India’s Trade Settlement Track Record May Be At Stake In This Options Dispute

This month, the Securities and Exchange Board of India is scheduled to pass its order on the call options sold by stockbroker Allied Financial Services Ltd. The dispute stems from illegal use of mutual fund units as a collateral, and the regulator will rule if such contracts should be annulled or settled.

While the amount involved is Rs 400 crore, foreign investors including Citigroup Mauritius had bought the contracts. Every day the regulator delays its decision adds to the reputation risk, said a senior executive at a brokerage firm providing custodial services. He spoke on the condition of anonymity since an investigation is on.

To be sure, SEBI had rejected the demand to annul the trades before the Securities Appellate Tribunal sent the matter back to it.

Investors and foreign brokerages choose exchanges for trading considering how robust the settlement process is. They also look for certification based on G-20 principles for market intermediaries. SEBI has adopted these norms, granting clearing corporations in India the qualified central counter party status that guards against risks stemming from defaults by brokers. It gives investors the confidence that all successful trades are guaranteed and will be settled.

In fact, Citibank argued in the appellate tribunal that its purchase of options sold by Allied Financial Services is a valid trade executed on an exchange platform and needs to be honoured. The delay in squaring off the contracts is not only putting the counterparties to a huge loss but will also have a cascading effect on settlement with other parties, the bank said.

Citi declined to comment on BloombergQuint’s emailed query.

Still, in this case there is no violation of the qualified central counterparty status, said a market veteran aware of the regulations—he spoke on the condition of anonymity as the regulator is involved. The framework doesn’t factor in judicial intervention, he said.

Vyapak Desai, partner at Nishith Desai Associates, said the delay in settlement is not because of NSE Clearing but due to the SAT order. The appellate tribunal should not have interfered with the market settlement process and, if required, should allow investors to recover costs because of the delay, said Desai.

How It Began

Allied Financial Services, through its clearing member IL&FS Securities Services Ltd., sold Nifty 5000 call options in December expiring in June. As a collateral, it offered mutual fund units and received a premium of Rs 380 crore. But Dalmia Bharat group alleged that the units of its companies were fraudulently transferred to be used as a security, and filed complaints with the police and SEBI, according to exchange filings. The regulator froze the mutual fund units, forcing IL&FS Securities to replace mutual fund units with cash since, being the counterparty, it was required to maintain the margin.

SEBI’s interim order found Allied Financial Services guilty, barring it from the securities market. IL&FS Securities approached the regulator to annul the options contracts saying that it was a victim of fraud, but SEBI rejected the demand.

When IL&FS Securities approached the NSE Clearing on the direction of the SAT, the clearing corporation said it can’t take parallel action when the regulator and the Economic Offences Wing of the police are investigating the matter.

IL&FS Securities moved the Supreme Court, which granted a stay on settlement and asked the SAT to decide. The appellate tribunal asked the market regulator to hear all parties afresh. But the market regulator deferred the July 10 hearing and said will move the Supreme Court against the appellate tribunal’s order.

Who Will Pay The Investors?

Being a clearing corporation, the responsibility to settle the contracts rests with NSE Clearing. And it follows the exchange’s waterfall mechanism:

1. The NSE Clearing can use the deposits by IL&FS Securities—the clearing member on behalf of Allied Financial Services—to settle. But since the settlement is in abeyance, it can’t use the deposits.
2. It can use the clearing member funds only if it declares the entity a defaulter. Since enough cash and cash equivalent has been provided by IL&FS Securities, the clearing corporation can’t declare it a defaulter.
3. If the first two mechanisms fail, the clearing corporation can use its own funds earmarked by the exchange.
4. It also has a core settlement guarantee fund for each of its trading segments like cash, futures and options, and certificate of deposits to ensure any shortfall is met.
5. As a last resort, it can dip into deposits of other clearing members even if they are not involved in the trade.

What that means is an investor will either get the securities or cash for a buy-sell trade.

NSE Clearing has so far maintained that it has the money to settle the trade but awaits the regulator’s decision on IL&FS Securities’ demand to annul the trades.

The clearing corporation, during hearings at the appellate tribunal, said annulling contracts will shake the confidence in the risk-management products even though amount involved is small.

The NSE Clearing declined to comment on BloombergQuint’s emailed queries as the matter was sub judice.

What If The Contracts Are Annulled?

If the trades are annulled, NSE Clearing will have to return the premium to buyers of the options. This will be recovered from IL&FS Securities, which will have to recover it from Allied Financial Services. If the stockbroker fails to pay, the clearing corporation will use the cash deposited by IL&FS unit to refund the premium.

But the bigger issue is other trades carried out based on the Nifty 5000 contracts sold by Allied Financial Services. Investors will have to bear the costs of unwinding all these positions.

All three — SEBI, SAT and the Supreme Court — the market veteran quoted earlier said, have to safeguard the sanctity of capital market trades.

(Updates an earlier version after SEBI said it will move the Supreme Court against the appellate tribunal’s order.)