When brokers trade stocks on a stock exchange, they don’t trade with each other but with only one counter party, the clearing-house. It is the clearing-house that becomes a buyer to every seller and a seller to every buyer.

It takes money from the buyers and shares from the sellers and passes them over. By putting the clearing-house in between, brokers don’t have to directly assume the default risk of other brokers, but only of the clearing-house.

Default risk is inevitable in stock trading because transactions and their settlement do not happen simultaneously but with a time lag. We all buy and sell things and we know that a sense of discomfort, i.e. counter party default risk, does not leave us till the transaction is settled. That’s because, “nothing good happens between trade and settlement.” In the rolling T+3 trade settlement cycle in stock exchanges, which is now the standard the world over, the time lag between trade and settlement is three days. At any given day, three days of trades remain unsettled. The more the trades and the longer they remain unsettled, the more is the likelihood of default. That’s why having a clearing-house as a central counter party is essential.

The clearing-house is of much lower risk than individual brokers because of two reasons. First, it uses a number of established risk management measures against the risk of default by any broker. Second, due to transparency in its operations, its credit worth is much easier to judge than that of individual brokers.

By acting as counter party to all trades, clearing-house is also able to “net” the trades. Instead of settling every trade, through delivery or payment, brokers have to settle their only net outstanding positions.

For instance, if a broker buys 10,000 shares of a company in a day and sells 8,000 of its shares, then only 2000 shares are to be settled at the clearing-house level.

This allows speculators to trade very large volumes and settle only the profits or losses and not the principal amounts involved. It is because of centralized risk management and netting, that so many trades are executed on a stock exchange. Without a clearing-house, the traded volume would have been a fraction of what it is with a clearing-house. Liquidity and price discovery, one of two core reasons for the existence of a stock exchange, rest on the existence of a clearing-house.

Clearing-house does not eliminate risk, it centralizes and manages it, and therefore, sound risk management is essential for the viability of a clearinghouse. Brokers may default but clearing-house must never because default of the clearing-house means end of the market or at least an indefinite suspension. Such a default can be so damaging to the investor confidence that it simply cannot be allowed to happen.

Since default risk of clearing-house stems from the default risk of brokers, clearing-house and the exchange take several measures to avoid or manage broker defaults include advance margin deposits, limits on share price volatility, real time monitoring of trading, clearing-house protection fund etc. Here we wish to focus on one of these risk management measures, the clearing-house protection fund.

If a broker defaults, clearing-house would try to make for his unsettled obligations by liquidating the positions of the defaulter. If shortfalls arise, they are made up for by this fund so that the rest of the market can settle its trades. Later, through sale of defaulter’s other assets, the exchange recovers what it can.

In developed markets, clearing is mostly done by companies separate from the stock exchange, though the exchange is often the majority shareholder in the clearing company. It is also not unusual to have the clearing company regularly credit rated by a credit rating company to maintain high standards of risk management and transparency in credit risk. For example, at Chicago Board of Trade (CBOT), which is one of the largest Futures exchanges in the world, the clearing is done by the Board of Trade Clearing Corporation (BOTCC) which receives the best possible triple-A rating from Standard & Poor’s.

Internationally clearing-house protection funds are made up of (i) initial contributions made by Exchange and its brokers (ii) regular contributions from brokers (iii) insurance coverage and (iv) standby lines of credit.

At the Stock Exchange Mumbai (BSE) in India, the exchange has contributed an initial sum to the fund. Every member has to deposit a refundable deposit of Rs1 million in a trade guarantee fund and only cash and bank guarantees of specified banks are accepted. All active members are required to make an initial fixed contribution and a variable contribution linked to the traded value by way of continuous contribution, which is debited to their settlement account in each settlement. The declaration of a member, who is unable to meet his settlement dues, as a defaulter is a pre-condition for invoking the provisions of this fund.

In Hong Kong stock exchange, the protection fund is made up of broker contributions, transfer from Hong Kong’s clearing reserves and insurance cover. The premium for the insurance cover is paid from interest received on bank deposits of cash contributions by participants and transfer from Hong Kong Clearing’s reserves.

Broker participants contribute in proportion to their average daily positions for previous month, subject to a minimum for every trading right held in the stock exchange, with the balance in cash or bank guarantees. The amount of contribution is reviewed monthly.

At the stock exchange of Thailand, clearing is carried out by the Thailand Security Depository Co Ltd. In the protection fund, brokers are required to pay in contributions to the fund, an entrance fee of 900,000 baht and monthly distributions of 0.008 per cent of the net value of all the securities’ transactions of each fund member each month, but not less than 1,000 baht per month.

In Singapore Stock Exchange, a clearing fund is applied in the event that a clearing member is unable to discharge its money obligations to Central Depository Ltd or if the CDP suffers any loss as a result of liquidating a clearing member’s position.

As of 30 June 2001, the clearing fund had a value of S$160 million consisting of (i) S$15 million in contributions (in the aggregate) from member firms (ii) S$25 million of CDP’s funds set aside for such purpose (iii) S$45 million in insurance coverage; and (iv) S$75 million from a standby line of credit.

In our three exchanges,The Karachi Stock Exchange,the Lahore Stock Exchange and the Islamabad Stock Exchange, clearing-house protection fund is made up of contributions from active brokers. A portion of the transaction fee charged by the exchange, which is Rs3.75 on every 100,000 of traded value, goes to the respective clearing-houses.

In line with international practices, we are moving towards having a single clearing-house for the three exchanges, namely the National Clearing Company (NCC) , which is a company separate from the three exchanges.

It would be appropriate that apart from routine contributions from brokers, we consider benefiting from other elements of clearing-house protection fund as seen internationally. Moreover, it would be useful if the NCC is regularly credit rated, so that independent professional view of the default risk is available to all market participants.