Trading Mechanism in Exchange Traded IRD

Trading Mechanism in Exchange Traded IRD (Part 1)

Definition: Exchange Traded Interest Rate Derivatives (ETIRD) are traded on a stock exchange as part of the currency derivatives segment.
Details: The trading mechanism involves various entities, including stock exchanges, clearing corporations, trading members, authorized persons, clearing members, and investors/clients.

Key Entities in the Trading System

Stock Exchanges: Provide a trading platform, disseminate information, and ensure equal access to investors.
Clearing Corporations (CC): Handle clearing, settlement, and risk management for trades executed on exchanges.
Trading Member and Authorized Person: Trading members are members of the stock exchange, while authorized persons are agents of the trading member who provide access to the trading platform.
Clearing Members: Have clearing and settlement rights in a recognized clearing corporation and help clear trades for their clients.
Investor/Client: Trade in ETIRD through a trading member of the currency derivatives segment.

Exchange Trading System

Features: Screen-based, fully automated, transparent, anonymous order matching, high-speed execution, and connected to multiple interfaces.
Trader Workstation (TWS): The terminal from which members access the trading system, providing transaction information and market data.
Order Management: Orders are entered, modified, and matched based on price-time priority.
Risk Management: Facilities are in place to avoid order entry-related errors.
Nationwide Reach: Trading members can access the trading system from anywhere in the country.

Trading Mechanism in Exchange Traded IRD (Part 2)

Definition: The trading mechanism for exchange-traded IRD involves the use of various systems and facilities to enable trading.
Details: Exchanges provide facilities such as Computer to Computer Link (CTCL), Internet-based trading (IBT), Direct Market Access (DMA), and Security trading through wireless technology facility (STWT) to enable trading.

Key Concepts

Order Placement: Clients can place orders through various channels, including internet, phone, and direct market access (DMA).
Risk Management: Brokers are required to perform risk management checks before sending orders to the Exchange.
Order Confirmation: The Exchange gives confirmation of the order and time stamps it.
Order Types: Orders can be market orders, limit orders, or other types, which determine the terms and conditions of execution.

Trading Facilities

Direct Market Access (DMA): A facility that allows brokers to offer clients direct access to the exchange trading system without manual intervention.
Algorithmic Trading: A type of trading that uses automated execution logic to generate orders.
High Frequency Trading (HFT): A type of algorithmic trading that is latency-sensitive and characterized by high daily portfolio turnover and high order-to-trade ratio.

Order Routing and Execution

Order Routing: Orders are routed to the Exchange for execution through the broker's trading system.
Order Execution: Orders are executed at the Exchange depending on the type of order and availability of counter orders.
Trade Confirmation: A trade confirmation message is sent to the broker's trading terminal after a trade is executed.

Order Book

Definition: An electronic list of buy and sell orders available for matching for a specific security or derivatives contract.
Details: The order book provides information on price, availability, and depth of trade, and is updated in real-time throughout the day.
Example: A typical order book displays the number of orders, quantity, and price for each buy and sell order.

Spread Order Book

Definition: A separate order book for calendar spread combinations.
Details: The spread order book allows dealers to set up spread combination contracts and place buy and sell spread orders.

Trading Mechanism in Exchange Traded IRD (Part 3)

Spread Contracts: Allow participants to trade the difference in price between two contracts, such as the 6.10% GOI bond 2031 future OCT21NOV21 spread contract.
Order Matching: Orders are matched in the spread order book based on price-time priority, where the price is the difference between the far month contract and the near month contract.
Trade Execution: Once a spread order is matched, trades are executed at the following prices:
- Traded price for the first leg contract = Reference price (Last Traded Price of the first leg contract)
- Traded price for the second leg contract = Reference price + the price difference entered for the spread order
Buy and Sell Side Spread:
- A buy side spread means selling the near month leg (first leg) and buying the far month leg (second leg).
- A sell side spread means buying the near month leg (first leg) and selling the far month leg (second leg).
Order Management: Consists of entering orders, order modification, order cancellation, and order matching.
Order Components: Include price, time, quantity/no. of contracts, security/contract, action (buy/sell), and client identity (UCC and PAN).
Order Entry: Trading members can enter various types of orders during market hours, with order conditions classified into price-related, time-related, and quantity-related conditions.
Types of Orders:
- Market Order: Executes a trade at the best available market price.
- Limit Order: Sets a specific price for buying or selling, aiming to buy at or below the market price or sell at or above it.
- Market Order with Protection: Combines a market order with a limit order, protecting against execution at unfavorable prices.

Trading Mechanism in Exchange Traded IRD (Part 4)

Order Matching: The incoming limit order will get matched with the best sell order in the book.
Stop Orders: Allow the Trading Member to place an order which gets activated only when the market price of the relevant security reaches or crosses a threshold price.
Stop Loss Order: A stop order can best be explained with an example, where a trader has a short-term bullish view on a debt security and may buy the bond future at a certain price.
Types of Stop Orders:
- Sell Stop Loss Order: Gets triggered when the market price falls below the trigger price.
- Buy Stop Loss Order: Gets triggered when the market price rises above the trigger price.
Time Condition:
- DAY: A Day order, valid for the day on which it is entered.
- IOC (Immediate or Cancel): Allows a Trading Member to buy or sell a security as soon as the order is released into the market.
- GTC (Good Till Cancelled): An order that remains in the system until it is cancelled by the Trading Member.
- GTD (Good Till Days/Date): Allows the trading member to specify the days/date up to which the order should stay in the system.
Quantity Condition:
- DQ (Disclosed Quantity): Allows the Trading Member to disclose only a part of the order quantity/lot to the market.
- MF (Minimum Fill): Allows the Trading Member to specify the minimum quantity by which an order should be filled.
- AON (All or None): Allows a Trading Member to impose the condition that only the full order should be matched against.
Other Conditions:
- Pro (Proprietary Trading): Trading members are allowed to trade on their own behalf.
- Cli (Client Trading): Trading members enter orders on behalf of a client.
Order Modification/Order Cancellation: Orders can be modified or cancelled during market hours if they have not been fully or partially executed.
Trade Execution: Occurs when a buyer and seller reach an agreement pertaining to the terms and price of a trade and the order to buy or sell a security is completed after the same is matched on the Exchange platform.

Trading Mechanism in Exchange Traded IRD (Part 5)

Trade Confirmation: After a trade is executed, the exchange sends a notification to the broker with details such as trade number, time, quantity, and price.
Trade Modification: Modifications are allowed for parameters like client code and custodian participant code, but there are specific conditions and timings for such changes.
Error Accounts: Brokers must disclose error accounts to the stock exchange and have a well-documented error policy in place.
Penalty for Modification: Stock exchanges may levy a penalty on trading members for modifying client codes, except in cases of genuine errors.
Trade Annulment: Trading members can request trade annulment within 30 minutes of trade execution, with a fee applicable based on the trade value.

Risk Management and Order Routing

Risk Management System: An efficient risk management system is crucial for protecting investor interests and ensuring efficient settlement.
Broker Responsibilities: Brokers are responsible for settling trades and must have an online risk management capability for all orders.
Margin Requirements: Clearing corporations levy margins on brokers based on their exposure and risk, which brokers must collect from clients upfront.
Risk Management Goals: The goal of a broking firm's risk management system is to measure and manage its own and its clients' exposure to various risks.

Types of Risk for Members

Operational Risk: The risk of monetary loss due to inadequate internal processes, manual and systems errors, or external events.
Market Risk: The risk of incurring losses due to adverse changes in financial asset prices, such as stock prices.
Credit Risk: The risk of default on a debt that may arise from a borrower failing to make required payments.
Legal Risk: The risk that an entity may not be able to enforce a contract against another party.
Systemic Risk: The risk that a disruption in one firm or market segment could cause a "domino effect" throughout the financial markets.

Trading Mechanism in Exchange Traded IRD (Part 6)

Risk Management: A stock broking firm must identify factors that can trigger operational, market, legal, systemic, and credit risk. It needs to establish procedures to manage these risks, including adapting trade-entry procedures, customer documentation, client engagement methods, trading limits, and other normal activities.
Monitoring of Unauthenticated News: SEBI has directed SEBI Registered Market Intermediaries to put in place proper internal code of conduct and controls to prevent the circulation of unauthenticated news. This includes:
- Not encouraging or circulating rumors or unverified information without verification
- Controlling access to social media platforms, instant messaging services, and other mediums
- Maintaining logs of usage as records
- Requiring employees to forward market-related news to the Compliance Officer for approval before sharing
SEBI Regulations: SEBI has introduced Chapter IVA in SEBI (Stock Brokers) Regulations, 1992, which requires stock brokers to comply with obligations/mechanisms for prevention and detection of fraud or market abuse, including:
- Systems for surveillance of trading activities and internal controls
- Obligations of the stock-broker and its employees
- Escalation and reporting mechanisms
- Whistle Blower Policy
Pre-Order and Pre-Trade Checks: Various checks are available on Trading Workstations (TWS) and trading systems of the Exchange, including:
- Price range check
- Quantity Freeze
- Single order quantity/value limit
- User order value limits
- Cumulative open order value checks
- UCC/PAN check
- Trade Execution Range
- Self-Trade Check
- Market price protection
- Kill Switch
- Cancel on Logout (COL)
Risk Disclosures: SEBI has introduced Risk Disclosures for trading in equity Futures & Options (F&O) segment, which must be displayed prominently on stock brokers' websites and to all their clients.
Investor Risk Reduction Access (IRRA) Platform: SEBI has introduced the IRRA platform to provide investors with an opportunity to square off/close open positions and/or cancel pending orders in case of disruption of trading services provided by the Trading Member.
Framework to Address Technical Glitches: SEBI has introduced a framework to address technical glitches in Stock Brokers' Electronic Trading Systems, including:
- Informing stock exchanges about technical glitches within 1 hour
- Submitting a Preliminary Incident Report within T+1 day
- Submitting a Root Cause Analysis (RCA) Report within 14 days
- Implementing corrective/preventive measures
Business Continuity for Interoperable Segments of Stock Exchanges: SEBI has decided to implement business continuity plans for interoperable segments of stock exchanges, including cash market, equity derivatives, currency derivatives, and interest rate derivatives.

Trading Mechanism in Exchange Traded IRD (Part 7)

Introduction to Trading Mechanism: The derivatives segment and interest rate derivatives allow participants to hedge their open positions by taking offsetting positions in identical or correlated indices on other exchanges.
Key Concepts:
- Hedging: Participants can hedge their open positions by taking offsetting positions in identical or correlated indices on other exchanges.
- Interoperability: The derivatives segment is interoperable, allowing participants to net off their open positions and release margin by taking offsetting positions on other exchanges.
Scenarios for Trading Mechanism:
- Identical or Correlated Trading Products: If identical or correlated trading products are available on another trading venue, participants can hedge their open positions by taking offsetting positions in those products.
- Scrips Exclusively Listed on an Exchange: Exchanges may create reserve contracts for scrips exclusively listed on other exchanges to ensure continuity.
- Index Derivatives Products: Exchanges may create index derivatives products that are highly correlated with products available on other exchanges to provide an avenue for hedging.
- Intimation to SEBI and Alternative Trading Venue: The affected exchange must intimate SEBI and the alternative trading venue within 75 minutes of an outage, and the alternative trading venue must invoke its business continuity plan within 15 minutes.
Cyber Security and Cyber Resilience Framework (CSCRF):
- Definition: A framework to provide standards and guidelines for strengthening cyber resilience and maintaining robust cybersecurity for SEBI-regulated entities.
- Objectives: To address evolving cyber threats, align with industry standards, encourage efficient audits, and ensure compliance.
- Cyber Resiliency Goals:
  - Anticipate: Maintain a state of informed preparedness from adversary attacks.
  - Withstand: Continue essential business functions during adversary attacks.
  - Contain: Localize containment of crisis and isolate trusted functions from untrusted ones.
  - Recover: Restore business functions after adversary attacks.
  - Evolve: Change business functions and cyber capabilities to minimize adverse impacts of adversary attacks.
Safeguards to Avoid Trading Disruption:
- Software Escrow Arrangement: Stock brokers may establish a software escrow arrangement with their software vendors to ensure smooth transition in case of vendor failure.
- Reducing Dependence on a Single Vendor: Large stock brokers may consider engaging multiple software vendors to reduce dependence on a single vendor.
Framework for Adoption of Cloud Services:
- Definition: A framework to highlight key risks and mandatory control measures for SEBI-regulated entities adopting cloud services.
- Applicability: Applicable to public cloud, community cloud, and hybrid cloud deployments.
- Conditions: REs must comply with conditions specified in the framework, including governance, risk, and compliance (GRC), selection of cloud service providers, data ownership, and security controls.
Surveillance:
- Definition: The process of monitoring positions, prices, and volumes in real-time to deter market manipulation.
- Key Features:
  - Online Surveillance Capability: Exchanges have online surveillance systems that monitor positions, prices, and volumes in real-time.
  - Alerts: The system generates alerts for material aberrations from normal activity.
  - Monitoring: The system monitors open interest, cost of carry, volatility, and closing prices.
Price Limit Circuit Filter:
- Definition: A mechanism to prevent acceptance of orders placed beyond the price limits set by the stock exchanges.
- Price Bands: The price bands for interest rate futures and options contracts are +/- 3% of the base price, with the option to expand the band by 0.5% after 30 minutes.

Trading Mechanism in Exchange Traded IRD (Part 8)

Definition: The trading mechanism for Exchange Traded Interest Rate Derivatives (ETIRD) involves various rules and regulations to ensure fair and efficient trading.
Details: The operating range for Overnight MIBOR futures is +/- 5% of the base rate of the contract, and the price band for Corporate Bond Index Futures is 5% of the previous closing price or base price.

Key Concepts

Price Bands: The price operating range for GOI bond options is based on the delta of the options contract and calculated using the previous close price of the underlying and volatility.
Trading Costs: Trading members should specify various charges, including brokerage, payable by the client to avoid disputes.
Brokerage: Brokerage can be charged as mutually agreed between the member and client, subject to the maximum permissible by the Exchange.
Statutory Levies: These include charges levied by Central/State governments, such as Goods and Service Tax, Security Transaction Tax (STT), and Stamp Duty.
Regulatory Levies: These include charges levied by SEBI, Exchanges, and Clearing Corporations, such as SEBI turnover fees and Exchange transaction charges.

Trading Costs and Brokerage

Brokerage Rules: The maximum brokerage chargeable by a trading member for futures is 2.5% of the contract value, and for options, it is 2.5% of the premium amount or Rs. 100 per lot.
SEBI Turnover Fees: Every stock broker/clearing member/self-clearing member shall pay a fee to SEBI at the rates specified by SEBI.
Stamp Duty: A mechanism for collecting stamp duty on securities market instruments has been created, with a rate of 0.0001% applicable on the buyer for Interest Rate Derivatives.

Sample Questions

A client can place an order in exchange-traded interest rate derivatives through all of the above (phone, internet, direct market access).
A Buy or Sell order that is lying unmatched in the order book is known as Active Orders.
A Market order is classified as a price-related condition.
Due to denial of matched orders by clients, Operational risk arises.
If the base rate of Overnight MIBOR futures is 5, then its operating range will be 4.75 & 5.25.