Secondary market

MKS

Functions

• Liquidity and marketability of equity and debt instruments

• Allocation of fund, economic growth

• Valuation

• Fair dealing to investors, protection

• Induce company performance

Till early 1990s

• Uncertain price• Uncertain delivery and settlement periods• Front running (trading ahead of a client based

on knowledge of the client order)• Lack of transparency• High transaction cost• Absence of risk management• Club mentality of brokers• Private off-market trading

Post-reforms stock market scenario

• Regional SE

• National Stock Exchange(1994)

• OTCEI (set up for SME sector)

• At present 23 SEs (19 regional, BSE, NSE, OTCEI, ICSE (stock exchange of stock exchanges)

REGULATION of SEs

• CG under SCRA, 1956: recognition of SE, supervision, control of SEs, regulation of contracts in securities, listing of securities, transfer, etc.

• SEBI to provide investor protection, promote & regulate market

Organisation, mgt. and membership of SEs

• Non-profit association (Bombay, Ahmedabad, Patna, Indore)

• Public ltd. company (Kolkota, Delhi, Kanpur, Ludhiana, Channai, etc.)

• Guarantee company (Hyderabad, Pune, Rajkot, Magadh)

• Sec. 25 company (OTCEI)• Tax-paying company (NSE)• OTCEI, BSE and NSE are demutualised

SEs

Demutualisation

Except NSE, BSE and OTCEI, SEs are broker owned and broker controlled – conflict of ownership

Demutualisation: separation of ownership and trading rights,tax paying entity, safeguards interest of investors, transparency, could be a listed company or a closely-held

company

SEBI Demutualisation

• Direct or indirect equity stake by a single shareholder cannot exceed 5%

• Brokers’ representation at board: 25%

• 51% by public (non-members)

• Transfer of member shareholders have to be with prior permission

• 49% foreign investment possible (26% FDI, 23% FII)

Listing

• Permits trading: March, 07: 6000 securities• Unlocks value of the company• Wealth creation----------------------------------------------------------- can list if - atleast 10% of securities subject to a minimum of 20

lacs securities have been offered to public for subscription

- net public offer is Rs100 crores - through book building and 60% to QIBs

Alternatively offer atleast 25% to public

Central Listing Authority

• SE to manage trading• CLA to manage listing• Model of LSE• To take care of conflict of interest of SEs when

they try to increase their listing fees to maximise income of the SE/ increase the number of companies by relaxing listing norms

• To manage pre-listing procedure (clearing prospectus) and post-listing procedure (end use of fund)

Architectural structure of secondary markets

Know the potential parties:

Natural buyers (act for own portfolio)

Natural sellers (act for own portfolio)

Brokers (for others)

Dealers (intermediary in a trade to place/sell an asset in/out of its own inventory), a special type of dealer- market maker

Cont..

• Order-driven market: natural buyers and sellers only act, no intermediary, price is determined by order flow of buy and sell orders (another name: auction-market)

• Quote-driven market: dealer determines price on the basis of market information and quotes (other name- dealer market/dealership market)

• BSE provides both the systems and NSE provides only the order driven system

Types of order driven market

• Continuous order-driven market

• Periodic call auction (price announced is determined by price scan auction or sealed bid auction

- price scan auction: auctioneer announces tentative price and participants respond

- sealed bid auction: closed bids

Trading locations

• Exchanges

• OTC market: non-exchange products are traded, they are quote-driven markets

Trading arrangement

Open outcry to screen-based trading:Whole market can be seenReal timePrice discoveryTrading shifted to broker’s premiseLess intermediaries, less costTime, cost savingEliminates fraudFaster linkage of markets

Order matching

• The best buy order is matched with the best sell order. • An order may match partially with other orders- multiple

trade• Best buy order: highest price (because viewed from

seller’s perspective)• Best sell order: lowest price (because viewed from

buyer’ perspective)• So, of all buy orders available in the market at any point

of time, a seller would obviously like to sell at the highest possible buy price.

Cont….

• Members proactively enter orders in the system• Orders displayed in the system till the full quantity is

matched by one or more of counter-orders and result into trade (s)/cancelled by the member

• Alternatively, members may be reactive and put in orders that match with existing orders in the system.

• Orders lying unmatched in the system are 'passive' orders and orders that come in to match the existing orders are called 'active' orders.

• Orders are always matched at the passive order price• So, earlier orders get priority.

Order matching

• Active order, passive order• Matching priority: An active buy order matches with the best

passive sell order if the sell order price is less than or equal to the active buy order price

An active sell order matches with the best passive buy order if the buy order price is equal to or greater than the sell order price

Cont…Unmatched orders queuing: By price: a buy order with higher price and a sell

order with a lower price gets higher priority By time: if there are more than one order at the

same price, the order entered earlier gets a higher priority

As soon an order enters the system, it gets

numbered and time stamped and then scanned for a match. If match is not found, then stored on price/time priority (passive order)

Order conditions- NSE

Time Conditions: DAY order: valid for the day on which it is entered. If no

trade happens, the order gets cancelled automatically at the end of the trading day

GTC - Good Till Cancelled (GTC) order: remains in the system until it is cancelled by the Trading Member/ matched, w.e.e. Maximum number of days a GTC order can remain in the system: notified by the SE from time to time

Cont…

GTD - Good Till Days/Date order: valid for the day/date specified Each day/date counted is a calendar day and inclusive of holidays and inclusive of the day/date on which the order is placed. Maximum number of days a GTD order can remain in the system: notified by the SE from time to time.

IOC - Immediate or Cancel (IOC) order: trade as soon

as the order is released, failing which the order will be removed from the market. Partial match is possible. Unmatched portion of the order is cancelled.

Cont….• Price Conditions Limit Price/Order – An order with price enters into the system.

Market Price/Order – An order to buy or sell securities at the best price obtainable at the time of entering the order.

Stop Loss (SL) Price/Order – An order which gets activated only when the market price of the relevant security reaches or crosses a threshold price. Until then the order does not enter the market.

• A sell order in the Stop Loss book gets triggered when the last traded price in the normal market reaches or falls below the trigger price of the order. A buy order in the Stop Loss book gets triggered when the last traded price in the normal market reaches or exceeds the trigger price of the order.

• If for stop loss buy order, the trigger is 93.00, the limit price is 95.00 and the market (last traded) price is 90.00, then this order is released into the system once the market price reaches or exceeds 93.00. This order is added to the regular lot book with time of triggering as the time stamp, as a limit order of 95.00

Cont…• Quantity Conditions Disclosed Quantity (DQ)- An order that allows the Trading Member

to disclose only a part of the order quantity to the market. For example, an order of 1000 with a disclosed quantity condition of 200 will mean that 200 is displayed to the market at a time. After this is traded, another 200 is automatically released and so on till the full order is executed. The Exchange may set a minimum disclosed quantity criteria from time to time.

• MF - Minimum Fill (MF) orders allow the Trading Member to specify the minimum quantity by which an order should be filled. For example, an order of 1000 units with minimum fill 200 will require that each trade be for at least 200 units. In other words there will be a maximum of 5 trades of 200 each or a single trade of 1000. The Exchange may lay down norms of MF from time to time.

Cont…

• AON - All or None orders allow a Trading Member to impose the condition that only the full order should be matched against. This may be by way of multiple trades. If the full order is not matched it will stay in the books till matched or cancelled.

• Note: Currently, AON and MF orders are not available on the system as per SEBI directives.

Trading rules

• Margin system, intra-day trading limit, exposure limit

• Margins are set to check price volatility• Margins are set for exposure on different stocks,

both on proprietary basis and on behalf of clients• Margins vary from broker to broker on individual

stocks depending on exposure • Many margins are paid upfront, keeps a tab on

the buying exposure, used for cash settlement

Cont….

• Daily margins Mark-to-market margins: notional losses are replenished Ad-hoc margin: unusually high trading volume scrips VaR margin (3 sigma standard deviation is used) takes

care of price movement for 99 percent of the times- measures the worst potential loss in a normal day; applicable to all securities in rolling settlement

• Intra-day trading limit: 20 times capital, can be exceeded with additional capital being provided

• Other measures: Capital adequacy norms, indemnity insurance, online position monitoring

Cont..

• Stocks are classified into 3 categories:

• Group-I: 80% of days trading within last 18 months with mean impact cost of </=1%

• Group-II: 80% of days trading within last 18 months with mean impact cost of >1%

• Remaining stock: Group-III

Daily margin = sum of mark to market margin plus VaR based margin

Impact cost

• An ideal stock can be traded at its ruling market price

• But, while buying, price paid is higher than the ruling price and while selling, sale price is less than ruling price

• Difference from ideal price in terms of percentage is impact cost

• Impact cost has to be calculated for an order value of Rs.1lac

Cont…

Order book of a stock looks like: Buy SellQuantity Price Quantity Price1000 98 1000 992000 97 1500 1001000 96 1000 101To buy 1500 stocks, ideal price = best buy + best sell / 2 =

[99 + 98] / 2 = 98.5Actual buy price = [1000 X 99 + 500 X 100] / 1500 = 99.33Impact cost = (99.33 – 98.5) / 98.5 X 100 = 0.84%

Circuit breakers

• Price bands to curb excess volatility (% either way): they don’t halt trading, an order beyond the band is not accepted. scrip wise 20% breaker is operational for additional safety.

• Market-wide circuit breaker: Sensex or NSE S&P CNX Nifty w.e.e.: 10%, 15% and 20%- suspension or halt, linked to time bands also

Stock-market index• Barometer of the market

• Benchmark for portfolios

• Underlying for futures and options

• Contains scrips with high capitalisation and high liquidity (bid-ask spread is minimum)

[bid-ask spread could be negative: known as crossed market]

Methods

• Full capitalisation: total no.of shares X market value per share determines the weightage

• Free float method: weight is less if shares available for trading is less, FFF is assigned to a company on a banding structure(10/20 bands) to which the company falls depending on the % of FF scrips it has.

Exact FF is rounded off to the higher multiple of 5/10

depending on banding structure. This FFF is multiplied with market capitalisation to find FF capitalisation. FF cap/ Total FF cap determines the weight of the scrip

Exclusions from FF

• Holdings by founders/directors/acquirers/bodies with controlling interest

• Govt. holding as promoter/acquirer• FDI holding• Strategic stakes by private corporate

bodies/individuals• Cross holdings by associates/group companies• Locked-in-shares• Employee welfare trust’s holding

Cont…

• Modified capitalisation weighted: limits the influence of the largest stock or group of stocks in the index by limiting their weights

• Equal weighting all stocks, so have equal impact on index movement

Criteria for stock selection• Market capitalization: Company market

capitalization in the Top 100 market capitalization’s of the BSE, market capitalization of each company should be more than 0.5% of the total market capitalization of the Index

• Trading frequency: scrip should have been traded on each and every trading day for the last one year. Exceptions can be made for extreme reasons like share suspension, etc.

Cont…

• Number of trades: scrip among the top 150 companies listed by average number of trades per day for the last one year.

• Industry representation: The companies should be leaders in their industry group.

• Listed history: The companies should have a listing history of at least one year on BSE.

• Track record: In the opinion of the index committee, the company should have an acceptable track record.

Market making system

• To provide liquidity to illiquidi stocks

• Puts up a buy quote or sell quote

• Differential rate is the profit

• Very active in USA market

• Requires large stock holding, so capital commitment and increased market risk

• Stock-lending and margin trading can help market making

Stock lending

• Enables a seller to borrow shares from a SEBI-registered intermediary and deliver them to the buyer

• When prices decline, he replaces shares by buying from market

• Pays interest to the lender• Lenders are MFs, insurance companies, custodian

banks, finance companies, etc.• Lenders should have NW of Rs.50 crores• Borrower to return back the same type and class security

with accrued benefits• Essentially a facility for short sellers (who sells without

owning) to settle delivery of scrips by borrowing

Advantages of stock lending

• An avenue for income for lenders

• Increases liquidity

• avoids delivery failure

• Stabilises market movement

Rolling settlement

A system to settle transactions in a fixed number of days after the trade is agreed

Weekly v. Rolling

Date

1 Buy 200 shares

2 Sell 100 shares

6

7

14 pay the net price of 100 shares

15 get 100 shares

T + 5 rolling settlement

Buy 200 shares

Sell 100 shares

Pay for and get 200 shares

Deliver 100 shares and get cash

Weekly v. Rolling

Trading period: 5 days

Settlement day: last day of the week

Squaring of transactions:

Any day of the period

(intra-day and intra-settlement)

Determination of settlement: open position at the end of trading period

T day

Daily settlement

Intra-day

Open position at the end of each trading day

advantages

• Reduces arbitrage opportunities

• Improves price discovery

• Reduces settlement risk

• Reduces volatility

RTGS

• Ensures transfer of fund on a real time and one to one basis (transaction by transaction and settlement of funds is final, irrevocable) in an electronic mode

• Inter-bank transactions, customer based inter-bank transactions, net-clearing transactions are done

• Operates by instruction from banks to clearing cell of RBI

STP

Electronic capturing and processing of transactions in one pass from initiation to final settlement (no re-entry by different participants)

A prerequisite for shorter settlement cycle

From July, 2004- all institutional trades are through STP

Avoids punching error, eliminates manipulation, more transparency

STP and RTGS will pave way for T+1 settlement

Margin trading

Banks finance trading in shares Allows to buy shares by providing 50%(w.e.f.

28.12.2004) of the deal value and borrowing 50% from banks through the brokers, or from brokers, NBFCs

The securities purchased are provided as collateral

So augments buying and selling power Allowed in actively traded securities Mechanism: Cash margin is 25% of overall margin

Mechanism of MT

• Investor has Rs.40,000; wants to buy share with quote of Rs.40; can buy 1000 shares

• With MT, can buy 2000 shares• The broker puts 2000 shares as collateral• Bank gives a loan of Rs.40,000 on a collateral of

Rs.80000 (2000 X 40) [Rs.20,000 in the form of cash]

• If the price falls below Rs.40, bank gives margin call through broker to furnish more funds/securities for the broker to pass on to the bank

SEBI Guidelines and Margin Trading

• Corporate brokers with net worth of at least Rs.3 crore eligible for providing margin-trading facility to their clients upon agreement in a format specified by SEBI

• the client shall not avail the facility from more than one broker at any time.

Cont..

• margin trading is available for Group 1 securities and those securities, which are offered in the initial public offers and meet the conditions for inclusion in the derivatives segment of the stock exchanges.

• a broker may use his own funds or borrow from scheduled commercial banks or NBFCs regulated by the RBI. A broker is not allowed to borrow funds from any other source.

Cont..

• The `total exposure' of the broker towards the margin trading facility should not exceed the borrowed funds and 50 per cent of his `net worth'.

• broker has to ensure that the exposure to a single client does not exceed 10 per cent of the `total exposure' of the broker.

• Initial margin has been prescribed as 50 per cent and the maintenance margin has been prescribed as 40 per cent.

• The stock exchange has to disclose the scrip-wise gross outstanding in margin accounts with all brokers to the market after the trading hours on the following day.

Settlement of Transactions

• Settlement of the transactions takes place after the end of the settlement period through the Clearing House/Clearing Corporation of the Stock Exchanges and not directly by the member-brokers.

• Presently, the transaction of stocks are traded on the basis of Rolling Settlement on a T+2 basis.

Delivery of Scrips Securities pay in:• The Member has to deliver the Securities (otherwise known as Securities

pay-in) to the Exchange as per the Statement of scrip-wise net deliveries downloaded

• securities pay in takes place by 11.00 a.m. on the pay in date through their depository participant.

• The Execution date for the Depository Participant is usually one day before the securities pay in date. The securities pay in takes place through both Depositories (i.e. NSDL & CDSL) simultaneously.

• Members have to deliver their shares in physical form to the clearing house by 12.00 p.m. on the securities pay in date.

Securities Pay-out : The securities pay out takes place on the same date as the securities pay in

date through both depositories (NSDL & CDSL) by 3 p.m.

Cont…

Computation of Net Payable or Net Receivable:

• Separately calculated for rolling settlement and odd-lot trade settlement

• Odd-lot: through a separate downloaded balance sheet.

+Turnover charges (slab based charges) and Securities Transaction Tax (STT)

Cont…..Funds Pay-in :• The Clearing Bank debits within 11 a.m. the

Settlement Accounts of the members maintained with the Bank with net payable amount appearing in Member’s Balance Sheet.

Funds Pay-out :• The Clearing Bank credits on after 3 p.m.

In both the cases, separate Balance Sheets are generated for Rolling Settlements and Odd Lot Settlements.

Auction

a mechanism utilised by the exchange to fulfill its obligation towards the buying trading members.

So, in case for a settlement, the selling trading members have delivered short, the exchange purchases the requisite quantity from the market and gives them to the original buying member.

Trade to Trade

• If a scrip is shifted on a Trade-to Trade settlement basis, selling/ buying of shares in that scrip would result into giving/ taking delivery of shares at the gross level and no intra day netting off would be permitted.

• The scrips which form part of 'Z group' are compulsorily settled on a trade to trade settlement basis. In addition to that Surveillance department transfers various scrips from time to time on a trade to trade settlement basis based on the criteria decided jointly by the Exchanges and SEBI.

Operational Procedure of Clearing House

Salient Features of Clearing, Settlements and Auction

• Settlement Procedure • Delivery of Scrips • Computation of Net Payable or Net Receivable • Auction (Closing out of Contracts) • Settlement Calendar Schedule and Procedure • Auction Calendar Schedule and Procedure

Settlement Procedure • Screen based trading: matching of orders and quotes takes place.

• End of the trading session: member to download his daily transaction reports from the system

Price is the closing price on settlement date. Netting of trades is done by the system.

Reports: Statement of scripwise net deliveries to be made by the member. Statement of scripwise net deliveries to be received by the member.

Balance Sheet showing the net receivable or not payable by the

Member.

National Securities Clearing Corporation Ltd.

• A wholly owned sub. of NSE to undertake clearing and settlement at the exchange

• Assumes counter-party risk of each member and guarantees settlement (even if a party fails to deliver securities or fund)

• Has a guarantee fund of Rs.4055 crores as at 31.03.2006

• Members contribute to this fund• A separate fund for futures and options segment• Four entities linked to NSCCL

Cont…

Clearing and settlement process

NSCCLCustodians/CMs

Clearing banks

Professional Clearing members

Depositories

Risk mgt. and Margin System• MTM (Mark To Market) Losses: Mark to market losses on outstanding

settlement obligations of the member.

• VaR Margins: Value at risk margins to cover potential losses for 99% of the days.

• Extreme Loss Margins: Margins to cover the expected loss in situations that lie outside the coverage of the VaR margins.

• Base Minimum Capital: Capital required for all risks other than market risk (for example, operational risk and client claims).

• Special Margin : Special Margin collected as a surveillance measure.

The members are required to maintain the liquid assets (collateral) to cover all the above five requirements.

Daily margin = MTM + VaR margin

MTM

• Calculated on notional loss the member would incur if all net outstanding positions in all securities of that member are closed at closing prices of that day

• In case net position is zero, the difference between buying and selling value would be considered as loss

VaR margin

VaR margin is applicable to all scrips under rolling settlement

• Gr-I: scripwise daily volatility is calculated which is 3.5 times the volatility

• Gr-II: 3.5sd or 3 times the index VaR w.e.h which is scaled up by square root of 3

• Gr-III: 5 times the index VaR scaled up by square root of 3

VaR

• Logarithmic return for day n is

For a scrip: LN(CPn / CPn-1)

For index: LN (CVn/CVn-1)

Initial volatility = sd = root of summation of squared deviation of daily returns from average return divided by n

Subsequent day volatility ?