Risk of Trade Execution

Risk of Trade Execution:

• Various types of transaction risk may involved due to delay between agreement on a trade and its execution in the securities market


• Delay is obviously required to execute the transaction


• Clearing and settlement period


• E.g., in Nepal: T+3 for equity (Previously it was T+5) and T+0 for bonds


• Securities market may have mechanism to address those risk to some extent


• Following types of risks of trade execution

1.       Principle risk:

• Risk to the seller that the buyer will fail to make payment of the securities


• May occur if there is gap between handing over securities and receiving money


• Can be eliminated by making delivery against payment (DAP)

2.       Replacement Risk

• Risk that a counterparty will fail to execute an agreement leaving you to find another deal


• The seller may face loss faced due to;


• Price fall of the security


• Cost associated to find another buyer etc.

3.       Liquidity Risk

• Risk that other transaction will be compromised because an agreed upon transaction is delayed


• E.g., money or securities may required to borrow to settle another transaction

4.       Operational Risk

• Risk that execution is delayed due to the failure of trading system


• Can incur other types of transaction risk

5.       Systemic Risk

• Risk that the failure of one trade or trader will cause the failure of other traders in a chain effect


• The chain effect occurs because one trade may rely on others and so on


• Not limited to a single market or economy as traders can simultaneously trade in many markets and problem of one can easily spill over to another

Clearing and Settlement

• Involves the process of clearing between the trades between the stock exchange members (brokers/dealers) and settlement of the transaction between the clients and the brokers

Clearing:

• Process of comparing and matching trades


• Involves confirmation of;


• Types and quantity of securities


• Transaction price and date


• Identification of buyers and sellers


• Netting is used to clear trades


• Advantage of netting is; the more transaction offset one another, there will be fewer actual delivery which ultimately result into;

  →          Cost minimization

  →          Time saving

  →          Risk minimization (Replacement Risk)                         

• Clearing houses are established for the purpose of clearing

Clearing houses receives trading information → confirms trades → netting     → Inform to depository and bank

                                                                                                                                         ↓

                                                                                                                                     Issue notice for delivery and payment

• Examples of clearing houses in US:


• Government Securities Clearing Corporation: government securities


• MBS Clearing Corporation: mortgage backed securities


• National clearing corporation: equity, corporate bonds, municipal bonds


• Options clearing corporation: options


• Board of Trade Clearing Corporation / Chicago Mercantile Exchange: financial futures and futures and options

Settlement:

• Fulfillment of obligations confirmed during clearing i.e. payment and certificate delivery and ownership transfer


• Ownership transfer is performed by depository institutions that immobilizes the physical securities so that they can be traded in book entry form i.e., actual certificates are kept in vault and the ownership of stock is recorded in computer “book entry system”


• Examples in US;


• Federal Reserve Board (Fed): Government securities


• Fed/ Depository Trust Company (DTC)/ Participatory Trust Company (PTC) : Mortgage backed securities


• DTC: Equity, corporate and municipal bonds

Figure: Clearing and settlement process in securities market

                                                                                               

Figure Adopted from: Securities Market Development for Policy Makers, May, 1996, World Bank, Economic Development Institute

• In Nepal, there is no depository institutions and clearing houses


• Clearing and settlement is done by stock exchange itself


• Ownership transfer is recorded by;


• Nepal Rastra Bank (central bank and its market makers): for government securities


• Listed companies/ Share registrar of the listed companies: for corporate equities and bonds


• Licensing provisions for share registrars have been made in recently issued Merchant Banking Regulation, 2008, issued by Securities Board of Nepal


• Initiation of establishing depository institution is currently being undertaken by the Government

Regulation of Securities Markets:

• Purpose of Regulation


• Operational Efficiency


• Minimum transaction cost


• Minimized risk


• Integration of market services


• Informational efficiency


• Ensure regular flow of credible information that could be supportive to fair price discovery


• Consumer Protection


• To protect consumer from market malpractices


• Following may be the malpractices that can be seen in the markets where there is weak regulatory mechanism


• Issuers might mislead the investors about potential risk and return


• Intermediaries can cheat the investors


• Insiders may buy securities for less than fair price from uninformed investors


• Players can manipulate price buying and selling small quantity and buy and sell large blocks at once


• Regulatory Framework


• Securities Acts


• Securities Rules, Regulations, Byelaws, Guidelines and Directives issued under the Acts


• Other related Acts


• Regulators


• Government Regulators


• Institutions created by the government under securities act


• Responsible for administering all the securities and related acts


• Responsible for executing government policies


• Regularly monitors markets and participants to ensure fairness, transparency and credibility of the market


• Self Regulators


• Self regulated under given legal framework


• Certain regulatory authority is provided by law


• Examples; Stock exchanges and securities dealers associations


• Basic Regulatory Provisions


• Securities regulator administers the securities laws


• Issuers of new securities must register the filing statements disclosing all relevant information, with securities regulator,


• Issuers whose securities are listed on the stock exchange must file annual reports and other periodic statements with securities regulator


• Any trading system that is “Securities Exchange” must register with the securities regulator


• Company insiders must file a report of any trading in a company’s securities


• Market manipulation and disclosure of false and misleading information are prohibited

Regulation of Nepalese Securities Markets:

• Regulatory Framework     


• Securities Act, 2006


• Establishment of SEBON, provisions for licensing of stock exchange and securities businesspersons, issue and trading regulation


• Securities Board of Nepal Regulation, 2007


• Stock Exchange Operation Regulation, 2007


• Securities Businessperson (Broker/Dealer/Market Maker) Regulation, 2007


• National Debt Act, 2002


• Authorized NRB for the primary as well as secondary market management of Government Securities


• Securities Exchange Regulation, 1993


• Securities Issue Related Guidelines


• Securities Allotment Guidelines, 1994


• Issue Management Guidelines, 1997


• Securities Registration and Issue Approval Guidelines, 2000


• Bonus Share Issue Guidelines, 2001


• Rights Issue Disclosures Policy, 2005


• Debenture Trust Deed Disclosure Policy, 2006


• Secondary Market Related Byelaws and Guidelines


• Securities Listing Bylaws, 1996


• Membership of Stock Exchange and Transaction Bylaws, 1998


• Government Securities Trading Management Bylaws, 2005


• Government Securities Trading Byelaws, 2005


• Guidelines on Business conduct for Stock Brokers, 2001


• Other Related Laws


• Companies Act, 2006


• Banks and Financial Institutions Act, 2006


• Insurance Act, 1992 etc.


• Regulators            


• Government Regulators:


• Securities Board of Nepal


• Apex regulatory body of Securities Market in Nepal


• Regulates issuance and secondary trading of corporate securities and trading of government securities in the stock exchange


• Nepal Rastra Bank (The Central Bank)


• Role in regulation of Government Securities trading in the stock exchange


• Margin regulation (Margin determination)


• Company Registrar's Office


• Responsible for administering Companies Act, which has various provisions regarding the issuance of securities, rights of shareholders, corporate reporting, company liquidation etc.


• Self Regulator:


• NEPSE can be considered as self regulators as;


• It can prepare byelaws


• Can issue membership to the brokers and dealers


• Can supervise and monitor its members and take certain enforcement actions such as trading suspension

Securities Market Regulation in USA:

• Regulatory Framework


• Securities Act, 1934


• Establishment of SEC


• Licensing of SE and Brokers/Dealers


• Trading regulation


• Issue Regulation


• Securities Reform Act, 1975


• Establishment of Municipal Securities Rule Making Board for self regulation of municipal bond market


• Government Securities Act, 1986


• Insider Trading and Securities Fraud Enforcement Act, 1988


• Commodity Exchange Act, 1936


• Requires trading to take place on designated exchanges


• Established licensing and regulation of future exchanges traders and brokers


• Other Securities Laws


• Glass Steagall Act, 1933: prohibits commercial banks to form the market for corporate securities


• Investment Advisor Act, 1940: Requires investment advisor to register with SEC


• Securities Investors Protection Corporation Act, 1970: SIPC established, which insures the accounts of customers of securities firms

• Regulators:


• Government Regulators


• US Securities and Exchange Surveillance Commission (SEC): Stock Bonds, Government Securities


• Federal Reserve Bank (Fed): Government Securities, Margin Regulation


• Commodity Future Trading Commission: Future and Options


• Self Regulators


• New York Stock Exchange (NYSE) and Other Exchanges


• National Association of Securities Dealers


• Municipal Securities Rule Making Board


• National Futures Association


• Options and Clearing Corporations