The NCCL issued a circular (NCCL/RISK-039/2020) on September 23, 2020 notifying members to take note of SEBI’s circular (SEBI/HO/CDMRD/DRMP/CIR/P/2020/176) dated September 21, 2020 on Alternate Risk Management Framework Applicable in case of Near Zero and Negative Prices.
Here are the details of that circular released by SEBI.
The circular drew attention to the extreme volatility observed in commodity prices globally, particularly in the case of crude oil. The prices of crude oil commodities had gone down to zero and past that, even to negative values. In such a scenario, margins of even 100% of the futures price would not have been sufficient to cover the steep price variations in the futures market.
To handle such a scenario of ’near zero’ and negative prices, SEBI constituted a Task Force of Clearing Corporations (CCs) and market participants to review the risk management framework in such cases.
Decisions taken based on the recommendations of the Task Force
The following have been decided upon based on the recommendations of the Task Force.
1. The Alternate Risk Management Framework (ARMF) shall be applicable in cases of near zero and negative prices for any underlying commodities or futures.
2. To identify the commodities that are to be treated as susceptible to the possibility of near zero and negative prices, the following characteristics have been recognized.
- Commodities that need specialized storage space in physical markets, which, if not followed, may cause environmental hazards or have other external implications
- Commodities that can’t be disposed of or destroyed easily, where the disposal or destruction of such commodities may cause an environmental hazard or may incur significant costs
3. The CCs shall ensure that their systems are ready to implement the ARMF as prescribed within 60 days of the said circular.
4. But CCs who do not currently provide for the clearing and settlement services of any such permitted commodity are not required to update their systems for the prescribed ARMF.
5. The exchanges shall take steps to make necessary amendments, if any, to their byelaws, rules and regulations for the implementation of the ARMF and notify their members about the provisions of the circular. Exchanges are also required to circulate this information on their website and communicate the status of the implementation of these provisions to SEBI.
Details of the Alternate Risk Management Framework in the event of Near Zero and Negative Prices
The annexure to SEBI’s circular gave the details of the activation, characteristics and deactivation of ARMF.
Activation of ARMF
1. If the CC foresees the possibility of negative or near zero prices for any commodity, then it shall activate an ARMF for such commodity derivatives.
2. The shift to the ARMF shall be conditional and based on triggers that indicate the likelihood of near zero or negative prices.
3. Some conditions that indicate this likelihood may warrant the activation of the ARMF are illustrated below.
- While comparing the intra-day highest/lowest prices, if there is a fall in the commodity prices by more than 50% within 20 trading days
- If the international exchange/CC having the benchmark contract decides to introduce such measures for negative prices (in case of internationally referenced contracts)
- If options contracts having strike price values of near zero/negative are introduced by the stock exchange for trading
- If the price of the underlying commodity/futures contract comes down to a level equal to or lower than the maximum price movement observed over the MPOR (Margin Period of Risk) in past 12 months
- In case one or more of the above-mentioned conditions or any other condition at the discretion of the CC occurs, indicating the possibility of negative prices
4. In case any of the above-mentioned conditions becomes applicable, the CC shall consult with the respective stock exchange, conduct a review and take a formal decision on whether there is a need to activate the ARMF.
5. The CC shall also communicate its decision to the market and other stock Exchanges/CCs.
6. If the Lead CC has activated the ARMF, then the other CCs shall also follow the same.
7. The CC shall intimate to the market well in advance the threshold price level below which the ARMF shall be activated.
Characteristics of ARMF
The ARMF shall have the following characteristics.
1. Normal Distribution: In a regular risk management framework, prices are assumed to be log normally distributed and volatility is calculated based on the difference in log prices. But in the case of alternate risk management framework, the prices shall be assumed to follow normal distribution, and volatility shall be based on the absolute differences in prices.
2. Minimum Margin in Absolute Terms: In the regular framework, a floor value for initial margin is given as a percentage. In case the prices turn negative, however, the floor value shall be higher of these two values.
- Floor value in percentage terms applied on the absolute value of price levels
- Floor value shall prescribed in absolute INR terms
3. Spread margin benefit: The correlation between different contracts on the same underlying may not remain valid in case of near zero/negative prices. So, the margin benefit on spread positions shall be completely withdrawn upon the activation of the ARMF.
4. Option Pricing Model: The theoretical price determination of options shall be done using appropriate models like the Bachelier model or any other model that can be applied to negative underlying prices.
5. Pre-expiry margins: For commodities in which the ARMF is activated, the appropriate pre-expiry margins shall be levied by CCs on cash settled contracts.
6. Extreme Loss Margin (ELM): In case the price of any futures contract goes below a threshold, ELM shall be levied on the higher of the following:
- Such threshold price
- The absolute price of the contract
7. Other margins: CCs may levy any other margins as per their own discretion.
Deactivation of ARMF
The following principles shall be considered by CCs for deactivation of the ARMF.
1. Deactivation of the ARMF shall be done when the conditions that triggered the activation of the ARMF no longer prevail.
2. In order to avoid frequent switching between alternate and regular frameworks, deactivation of the ARMF should be done after a reasonable period from its activation.
3. In case the entry and exit of the ARMF is defined in terms of specific price points, the exit point shall be kept sufficiently above the entry point to avoid frequent switching between alternate and regular frameworks.
4. The deactivation of the ARMF and the reactivation of regular framework is to be done when the margin requirement under the two frameworks sufficiently converges.