CLEARING, SETTLEMENT AND RISK MANAGEMENT IN EXCHANGE TRADED CURRENCY DERIVATIVES

Clearing, Settlement and Risk Management in Exchange Traded Currency Derivatives

Definition: The process of determining the obligations and discharging them through settlement, with the Clearing Corporation acting as a central counterparty.
Details: The Clearing Corporation is responsible for the clearing and settlement of all trades executed in Exchange-Traded Currency Derivatives, guaranteeing their financial settlement.

Key Concepts

Clearing Mechanism: The process of working out open positions and obligations of clearing members, considering exposure and daily margin purposes.
Settlement Mechanism: A two-way process involving the transfer of funds and securities on the settlement date, with a multilateral netting procedure to determine net settlement obligations.
Risk Management: The process of managing risk through position limits, margins, and monitoring of positions on a continuous basis.

Entities in Clearing and Settlement

Clearing Corporation: An entity responsible for clearing and settlement of trades, acting as a central counterparty and providing financial guarantees.
Clearing Members: Entities with clearing and settlement rights, helping in the clearing of trades of their clients, and performing functions such as clearing, settlement, and risk management.
Clearing Banks: Entities acting as intermediaries between clearing members and the clearing corporation, handling pay-in and pay-out of funds.
Depository and Depository Participants: Entities facilitating holding of securities in electronic form and enabling transfer of securities by book entry.

Interoperability of Clearing Corporation

Definition: The concept of linking multiple Clearing Corporations, enabling a Clearing Member to select the Clearing Corporation of its choice to clear and settle trades executed in multiple exchanges.
Benefits: Choice to participants, better capital utilization, reduced trading disruption, reduced aggregate exposure, reduced operational complexity, and enhanced market competition and lower cost of clearing.
Framework: Applicable to all recognized clearing corporations, except those operating in International Financial Services Centre (IFSC), and all products available for trading on stock exchanges, except commodity derivatives.

Clearing Mechanism

Definition: The clearing mechanism involves working out open positions and obligations of clearing members.
Details: The open position is considered for exposure and daily margin purposes. The open positions of Clearing Members (CMs) are arrived at by aggregating the open positions of all the Trading Members (TMs) and all custodial participants clearing through him.

Determination of Settlement Obligations

Settlement of Admitted Deals: Admitted deals executed on a trading day are cleared on a netted basis, by the Clearing Corporation as prescribed under the relevant regulation.
Confirmation of Trades: Custodial participants are required to register themselves with the Clearing Corporation through their clearing members and avail a unique code which is linked to their clearing member.
Settlement Obligation: The clearing Corporation receives the details of trades and prices from the exchange. Settlement obligations are computed using a predefined methodology specified for the segment/product.

Methods of Determining Obligations

Daily Mark to Market Settlement: Daily settlement prices are computed for futures contracts based on a specified methodology. All open positions are marked to market at the settlement prices to determine mark-to-market obligations to be settled in cash.
Final Settlement: All positions of a clearing member in cash-settled futures contracts, at the close of trading hours on the last trading day of the contract, are marked to market at the final settlement price and settled.
Premium Settlement: Premiums in respect of admitted deals in options contracts are cash-settled by debit/credit of the clearing accounts of clearing members with the respective clearing bank.
Exercise Settlement: In the case of ETCD, all in-the-money contracts are exercised automatically and are randomly assigned to short positions in option contracts with the same series.
Netted Obligation: Funds obligation is generated on a netted basis considering the obligations of a clearing member in the ETCD and ETIRD segments.

Position Limits

Definition: Position limits are the maximum exposure levels specified for the entire market and for each trading member or investor.
Details: The regulator has specified the maximum allowable position limit at client level, member level, currency level etc.
Position Limits for Different Entities:
- Trading Member (Banks and Non-Banks): The position limits for trading members are specified as a percentage of the total open interest or a fixed amount, whichever is higher.
- Domestic Clients, Non-Resident Indians (NRIs) and FPI Cat II: The position limits for domestic clients, NRIs, and FPI Cat II are specified as a percentage of the total open interest or a fixed amount, whichever is higher.
- Prop Position for Stock-Broker (other than bank): The position limits for stock-brokers are specified as a percentage of the total open interest or a fixed amount, whichever is higher.
- Consolidated Position Limits for Stock Brokers: The consolidated position limits for stock-brokers are specified as a percentage of the total open interest across all FCY-INR pairs.

Key Concept 1: Position Limits

Definition: Position limits refer to the maximum amount of a particular currency derivative that a market participant can hold.
Details: The position limit is set at USD 100 million equivalent across all currency pairs involving INR, put together, and combined across all exchanges.

Key Concept 2: Single Limit Across Currency

Explanation: As per the RBI circular, users may take positions up to a single limit of USD 100 million equivalent across all currency pairs involving INR.
Key Points:
- Exchanges shall provide facility to users intending to take position beyond USD 100 million to designate an Authorised Dealer/Custodian.
- Exchanges shall provide information on day-end open positions and intra-day highest position of the user to the designated Authorised Dealer/Custodian.
- The onus of complying with the directions shall rest with the user.

Key Concept 3: Position Limits - Other Guidelines

Previous Day's Open Interest: The previous day's open interest at the respective exchanges is considered for the purpose of computation of position limits.
Position Limit Linked to Open Interest: The position limit linked to open interest is applicable at the time of opening a position.
Key Points:
- Positions need not be unwound immediately in the event of a drop of total open interest.
- Eligible market participants are not allowed to increase their existing positions or create new positions till they comply with the applicable position limits.
- Stock exchanges may direct market participants to bring down their positions to comply with the applicable position limits within the prescribed time period.

Key Concept 4: Monitoring of Position Limits

Explanation: Monitoring of position limits is done by the Exchanges and/or clearing corporation.
Key Points:
- When the open position of any trading member/client exceeds the specified limit, it is treated as a violation.
- The clearing member is accountable for the positions of all trading members and clients of trading members clearing through him.
- Exchange/Clearing Corporation may take actions against a trading member for client-level position limit violation.

Key Concept 5: Settlement

Definition: Settlement follows clearing and consists of receipt and payment of cash and/or delivery of underlying after multilateral netting in the clearing.
Details: Currently, all Exchange-Traded Currency Derivatives contracts are cash settled in Indian Rupees.
Key Points:
- All open positions on the last trading day of the futures contract are marked to the final settlement price of the relevant futures contract and settled in cash.
- The profit/loss resulting therefrom is paid to/received from such member in accordance with the settlement procedures.
- The daily settlement of ETCD trades is on T+1 working day and final settlement of ETCD trades is on T+2 working day.

Key Concept 6: Daily Mark to Market (MTM) Settlement

Explanation: Daily settlement prices are computed for currency futures contracts based on the specified methodology.
Details: All positions of a clearing member in currency futures contracts are marked to market at the daily settlement price and settled in cash.
Key Points:
- The settlement is done by debit/credit of the clearing accounts of clearing members with the respective clearing bank on T+1.
- All open positions are carried forward at the latest daily settlement prices.

Clearing, Settlement and Risk Management in Exchange Traded Currency Derivatives

Introduction to Clearing and Settlement

Definition: Clearing and settlement refer to the process of transferring securities and funds between buyers and sellers.
Details: In the context of currency derivatives, clearing and settlement involve marking positions to market, settling profits and losses, and ensuring that all obligations are fulfilled.

Mark to Market (MTM) Settlement

Definition: MTM settlement involves valuing open positions at the current market price and settling the difference in cash.
Details: For currency futures, MTM settlement is done on a daily basis, and the profit or loss is calculated based on the difference between the current market price and the previous day's settlement price.

Example of MTM Settlement for USD Futures

| Date | Sell Price | Settlement Price | MTM Spread | P&L per Contract | | --- | --- | --- | --- | --- | | 21-XX-20 | 74.9000 | 74.6925 | 0.2075 | 207.50 | | 22-XX-20 | 74.6925 | 74.6225 | 0.0700 | 70.00 | | 23-XX-20 | 74.6225 | 74.8425 | -0.2200 | -220.00 | | 24-XX-20 | 74.8425 | 74.8550 | -0.0125 | -12.50 | | 27-XX-20 | 74.8550 | 74.8200 | 0.0350 | 35.00 | | 28-XX-20 | 74.8200 | 74.8450 | -0.0250 | -25.00 | | 29-XX-20* | 74.8450 | 74.7667* | 0.0783 | 78.30 |

MTM Settlement for Cross Currency Contracts

Definition: For cross currency contracts, MTM settlement is done in the quote currency, but the settlement is in cash in Indian Rupees (INR).
Details: The latest available FBIL reference rate for USD-INR is used to arrive at the settlement value of cross currency positions in INR for EUR-USD and GBP-USD contracts.

Example of MTM Settlement for Cross Currency Futures

| Trade Date | Buy Price | Settlement Price | MTM in USD | FBIL Ref Rate | MTM in INR | | --- | --- | --- | --- | --- | --- | | 23-XXX-20 | 1.1570 | 1.1577 | 7 | 74.7548 | 523.28 | | 24-XXX-20 | 1.1577 | 1.1571 | -6 | 74.8672 | -449.20 |

Premium Settlement for Option Contracts

Definition: Premium settlement for option contracts involves settling the premium payable or receivable by the clearing members.
Details: The premium is settled in cash on T+1, and the variation in premium is adjusted against the collateral placed.

Final Settlement

Definition: Final settlement involves marking all open positions to market at the final settlement price and settling in cash on T+2.
Details: For currency futures, final settlement is done on the last trading day of the contract, and for currency options, final exercise settlement is done on the expiry date.

Funds Settlement

Definition: Funds settlement involves settling the obligations of clearing members in terms of funds.
Details: Clearing members are required to maintain a separate and distinct primary clearing account for each segment with a designated clearing bank.

Risk Management

Definition: Risk management involves implementing measures to mitigate potential losses.
Details: The clearing corporation has a comprehensive risk management framework that includes margins, liquid assets, base minimum capital, pre-trade risk controls, and position limits.

Key Features of Risk Management System

Online real-time risk management: Monitoring of margins and position limits in real-time.
Use of different kinds of margins: To cover all kinds of losses.
Intra-day and end of day mark-to-market margins: To settle profits and losses.
Client-level margining: To monitor and manage client-level risks.
Alerts to members on various levels of collateral utilization: To notify members of potential risks.
Risk reduction mode: To reduce potential losses.
Automatic disablement from trading when limits are breached: To prevent further losses.

Clearing, Settlement and Risk Management in Exchange Traded Currency Derivatives

Risk Management Framework

The risk management framework for Exchange Traded Currency Derivatives (ETCD) consists of:
- Margins: To cover potential losses
- Liquid Net Worth & Liquid Assets: To ensure sufficient assets to cover losses
- Pre-trade risk control: To monitor and control risk before trades are executed
- Risk Reduction Mode: To reduce risk in case of high volatility or other market conditions
- Position Limits: To limit the size of positions that can be held by traders

Margining

Definition: Margining is a process by which a clearing corporation computes the potential loss that can occur to open positions held by members across all clients.
Details: The clearing corporation collects margins from its members, and members collect margins from their respective clients. Margins are computed at the client-level positions, with no netting of positions between clients or members.

Initial Margin

Definition: Initial margin is payable on all open positions of clearing members, up to the client level, and is payable upfront.
Details: Initial margin includes:
- SPAN margins: Computed using the SPAN system
- Margin on consolidated crystallized obligations: Computed based on payable obligations at the client level
- Delivery margins: Computed based on delivery obligations
- Additional margins: Specified by the clearing corporation from time to time

Computation of Initial Margin

The clearing corporations use the SPAN system for real-time initial margin computation.
SPAN methodology: Takes an integrated view of the risk involved in the portfolio of each individual client.
Value-at-Risk (VaR): A measure of the maximum likely price change over a given interval and at a given confidence level.
Parameters for computation of SPAN margin:
- Price Scan Range (PSR): The probable price change over a one-day period.
- Volatility calculation: The standard deviation (volatility estimate) is calculated using the Exponential Weighted Moving Average (EWMA).
- Volatility Scan Range: Fixed at 25% of annualized EWMA volatility, subject to a minimum of 3%.

Net Option Value

Definition: Net Option Value is computed as the difference between long option positions and short option positions, valued at the last available closing price of the option contract.
Details: The Net Option Value is added to the Liquid Net Worth of the clearing member.

Calendar Spread Charge

Definition: A calendar spread charge is levied on futures positions in one expiry month that are hedged by an offsetting position in a different expiry month.
Details: The calendar spread charge is computed based on the delta of the portfolio in each month.

Margin on Consolidated Crystallized Obligation

Definition: The margin on consolidated crystallized obligation represents payable obligations at the client level.
Details: The margin is computed based on:
- Intra-day payable crystallized obligations: Based on closed-out futures positions and premium payable/receivable at the client level.
- End-of-day payable obligations: Based on futures mark-to-market profit/loss, options premium payable/receivable, options exercise/assignment, and futures final settlement.

Extreme Loss Margin

Definition: Extreme Loss Margin is an additional margin collected from clearing members to cover extreme losses.
Details: The Extreme Loss Margin is computed based on the mark-to-market value of the gross open positions for futures and the notional value of the open short option position for options.
Parameters for computation of Extreme Loss Margin:
- Product-specific margins: Specified for each currency pair.
- Calculation of Extreme Loss Margin: Computed as a percentage of the mark-to-market value or notional value.

Clearing, Settlement and Risk Management in Exchange Traded Currency Derivatives

Key Concepts

Margin Calculation: The margins are aggregated first at the trading member level and then at the clearing member level.
Additional Margin: Exchanges/Clearing Corporations can impose additional risk containment measures over and above the risk containment system mandated by SEBI.
Liquid Assets: Clearing members can provide for margins in any one or more of the eligible collateral modes, including cash, bank guarantees, fixed deposit receipts, approved securities, and other forms of collateral.
Liquid Net Worth: Computed as liquid assets less initial margin and extreme loss margin payable at any point in time, with a minimum requirement of Rs.50 lakhs for clearing members in the Currency Derivatives segment.

Liquid Assets and Liquid Net Worth

Cash Component: Includes cash, bank guarantees, fixed deposit receipts, units of money market mutual funds, Gilt funds, Government of India Securities, and other forms of collateral, with a minimum requirement of 50% of total liquid assets.
Non-Cash Component: Includes all other forms of collateral deposits, such as demat securities, units of other mutual funds, and other forms of collateral.
Haircut: A percentage reduction applied to the value of securities, with varying rates for different types of securities.

Risk Reduction Mode

Trigger: Activated when a specific percent (currently 90%) of the stock broker's/clearing member's collateral available for adjustment against margins gets utilized.
Restrictions: Includes cancellation of unexecuted orders, only permitting orders with Immediate or Cancel attribute, checking for sufficiency of margins for new orders, and rejecting orders without adequate margins.
Reversal: The stock-broker is moved back to the normal risk management mode when the percentage of utilized collateral is lower than the utilization level specified by the clearing corporation (currently 85%).

Margin Collection by Clearing Corporation

Initial Margin and Extreme Loss Margins: Payable upfront by clearing members, with trading members required to collect these margins from their clients on an upfront basis.
Margin Monitoring: Clearing members' total margin requirements are monitored against their total available collateral on a real-time basis.
Collateral Modes: Clearing members can provide for margins in any one or more of the eligible collateral modes, with the ability to deposit liquid assets in a combination of various liquid assets.
Facilities: Clearing corporations provide facilities for transferring collaterals from one segment to another on an intraday basis, releasing collateral intra-day and at the end of the day, and enabling clearing members to re-pledge client/trading member proprietary securities through Margin Pledge facility.

Clearing, Settlement and Risk Management in Exchange Traded Currency Derivatives (Part 7)

Margin Collection and Reporting

Margin Collection: The Trading Member/Clearing Member can collect the margin from its client in various forms as specified by SEBI/Exchanges/Clearing Corporation from time to time.
Penalty for Short Collection: SEBI has laid down a framework to enable verification of upfront collection of margins from clients in Cash and Derivatives segments. A penalty is levied on the Trading Member/Clearing Member for short collection/non-collection of margins.
Margin Related Information: Stock Brokers should send margin related information to their clients, which includes:
- Client code and name
- Trade day (T)
- Margin deposit available for the client on day T
- Margin adjustments for day T
- Margin status at the end of T day

Providing Margin Related Information to Clients

Daily Margin Statement: Such margin related information (Daily margin statement) is issued by Stock Brokers to their clients on T-Day itself or within the specified timelines.
Record Keeping: Brokers should maintain proper records of client collateral and prevent misuse of client collateral.

Mechanism for Client Collateral

Pledge/Re-pledge in the Depository System: Margin obligations must be settled only by way of Pledge/Re-pledge in the Depository System.
Framework to Enable Verification of Upfront Collection of Margins: SEBI has implemented various measures like margin pledge, re-pledge, and a framework to enable verification of upfront collection of margins from clients in Cash and Derivatives segments.
Segregation and Monitoring of Collateral at Client Level: A reporting mechanism shall be specified by the Clearing Corporations (CCs) to provide visibility of client-wise collateral at all levels.

Core Settlement Guarantee Fund

Settlement Guarantee Fund: The details of the Core Settlement Guarantee Fund will be discussed in the next section.

CLEARING, SETTLEMENT AND RISK MANAGEMENT IN EXCHANGE TRADED CURRENCY DERIVATIVES

Settlement Guarantee Fund (SGF): A fund established by every recognized clearing corporation to guarantee the settlement of trades executed in a respective segment of a recognized stock exchange.
Core SGF: A separate Core Settlement Guarantee Fund for each segment of a recognized stock exchange, including the Currency Derivatives Segment.
Minimum Required Corpus (MRC): The minimum amount required in the Core SGF, calculated based on daily stress tests and reviewed monthly.

Key Components of Core SGF

Clearing Corporation Contribution: At least 50% of the MRC, considered as part of the clearing corporation's net worth.
Stock Exchange Contribution: At least 25% of the MRC.
Clearing Member Primary Contribution: Not more than 25% of the MRC, assessed pro-rata based on the risk brought to the system.
Penalties and Interest: Accrue to the Core SGF and attributed to contributors proportionally.

Default Waterfall

Monies of Defaulting Member: Utilized first, including primary contribution to Core SGF and excess monies in other segments.
Insurance: Utilized next, if available.
CC Resources: Utilized up to 5% of the segment MRC.
Core SGF: Utilized in a specific order, including penalties, CC contribution, and non-defaulting members' primary contribution.
Proportion of Remaining CC Resources: Utilized based on the ratio of segment MRC to the sum of MRCs of all segments.
Capped Additional Contribution: By non-defaulting members, up to a specified limit.

Cyber Security and Cyber Resilience Framework (CSCRF)

Objective: To address evolving cyber threats, align with industry standards, and ensure compliance by SEBI-regulated entities.
Market Infrastructure Institutions (MIIs): Include stock exchanges, depositories, clearing corporations, KYC registration agencies, and qualified registrars and transfer agents.
5 Cyber Resiliency Goals:
1. Anticipate: Maintain informed preparedness against adversary attacks.
2. Withstand: Continue essential business functions during attacks.
3. Contain: Localize containment of crisis and isolate trusted functions.
4. Recover: Restore business functions after attacks.
5. Evolve: Change business functions to minimize adverse impacts of attacks.