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  • May 11th, 2005
  • Comments Off on NCEL sets up electronic money market instrument
National Commodity Exchange Limited (NCEL) has established an electronically tradable money market instrument which would help replace badla system from margin financing, boosting secondary debt market in the country. According to sources, NCEL has established an interface between banking system and the securities markets whereby banks can provide loans backed by securities, as collateral, to the members of the stock exchanges to replace badla. Besides the oft-cited reasons for elimination of badla, the most ignored reason is that in badla, settlement can be deferred indefinitely. The 'counter-party' credit risk is commensurately larger.

The extent of the counter-party credit risk is determined by a) the extent of leverage, and b) the time horizon over which volatility impacts upon the position. Therefore, large leveraged positions over longer tenures can generate large losses, lead to defaults and can also trigger a dominoes effect in the securities markets.

Proponents of badla favour it because it is secure and is easily available.

Margin financing requires technology to undertake continuous valuation of the collateral, and calculation of collateral requirements and liquidation of collateral, if the borrower does not meet the margin call. Additionally, financial institutions will be required to undertake a detailed credit analysis of each and every borrower, which substantially increases the cost of doing business for both the lending banks and the borrowers.

NCEL has a solution, which addresses the above issues through: a) centrally managing counter-party credit risk and default risk; b) providing easy and efficient availability of financing at publicly observable rates for tenors ranging from one day to one year; c) real-time continuous valuation of collateral; d) real-time management of risk; and e) substantially reducing the cost of doing business, for both the borrower and the lender.

NCEL has innovated and developed 'Collateralized Borrowing and Lending Obligation (CBLO)', a money market instrument backed by approved securities, which can be listed on NCEL and traded electronically by financial institutions by bidding for debt contracts being offered by members of the stock exchanges.

CBLO is simply a debt instrument issued in electronic book entry form for maturity periods ranging from one day to one year. The benefit of electronic trading is that all participants and their orders will be neared equally and the trading screen will display orders anonymously, showing bids and offers for various tenors with size and the last trade price (interest rate), but without any counter-party information. This will provide a level playing field to all market participants in a completely transparent manner.

NCEL, using the Central Counter-party (CCP) clearing house business model, will be a buyer to every seller, and a seller to every buyer, through a process of Novation, and will manage the credit and market risks by its pre-trade risk checks against initial margins determined by using the industry standard Value-at-Risk methodology, mark-to-market daily settlement of variation margins, online surveillance and market monitoring, and unambiguous default and emergency processes including a last resort Settlement Guarantee Fund (SGF). All margins and clearing deposits make up the capital of the SGF to mitigate credit market, transactional and liquidity risks and therefore the quantum of capital of the SGF increases proportionately with the level of activity.

Daily collection of variation margin, and clearing and settlement of CBLO contracts will require an intensive and performance-sensitive payment system. NCEL, in collaboration with Muslim Commercial Bank Limited, has also developed the capability and processes for electronic collection of margin payments and transfer of funds on a T+0 basis.

Central Depository Company of Pakistan would be used for paperless pledging and settlement of securities.

During the settlement process, NCEL will assume certain risks, which may arise due to a default by market participants to honour their obligations. Settlement being on Delivery Versus Payment (DVP) basis, the risk from a default is the market risk (change in price of the underlying securities). NCEL processes are designed to cover test risks through its margining process.

NCEL is the only institution in Pakistan which has the technology, already in place, to undertake daily mark-to-market of the underlying collateral for the open positions, generate margin calls and collect variation margins electronically, thus completely eliminating the credit risk, amongst the market participants from the market.

At NCEL, Basel II capital adequacy framework is being used for measuring credit, market and operational risks to its CCP, thus ensuring that NCEL's SGF has adequate resources (initial margins, variable margins, variation margins, volatility [volatility based] margins and clearing deposits of market participants) to mitigate these risks. Another important aspect of the centrality, using CCP, is that it will allow close monitoring of the interest rate risk, concentration risk and collateral management risk as prescribed by the Pillar II (Supervisory Review Process) of the Basel II Accord.

NCEL has the intellectual capital, technology, infrastructure, processes and procedures already in place to support the listing, trading and settlement of CBLOs and therefore it would not require any major rework to launch this innovative product much before the phasing out of badla deadline of August 26, 2005.

Investments in gilt securities and listed TFC's have, for the past few decades, predominantly been a market dominated by the banks and financial institutions. Investments are being done primarily with the objective of holding till maturity. As a result, activity in the secondary market has been very subdued and consequently volumes very low. Existence of high coupon rates usually assured adequate returns on investments even without any churning of portfolios. Appetite for trading is almost non-existent. Moreover, lack of depth and non-availability of timely and reliable market information work as a barrier against the development of secondary debt market.

Screen based trading of a Collateralized money market instrument, like a CBLO, will greatly help in jump-starting the secondary market trading of debt securities and development of the debt market.

Financial institutions, in particular those, which offer debt contracts to their depositors and accept debt contracts from their borrowers, would greatly benefit by the introduction of screen based trading of money market instruments, such as CBLO, as it will allow them to increase their product offerings, without taking on additional market risks, as well as operate efficiently, particularly in an environment where interest rates are on the increase. Without having a vibrant secondary debt market, their choices are only limited to sell or hold and, in the case of the latter, it may require marking their portfolios to market. Either way, it will impact their earnings adversely.

Copyright Business Recorder, 2005


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