Executive Summary:
This SEBI circular, dated September 21, 2020, outlines an Alternate Risk Management Framework (ARMF) for Commodity Derivatives Segments (CDS) in scenarios of near-zero and negative commodity prices. It instructs Clearing Corporations (CCs) to prepare their systems for ARMF implementation within 60 days, while exempting those not currently clearing susceptible commodities if certified by their Risk Management Committee. Exchanges are advised to amend bylaws and inform members.
Key Points / Main Content:
Alternate Risk Management Framework (ARMF)
* ARMF applies to commodity futures susceptible to near-zero and negative prices.
* Susceptible commodities: those needing specialized storage, posing environmental hazards, or incurring significant disposal costs.
ARMF Activation:
* CCs activate ARMF if they foresee the possibility of negative/near-zero prices in any commodity derivative.
* Triggers for activation include:
* Commodity price fall of >50% within 20 trading days.
* International exchange implementing measures for negative prices.
* Introduction of option contracts with near-zero/negative strike prices.
* Contract price falls to or below the maximum price movement observed over the MPOR (Margin Period of Risk) in the past 12 months.
* CCs, in consultation with exchanges, decide on ARMF activation and communicate the decision to the market.
* Lead CC activation mandates other CCs to follow suit.
* CCs should provide advance notice of the threshold price for ARMF activation.
ARMF Characteristics:
* Price distribution shifts to normal distribution; volatility based on absolute price differences (EWMA).
* Initial margin floor value applied on absolute value of price levels and in absolute INR terms (higher of the two).
* Spread margin benefits are withdrawn.
* Option pricing uses models applicable to negative prices (e.g., Bachelier model).
* Pre-expiry margins levied on cash-settled contracts.
* Extreme Loss Margin (ELM) is levied if the future contracts go below a threshold (threshold/absolute price, whichever is higher).
ARMF Deactivation:
* ARMF deactivation occurs when triggering conditions no longer prevail, with a reasonable time lag.
* Exit point should be sufficiently above the entry point to avoid frequent switching.
* Deactivation occurs when margin requirements under both frameworks converge.
* Zero or negative prices excluded from models under the regular margin framework.
Implementation:
* CCs must ensure system readiness for ARMF within 60 days of the circular date.
* CCs not currently clearing susceptible commodities are exempt until they plan to launch such commodities, subject to Risk Management Committee certification.
Exchanges Responsibilities:
* Amend bylaws, rules, and regulations as needed.
* Inform members and disseminate the circular on their websites.
* Communicate implementation status to SEBI.
Impact Analysis:
Clearing Corporations (CCs):
* Impact: Required to implement and maintain the ARMF, assess commodity susceptibility, and potentially modify systems and risk management practices.
* Action Required: Assess system readiness, update systems within 60 days (if applicable), establish ARMF activation and deactivation procedures, and communicate with exchanges and market participants.
Exchanges:
* Impact: Need to amend bylaws and rules to accommodate the ARMF and ensure member compliance.
* Action Required: Review and amend bylaws, inform members of the new framework, and report implementation status to SEBI.
Members of Exchanges:
* Impact: Subject to new margin requirements and risk management procedures under the ARMF.
* Action Required: Understand the ARMF, monitor communications from exchanges and CCs, and adjust trading strategies accordingly.
Investors:
* Impact: Protected from extreme volatility in commodity derivatives markets due to near-zero or negative prices.
* Action Required: No direct action required, but should be aware of the new risk management framework.
Key Entities Referenced
Securities and Exchange Board of India (SEBI): Regulatory body for the securities market in India, which issued the circular.
Commodity Derivatives Segment (CDS): A segment of the securities market dealing with commodity derivatives.
Clearing Corporations (CCs): Organizations that provide clearing and settlement services for commodity derivatives transactions.
Alternate Risk Management Framework (ARMF): A risk management framework applicable in cases of near zero and negative prices for underlying commodities futures.
Risk Management Committee: A committee within Clearing Corporations responsible for risk management oversight.
Securities and Exchange Board of India Act, 1992: The act under which SEBI derives its powers.
Exponentially Weighted Moving Average (EWMA): A type of weighted moving average that applies exponentially decreasing weights to data points over time.
Extreme Loss Margin (ELM): An additional margin levied by Clearing Corporations when the price of a futures contract falls below a threshold.
CIRCULAR
SEBI/HO/CDMRD/DRMP/CIR/P/2020/176 September 21, 2020
To
The Managing Directors / Chief Executive Officers
All Clearing Corporations having Commodity Derivatives Segment
Sir / Madam,
Sub: Alternate Risk Management Framework Applicable in case of Near Zero
and Negative Prices
1. SEBI, vide Circulars CIR/CDMRD/DRMP/01/2015 dated October 01, 2015 and
SEBI/HO/CDMRD/DRMP/CIR/P/2016/77 dated September 01, 2016, has, inter
alia, prescribed the Risk Management Framework for the Commodity
Derivatives Segment (CDS). In addition to circulars issued in the interregnum,
the framework was further strengthened vide circular no. SEBI/HO/CDMRD/
DRMP/CIR/P /2020/15 dated January 27, 2020.
2. In recent times, extreme volatility has been observed in commodity prices
globally, particularly in the case of Crude Oil, wherein the prices had
unprecedentedly gone down to zero and subsequently, even negative. In such a
scenario, margins equivalent to even 100% of the futures price would not have
been sufficient to cover the steep upward or downward price variations in the
futures market.
3. In order to enable risk management framework 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. The following has been decided based upon the
recommendations of the said Task Force: -
3.1. Alternate Risk Management Framework (ARMF) shall be applicable in such
cases of near zero and negative prices for any underlying
commodities/futures. Details of the ARMF are given at Annexure-I to this
circular.
3.2. To begin with, the commodities having the following characteristics may be in
principle treated as susceptible to the possibility of near zero and negative
prices: -
Page 1 of 53.2.1. Commodities that need specialized storage space in physical markets,
which, if not followed, may cause environmental hazards or have other
external implications AND
3.2.2. Commodities that can’t be disposed of/ destroyed with ease i.e.
disposal/destruction of such commodities may cause an environmental
hazard or may incur significant cost.
3.3. The CCs shall ensure the readiness of their systems to implement the
prescribed ARMF within 60 days of the date of this circular.
3.4. However, CCs who do not presently provide for the clearing and settlement
services of any such susceptible commodity, are not required to update their
systems for the prescribed ARMF. This is subject to certification by their Risk
Management Committee that none of the products being presently cleared by
the CC are susceptible to near zero and negative prices as per Clause 3.2
above. However, before the launch of any such susceptible commodities in
future, they shall ensure that their systems are updated for the ARMF.
4. The exchanges are also advised to:
4.1. take steps to make necessary amendments, if any, to the relevant bye-laws,
rules and regulations for the implementation of the same.
4.2. bring the provisions of this circular to the notice of their members and also to
disseminate the same on their website.
4.3. communicate to SEBI, the status of implementation of the provisions of this
circular.
5. This circular is issued in exercise of the powers conferred under Section 11 (1) of
the Securities and Exchange Board of India Act, 1992, to protect the interests of
investors in securities and to promote the development of, and to regulate the
securities market.
6. This circular is available on SEBI website at www.sebi.gov.in.
Yours faithfully
Vishal V. Nair
Deputy General Manager
Division of Risk Management
Commodity Derivatives Market Regulation Department
vishaln@sebi.gov.in
Page 2 of 5Annexure - I
Alternate Risk Management Framework in the event of Near Zero and Negative
Prices
A. Activation of Alternate Risk Management Framework (ARMF)
1. In case the Clearing Corporation (CC) foresees the possibility of
negative/near zero prices in any commodity, then for such commodity
derivatives, it shall activate an ARMF. This framework will be capable of
estimating the risk in the event of negative/near zero prices of the
underlying/futures.
2. The shift to the ARMF shall be conditional, based on triggers indicating the
likelihood of near zero/ negative prices. Some of the conditions/circumstances
which are indicative in nature and may warrant the activation of the ARMF are
illustrated below: -
2.1. There is a fall in the commodity prices by more than 50% within 20 trading
days, while comparing the intra-day highest and lowest prices.
2.2. In case of internationally referenced contracts, the international exchange/
clearing corporation having the benchmark contract decides to introduce
such measures for negative prices.
2.3. Options contracts having strike price values of near zero/negative are
introduced by the stock exchange for trading.
2.4. Price of the underlying commodity/futures contract comes down to the
level equal to or lower than the maximum price movement observed over
the MPOR (Margin Period of Risk) in past 12 months.
2.5. Any other conditions as per the discretion of the CC, which might indicate
the likelihood of negative prices.
3. In case one or more of the above mentioned conditions or any other additional
conditions that may be identified by the CC becomes applicable, the CC in
consultation with their respective stock Exchange will conduct a review and
take a formal decision on whether there is a need to activate the ARMF. The
CC shall subsequently also communicate its decision to the market and other
stock Exchanges/CCs. If the Lead CC, as defined in SEBI circular no.
Page 3 of 5SEBI/HO/CDMRD/DRMP/CIR/P/2020/15 dated January 27, 2020, has
activated the ARMF, then the other CCs shall also follow the same.
4. The CC shall strive to intimate to the market, well in advance, the threshold
price level, below which the ARMF shall be activated.
B. Characteristics of the ARMF: The ARMF shall have the following
characteristics: -
5. Normal Distribution: In the regular risk management framework, prices are
assumed to be log normally distributed and volatility is calculated based on
the difference in log prices. This assumption is valid only for positive prices,
as logarithm of zero or negative prices is not defined.
In a scenario wherein the ARMF gets triggered, the prices shall be assumed
to follow normal distribution. Therefore, in such scenario, volatility shall be
based on the absolute differences in prices. This volatility shall be determined
based on EWMA (Exponentially Weighted Moving Average) as per the
parameters of the regular framework.
6. Minimum Margin in Absolute terms: In the regular framework, a floor value
for initial margin is prescribed in percentage terms. In case the prices turn
negative, floor value in percentage terms shall be applied on the absolute
value of price levels. Further, floor value shall also be prescribed in absolute
INR terms. The higher of the two values shall be the applicable floor for the
initial margin. The CC shall determine and notify such floor value based on
past price movements and past margin amounts observed in respect of such
commodities.
7. Spread margin benefit: The correlation between different contracts on the
same underlying may not hold in the event of near zero/negative prices.
Therefore, margin benefit on spread positions shall be completely withdrawn
upon the activation of the ARMF.
8. Option Pricing Model: The theoretical price determination of options shall be
done using appropriate models like the Bachelier model, or any other model
which can be applied on negative underlying prices.
Page 4 of 59. Pre-expiry margins: The appropriate pre-expiry margins shall also be levied
by CCs on cash settled contracts, in respect of those commodities in which
the ARMF is triggered.
10. Extreme Loss Margin (ELM): In case the price of any futures contract goes
below a threshold, ELM shall be levied on such threshold price or absolute
price of the contract, whichever is higher. The CC shall decide threshold price
in respect of each commodity on which ELM under the ARMF shall be made
applicable.
11. Other margins: CCs may levy other margins such as additional margins,
special margins, concentration margins etc. as per their own discretion.
C. Deactivation of ARMF
12. The following principles shall be taken into account by CCs for deactivation of
the ARMF i.e. switching from alternate to regular risk management
framework: -
12.1. The de-activation of the ARMF shall be done when the conditions that
triggered the activation of the ARMF no longer prevail. The exit from the
ARMF shall be done after a reasonable time lag so as to avoid frequent
switching between alternate and regular frameworks.
12.2. 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.
12.3. The de-activation of the ARMF and re-activation of regular framework will
be done when the margin requirement under the two frameworks
sufficiently converges.
13. The observation of a zero or negative prices shall have to be excluded from
model under regular margin framework since log return involving zero or
negative price is not defined.
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