as 5%. For Group II shares, the number arrived at as above, is multiplied by 1.732051 (that is, square root of 3). The number so obtained is the VaR margin rate. For Group III securities VaR margin rate would be 5.0 times volatility of the Index multiplied by 1.732051 (that is, square root of 3).

Mark to Market Margin (MTM Margin) Mark to Market margin is calculated at the end of the day on all open positions by comparing transaction price with the closing price of the share for the day. In the above example a buyer purchased 1000 shares @ Rs.100 at 11 am on July 1, 2008. If close price of the shares on that day happens to be Rs.75, then the buyer faces a notional loss of Rs.25,000 on his buy position. In technical this loss is called as MTM loss and is payable by July 2, 2008 (that is next day of the trade). In

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case price of the share falls further by the end of July 2, 2008 to Rs. 70, then buy position would show a further loss of Rs.5,000. This MTM loss is payable. In case, on a given day, buy and sell quantity in a share are equal, that is net quantity position is zero, but there could still be a notional loss / gain (due to difference between the buy and sell values), such notional loss also is considered for calculating the MTM payable. MTM Profit/Loss = [(Total Buy Qty X Close price) - Total Buy Value] - [Total Sale Value - (Total Sale Qty X Close price)]

Extreme Loss Margin The extreme loss margin aims at covering the losses that could occur outside the coverage of VaR margins. The Extreme loss margin for any stock is higher of 1.5 times the standard deviation of daily LN returns of the stock price in the last six months or 5% of the value of the position. This margin rate is fixed at the beginning of every month, by taking the price data on a rolling basis for the past six months.

According to the example mentioned above, the VaR margin rate for shares of ABC Ltd. was 13%. Suppose the 1.5 times standard deviation of daily LN returns is 3.1%. Then 5% (which is higher than 3.1%) will be taken as the Extreme Loss margin rate. Therefore, the total margin on the security would be 18% (13% VaR Margin + 5% Extreme Loss Margin). As such, total margin payable (VaR margin + extreme loss margin) on a trade of Rs.10 lakhs would be Rs. 1,80,000.

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Upfront Margin Collection are required to ensure collection of upfront margin from their clients at rates mentioned below and deposit the same in a separate clients , in respect of trades in normal market in which would result in a margin of Rs 50,000 more, after applying the margin percentages as given below. Groups (Securities Covered)

Upfront Margin Rate

Group I

15%

Group II

30%

Group III

45%

Failure to pay margins Non-payment of either the whole or part of the margin amount due will be treated as a violation of the Bye Laws of the Clearing Corporation and will attract penal charges @ 0.09% per day of the amount not paid throughout the period of nonpayment. In case a member has a margin shortage of Rs. 10 lacs or above for more than 10 occasions in the past 4 weeks, the gross exposure multiple of the member will be reduced to one level lower at the time of re-activation of their trading terminals as giver. Under Slab

Multiple

Full Exposure

8.50 times

1st level

7.00 times

2nd level

5.00 times

3rd level

3.00 times

4th level

2.00 times

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If there is no margin shortage for the next I week of Rs. 10 lacs or more, the exposure limits shall be restored to the previous levels. In addition, NSCCL may, within such time as it may deem fit, advice the exchange to withdraw any or all of the hip rights of the member including the withdrawal of 'trading facilities without any notice. In the event of withdrawal of trading facilities, the outstanding positions of the member may be closed out, to the extent possible, forthwith or any time thereafter by NSCCL, at its discretion by placing at the Exchange, counter orders in respect of the outstanding position of the member, without any notice to the member, and such action shall be final and binding on the member.

Margins based on turnover & Exposure limits (Initial margins) Intra-day turnover limit are subject to the intra-day trading limits. Gross turnover (buy + sell) intra-day of the member should not exceed the thirty three and one-third (33 1/3) times the base capital (cash deposit and other deposits in the form of securities or bank guarantees with NSCCL and NSE).

violating the intra-day gross turnover limit at any time on any trading day are not being permitted to trade forthwith. Member‟s trading facility is restored from the next trading day with a reduced intraday turnover limit of 20 times the base capital till deposits in the form of additional deposits (additional base capital) is deposited with NSCCL. are given a maximum of 15 days time from the date of the violation to bring in the additional capital. Upon failing to deposit the additional capital within the stipulated time, the reduced turnover limit

53

of 20 times the base capital would be applicable for a period of one month from the last date for providing the margin deposits.

Upon the member violating the reduced intra-day turnover limit, the above-mentioned provisions apply and the intra-day turnover limit will be further reduced to 15 times. Upon subsequent violations, the intra-day turnover limit will be further reduced from 15 times to 10 times and then from 10 times to 5 times the base capital. are not permitted to trade if any subsequent violation occurs till the required additional deposit is brought in.

Gross Exposure Limits are also subject to gross exposure limits. Gross exposure for a member, across all the securities in rolling settlements, is computed as the absolute (buy value - sell value), i.e. ignoring +ve and -ve signs, across all open settlements. Open settlements would be all those settlements for which trading has commenced and for which settlement pay in is not yet completed. The total gross exposure for a member on any given day would be the sum total of the gross exposure computed across all the securities in which the member has an open position.

Gross exposure limit would be: Total Base Capital Up to Rs. 1 crore > Rs. 1 crore

Gross Exposure Limit 8.5 times the total base capital 8.5 crores + 10 times the total base capital in excess of Rs 1 crore

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Or any such lower limits as applicable to the . The total base capital being the base minimum capital (cash deposit and security deposit) and additional deposits, not used towards margins, in the nature of securities, bank guarantee, FDR or cash with NSCCL and NSE.

Security-wise Differential Exposure Limits In case of securities that are traded in the Rolling settlement (Type 'N' and security series 'EQ'), the GE multiple for each security are as under:

Groups (Securities Covered)

Covered Multiple

Group I

1 time

Group II

2 times

Group III

5 times

All new securities to be traded on the Exchange shall be subject to exposure multiple of 2 times. It is clarified that while computing the gross exposure at any time for a particular trading day, for the purpose of the above limits, are required to add the net outstanding positions of the previous settlement period to the cumulative net outstanding positions as of that particular trading day until the securities pay in day for the previous settlement period. exceeding the gross exposure limit are not permitted to trade with immediate effect and are not permitted to do so until the cumulative gross exposure is reduced to below the gross exposure limits (as defined above or any such lower limits as applicable to the ) or they increase their limit by providing additional base capital.

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who desire to reduce their gross exposure may submit their order entry requirements as per the prescribed format and if desire to increase their limits additional deposits by way of bank guarantee or Fixed Deposit Receipt (FDR) have to be submitted to NSCCL. Additional deposits by way of securities in electronic form (demat securities) may be deposited as per procedures. The additional deposits of the member are used first for adjustment against gross exposure of the member. After such adjustments, the surplus additional deposits, if any, excluding deposits in the form of securities is utilized for meeting the margin requirements.

Violation Charges exceeding the gross exposure limit are not permitted to trade with immediate effect (trading terminals are disabled automatically. A penalty of Rs.5,000 is levied for each violation of gross exposure limit and Intra Day Turnover limits, which shall be paid by next day. The penalty is debited to the clearing of the member. Non-payment of penalty in time will attract penal interest of 15 basis points per day till the date of payment. In respect of violation of stipulated limits on more than one occasion on the same day, each violation would be treated as a separate instance for purpose of calculation of penalty. The penalty as indicated above would be charged to the irrespective of whether the member brings in additional capital subsequently.

Additional Base Capital may provide additional margin/collateral deposit (additional base capital) to NSCCL, over and above their minimum deposit requirements (base

56

capital), towards margins and/ or exposure / turnover limits. may submit such deposits in any one form or combination of the following forms: 

Cash



Fixed Deposit Receipts (FDRs) issued by approved banks and deposited with Approved Custodians or NSCCL



Bank Guarantee in favour of NSCCL from approved banks in the specified format.



Approved securities in demat form deposited with approved Custodians.

All Additional Base Capital (ABC) given in the form of cash / FDR (hereinafter referred to as 'Cash Component) should be at least 30% of the total ABC and cash margins in respect of every trading member. Incase where non - cash component is more than 70 % of the total additional base capital, the excess non-cash component is ignored for the purpose of exposure limits requirements and / or margins requirements.

Exemption for institutional deals Deals executed on behalf of the following entities are considered as institutional deals: 

Financial Institutions



SEBI ed FII‟s



Banks



SEBI ed Mutual Funds

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While computing margins, institutional deals are excluded. Deals

are

identified by the use of the participant code in the trades reported. Deals entered into on behalf of custodial participants i.e. carrying custodial participant code are considered as institutional deals unless not confirmed by the respective custodians in which case the deals shall attract margins.

Non-Custodial Institutional Deals are identified by the use of the participant code `NCIT'. The NCIT' deals will be exempted for margin purposes (However, VaR based margin which is charged on institutional trades on the net outstanding sale position, in securities shall be applicable in this case also) and the settlement obligation will remain with TM clearing member. Non Custodial Institutional deals, which are not marked as 'NCIT' at the time of order entry, will not be exempted. All TM clearing are required to provide details of the contract notes for all Non-Custodial Institutional Trades through a file as per the procedure.

Exemption upon delivery of securities If deliver the securities prior to the securities pay in day, then the margin payable by the member will be recomputed after considering the above pay in of securities. The margin benefit on of early pay in of securities shall be given to the extent of the net delivery position across all clients of the member. The early pay in would be allocated to clients having net deliverable position, on a random basis, till such time that the system is developed to provide the early pay in benefit on a client basis. However, are required to ensure to on

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appropriate early pay in benefit of margin/exposure to the relevant client, until the above system is in place.

The value of the advance pay in made is reduced from the cumulative net outstanding sale position of the member for the purpose of gross exposure limits.

may note that early pay in of securities only up to the working day prior to the scheduled settlement pay in day shall be considered for the purpose of early pay in benefits. In case any member makes early pay in on the scheduled day of pay in for the settlement, no benefit will accrue to the member. Such early pay in shall not be adjusted against the settlement pay in obligation and it would be treated as short delivery. are therefore alerted to ensure that no early pay in is made on the scheduled day of settlement pay in.

Pay in of funds and securities prior to scheduled pay in day The relevant authority may require to pay in funds and securities prior to the scheduled pay in day for funds and securities. The relevant authority would determine from time to time, the who would be required to pay in funds and securities prior to the pay in day. The relevant authority would also determine securities and funds which would be required to be paid in and the date by which such pay in shall be made by the respective .

The value of such prior pay in of funds and securities will not be reduced from the cumulative net position of the member for the purpose of gross

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exposure reduction. There will be no margin exemption available for such pay in of funds and securities.

Measures taken by BSE for risk management Certain steps or measures are taken by BSE towards the reduction of risks of stock brokers. 

Know your client (KYC) According to know your client scheme the member brokers of the

exchange are required to obtain detailed information of clients prior to commencement of any transactions with new clients. A similar procedure is also to be followed for existing clients. This information is to be made available to the exchange authorities whenever called for. In case the member broker fails to furnish the same, it may result in penalties to the member brokers. 

Surveillance / Inspection Surveillance / Inspection department carries out inspection of the

member brokers records and keep a regular check on the activities of member brokers as well as sub brokers as regards the compliance of the risk management procedures. 

Insurance The exchange presently has in place insurance policies to protect itself

in the event of losses on of fire, damage to computer systems and a comprehensive policy that covers risks faced by the exchange, its member brokers and the clearing houses. The risks covered under the basic cover of the policy are detailed as below. »

Loss of member on of fake / forged / stolen shares being introduced by the clients.

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»

Loss to on of fraud by employees.

»

Direct financial losses suffered by the member broker on of physical loss, destruction, theft or damage to securities and cash.



»

Loss on of securities lost in transit.

»

Loss suffered on of incomplete transaction.

»

Loss on of errors and omission.

Verification of shares ’ office The exchange has outlined the process i.e. in case the transaction in a

script with one particular client in a settlement exceeds Rs. 10 lacs then the member has to send the photocopies of the transfer deeds and the share certificates to the company / registrar for verification of the material particulars. The basic idea behind the introduction of this procedure is to prevent the fake / forged / stolen shares from being introduced in the market.

Measures taken by SEBI The Securities and Exchange Board of India (SEBI) along with Government have been streson the need for strict regulation of secondary market and bringing the transparency on the floor of stock exchanges. The steps taken by the SEBI and Government in order to regulate and control the activities of stock exchanges and reduce the risk of investors and sock brokers are as follows.



Uniform Trading hours at all the stock exchanges in the country to check the arbitrage.



Registration of all market players such as brokers, sub brokers, registrars to issues, merchant bankers, portfolio managers, underwriters, debenture trustees,

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custodians etc so as to have access/inspection of their books, records and verification of transactions. 

Regulation on insider trading with the object to curb it completely and punish the guilty.



Compulsory audit of s of all member brokers and ed intermediaries by practicing chartered ants.



Indirect supervision through stock exchanges in day-to-day business by fixing margins, imposing curbs, penalties and fines etc.



Systematization and computerization in order to reduce the paper work and ensure transparency in transactions.



Mentioning of brokerage separately in broker contract notes.



Brokers have to notify all transaction to the stock exchanges including off the floor trades.



Uniform good/bad delivery norms.



Capital adequacy norms prescribed for brokers.



Brokers have to keep the clients money in a separate bank .



Forward trading being banned on stock exchanges.



Derivative trading in index based futures of 1, 2 or 3 months.



Dematerialization of almost all the securities.



Total transparency and automation of stock exchanges.



Effective margin system for smooth settlement.



Circuit breaker system to check volatility of particular scrip and the exchange.



Introduction of Internet and online trading.

Recent steps taken by SEBI 62



Compliance Officer Each company is required to appoint the compliance officer who

would be able to the rumors and information floating in the market about the company and inform the same to the stock exchanges. This will help reduce the encouragement to rumors about companies, which aids in price control and stability. 

Streamlining Investor protection fund The committee set up by SEBI to review the sources and utilization of

investor protection fund of stock exchanges has made following recommendations »

Funds should be on trust structure and set upon under Indian Trust Act, 1882 with independent trustees.

»

Regular contributions from active member brokers and stock exchanges.

»

Fund to be utilized only for investor claims and not for broker claims.

»

Trustees to ensure that fund is not deployed in risky instruments or for the benefit of any member but only in prescribed avenues.

» 

Time schedule to be specified while setting investor claims.

Appointment of s To get rid of bad deliveries, SEBI has decided to appoint

to implement the signature guarantee and certificate authentication programs. The s appointed by SEBI act on behalf regulator in resolving problems arising out of signature mismatch. 

Service centers for investors SEBI has directed all stock exchanges to constitute service centers for

investors to enable the investors to have a form for recording and counseling of their

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grievances as well as access financial and other information of companies on government norms, policies, rules, regulations, etc. 

Investor Education SEBI has taken steps to educate the investors through various

awareness programmes, and publications etc. 

Corporate Governance SEBI has prescribed the corporate governance norms for all listed

companies to ensure transparency and better disclosure practices.

FINDINGS

The study of risk management in stock broking firm was really an interesting and informative project. Though the concept of risk management in stock broking firm is a new concept in India, it is emerging as an utmost important practice. Due to high volatility of market brokers are always exposed to the risk and they have to suffer heavy financial losses. The findings drawn during the project are as follows.



Risk is the possibility of happening uncertain events. It is the chance of happening of something that may affect the desired results. Risk may hamper the pre determined outcomes and result into losses.



To cope up with the situation and reduce the evil effects of it such risks can be avoided, retained, reduced or transferred.

64



The Indian capital market is very volatile and because of this brokers are always at a risk of non receipt of payments from clients and sub brokers.



Stock broking firms face the market risks, financial risks, credit risks, liquidity risks and operational risks.



To tackle such risks Value at Risk (VaR) Margin, Mark to Market (MTM) Margin, Extreme Loss Margin are collected from clients and maintained at the exchange.



Non payment of margins is treated as violation of the bye laws of NSCCL and attracts penalties. In extreme cases NSCCL may withdraw the hip rights of member broker.



Intra day turnover limit and gross exposure limit are allowed to member brokers against the minimum base capital and additional base capital. The violating the limits are penalized and not permitted to trade forthwith. Member‟s trading facility is restored from the next trading day with a reduced intra day and gross exposure limit.



If member delivers the securities prior to the scheduled securities pay in day, the margin payable by broker is then recomputed and margin is released to the extent of early pay in.



NSE, BSE, SEBI and NSCCL have taken various steps like KYC, circuit filters, surveillance, inspection, compulsory audit of s etc. to ensure the minimum risk.



The technological advancements and infrastructural development have helped broking firms to keep a regular check on its clients and sub brokers. It has also enabled the exchanges to monitor on line where the correct and immediate position of is monitored on real time basis.

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SUGGESTIONS AND CONCLUSION

Inspite of strict surveillance and stringent policies towards reducing the risk, brokers have to suffer financial losses. Many times strict adherence to the provisions laid down by the exchanges and SEBI is neglected and it results in to losses. The one important reason behind this can be lack of proper implementation of the rules and regulations. Therefore following are the suggestions which would help reduce the risk and losses at exchanges and member brokers.



Every stock broking firm must have a Risk Management or Surveillance Department to keep a strict watch on market and the activities of its sub brokers, franchisees and investors etc.

66



There has to be minimum qualification criteria for the member broker, sub broker and franchisee and employees especially dealers. The criteria can be various modules of NCFM or BCFM (e.g. a dealer must the NCFM or BCFM Dealer‟s module.)



Such qualified staff would help in reducing the mistakes and errors as they have a proper understanding of the procedure.



While providing acceptance to the limits it must be scrutinized that broker or sub broker has a required amount of credit in his bank .



Also while giving refunds to the broker or sub broker it must be checked that he has maintained a minimum required balance (Minimum Base Capital).



In both the cases of acceptance to the limit and refund of capital the margins must be recomputed and increased or decreased immediately.



The member brokers and sub brokers must strictly adhere to the limits and gross exposure provided to them and in case of need a specified amount must be deposited first with the exchange.



The clients should be asked to call dealers on the phones only on which the conversation can be recorded. Thus, clients‟ calls on personal phones should be avoided. It helps to reduce the miscommunication and conflicts between client and broker.



All the documents along with applications for client and sub broker must be verified thoroughly and all the requirements (e.g. Letter from bank, copy of book, signature, letter of landlord in case of tenant etc) must be fulfilled.



The senior officers of broker must visit periodically to its sub brokers and franchisees to keep a check and understand their problems.

67



Risk Management or Surveillance Department should generate a report containing the position, limits, gross exposure, acceptance, refund etc. The report should be send to senior management for verification.

CONCLUSION

Working with PSE Securities Ltd. for study of risk management in stock broking firm was a great experience. The activities of risk management or surveillance are the heart of the broking industry and they should be taken care of.

Prices of shares in Indian stock market change very swiftly, they are very volatile and unpredictable too. The brokers are always at a risk that investors may not pay in the securities or funds due to increase or decrease in prices of shares. Therefore, broking firm is a very risky business and chance of financial losses lies in almost each and every activity of the business. However, with the margin system and use of advanced technology the transparency of market is growing.

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Therefore to conclude it can be noted that though the business of stock broking is always exposed to the risk of non receipt of payments or loss of money but such risks can be managed and reduced through strict adherence to the rules and regulation mentioned by exchanges, SEBI and NSCCL. This will not only reduce the risk but also help organization run smoothly and grow further.

LIMITATIONS

During the study certain limitations were faced, in the absence of which the study could have been better. Those limitations are as follows.



The time period of 2 months was a very short span to complete the study.



The study was conducted in Pune city only, which restricted the scope of study.



It was not possible to study certain confidential data.



The PSE Securities Ltd. deals in the cash segment only and not in the derivatives segment, that put restrictions on the study.



The data provided by persons cannot be held 100% true. 69

BIBLIOGRAPHY 

Books »

V.K. Bhalla, (2002), Portfolio Analysis and Management, S. Chand and Co. Ltd., New Delhi, pp1-24

»

National Stock Exchange, (Oct. 2007), Capital Market (Basic) Module Work Book NSE, Mumbai, pp 151-159

»

V.A Avadhani, (2006), Securities Analysis and Portfolio Management, Himilaya Publishing House, Mumbai, pp46-54.

»

National Stock Exchange, (Oct. 2007), Capital Market (Dealers) Module Work Book NSE, Mumbai, pp 84-95.



Journals or Magazines »



tly Published by NSE and BSE; Understanding Margins, pp 3-10

Internet sites

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»

Assessed on 15th June 2008, 10 a.m.

»

Assessed on 29th June 2008, 4 p.m.

»

Assessed on 29th June 2008, 4:30 p.m.

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Assessed on 6th July 2008, 5:30 p.m.

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Assessed on 12th July 2008, 6 p.m.

»

Assessed on 12th July 2008, 6:30 p.m.

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