Sebi Introduces New Stress Testing Methods to Strengthen Equity Derivatives Market

The Securities and Exchange Board of India (Sebi) has launched new stress testing methods to better manage credit risks in clearing corporations (CCs) for equity derivatives. These changes, first announced on October 16, 2023, aim to improve how CCs calculate potential losses when closing client positions.

On October 1, Sebi added new ways to figure out the Minimum Required Corpus (MRC) for the Settlement Guarantee Fund (SGF), which covers losses from failed trades. Key methods include:

1. Stressed Value at Risk (VaR): This method looks at price changes during stressful periods, doubling observed volatility to predict future price movements.
2. Filtered Historic Simulation: This adjusts past returns based on current market volatility.
3. Factor Model: This focuses on extreme movements in the Nifty index over a three-day period since 2000.

These methods help identify rare but impactful market events, enhancing the equity derivatives market’s resilience against extreme conditions, according to Puneet Sharma, CEO at Whitespace Alpha.

However, these measures might create challenges for long-short hedge funds. Increased volatility and tighter liquidity could lower trading volumes initially. While these new rules are meant to improve market stability in the long run, they may also increase costs for clearing members, which could be passed on to traders.

To help manage the higher MRC, Sebi has allowed a one-time transfer of funds between market segments. This includes transferring excess funds from the equity cash segment to the derivatives segment and allowing penalties and interest to be moved as well.

Sebi categorized clearing corporations into two groups based on their equity derivatives trading volume, with specific rules for calculating credit exposure for each category. The new stress testing methods will apply uniformly across CCs, and they must develop a standard operating procedure within 30 days.

Overall, while there are short-term challenges, these measures are expected to strengthen the market, increase investor confidence, and potentially attract more institutional investors.