Trading, Clearing and settlement

TYFM - Sem V
Trading System

• Entities in the trading system

 Trading Members
 Trading cum Clearing Members (TM-CM)
 Professional Clearing Members (PCM)
 Self Clearing Member (SCM)
 Participants
Trading Members:

• They are members of Stock Exchanges.

• They can trade either on behalf of their clients or on their own
account.
• The exchange assigns a trading member ID to each of its trading
member.
• A trading member can have more than one user.
Trading cum Clearing Members:

• A Clearing Member (CM) who is also a Trading Member (TM) of

the exchange.

• Such CMs may clear and settle their own proprietary trades, their
clients' trades as well as trades of other TM's & Custodial
Participants
Professional Clearing Member:

• Professional clearing member clears the trades of his associate

Trading Member and institutional clients.

• PCM is not a Trading Member of the exchange.

• Typically banks or custodians become a PCM and clear and settle

for TM's as well as for Custodial Participants
Self Clearing Member (SCM)

• A Self Clearing Member is also a Trading Member on the

exchange.
• Such CMs may clear and settle only their own proprietary trades
and their clients' trades but cannot clear and settle trades of other
TM's.
Participants:
• Participant is a client of a trading member. Clients may trade
through various trading members but settle through a single
clearing member.
Order types and conditions

These conditions are broadly divided into the following categories:

• Time conditions
 Day Order
 IOC
• Price conditions
 Limit Order
 Market Order
 Stop Loss Order
• Various combinations of the above are allowed providing flexibility to
the users.
Order Matching Rules

• In India, F&O platforms offer an order driven market, wherein

orders match automatically on price time priority basis.
• Orders, as and when they are received, are first time stamped
and then immediately processed for potential match.
• If a match is not found, then the orders are stored in different
'books'.
• Orders are stored in price-time priority in various books in the
following sequence:
 Best Price
 Within Price, by time priority.
Order Matching Rules

• The best buy order will match with the best sell order.
• An order may match partially with another order resulting in
multiple trades.
• For order matching, the best buy order is the one with highest
price and the best sell order is the one with lowest price.
• This is because the computer views all buy orders available from
the point of view of a seller and all sell orders from the point of
view of the buyers in the market.
Clearing and Settlement

• Clearing Corporation/ Clearing House is responsible for clearing and

settlement of all trades executed on the F&O Segment of the Exchange.
• Clearing Corporation acts as a legal counterparty to all trades on this
segment and also guarantees their financial settlement.
• The Clearing and Settlement process comprises of three main activities, viz.,
Clearing, Settlement and Risk Management.
• Clearing and settlement activities in the F&O segment are undertaken by
Clearing Corporation with the help of the Clearing Members and Clearing
Banks.
Clearing Members

Broadly speaking there are three types of clearing members

•Self clearing member: They clear and settle trades executed by
them only, either on their own account or on account of their clients.
•Trading member–cum–clearing member: They clear and settle their
own trades as well as trades of other trading members and custodial
participants.
•Professional clearing member: They clear and settle trades
executed by trading members.
Clearing Banks

• Funds settlement takes place through clearing banks.

• For the purpose of settlement all clearing members are required
to open a separate bank account with Clearing Corporation
designated clearing bank for F&O segment.
Clearing Mechanism

• The first step in clearing process is calculating open positions and obligations
of clearing members.
• The open positions of a CM is arrived at by aggregating the open positions of
all the trading members (TMs) and all custodial participants (CPs) clearing
though him, in the contracts which they have traded.
• The open position of a TM is arrived at by adding up his proprietary open
position and clients’ open positions, in the contracts which they have traded.
• A TM’s open position is the sum of proprietary open position, client open long
position and client open short position.
Settlement Mechanism

In India, SEBI has given the stock exchanges the flexibility to offer:
•Cash settlement (settlement by payment of differences) for both stock options
and stock futures; or
•Physical settlement (settlement by delivery of underlying stock) for both stock
options and stock futures; or
•Cash settlement for stock options and physical settlement for stock futures;
or
•Physical settlement for stock options and cash settlement for stock futures.
At present, derivative contracts on both individual stocks and on stock indices
are cash settled on NSE and MCX-SX but on BSE, derivative contracts on stock
indices are cash settled while those on individual stocks are delivery based.
Settlement Schedule

Settlement of Futures Contracts on Index or Individual Securities

•In Futures contracts, both the parties to the contract have to
deposit margin money which is called as initial margin.
•Futures contract have two types of settlements :
 the MTM settlement which happens on a continuous basis at the end of
each day,
 and the final settlement which happens on the last trading day of the
futures contract.
Settlement Schedule

• Mark to Market (MTM) Settlement

• Mark to Market is a process by which margins are adjusted on the
basis of daily price changes in the markets for underlying assets.
The profits/ losses are computed as the difference between:
• The trade price and the day's settlement price for contracts
executed during the day but not squared up.
• The previous day's settlement price and the current day's
settlement price for brought forward contracts.
• The buy price and the sell price for contracts executed during the
day and squared up.
Settlement Schedule

• The clearing member who suffers a loss is required to pay the MTM loss
amount in cash which is in turn passed on to the clearing member who has
made a MTM profit.
• The pay-in and pay-out of the mark-to-market settlement are affected on the
day following the trade day (T+1) where trading member is responsible to
collect/ pay funds from/ to clients by the next day.
• Clearing Members are responsible to collect and settle the daily MTM
profits/losses incurred by the TMs and their clients clearing and settling
through them.
• After completing day’s settlement process, all the open positions are reset to
the daily settlement price. These positions become the open positions for the
next day
Settlement Schedule

Final Settlement
•On expiration day of the futures contracts, after the close of trading
hours, clearing corporation marks all positions of a clearing member
to the final settlement price and the resulting profit/ loss is settled in
cash.
•Final settlement loss/profit amount is debited/ credited to the
relevant clearing member’s clearing bank account on the day
following expiry day of the contract.
•All long positions are automatically assigned to short positions in
option contracts with the same series, on a random basis.
Settlement of Options Contracts on Index or Individual
Securities
Options contracts have two types of settlements. These are as follows
•1) Daily premium settlement,
•2) Final settlement
Daily Premium Settlement
•In options contract, buyer of an option pays premium while seller
receives premium.
•The amount payable and receivable as premium are netted to
compute the net premium payable or receivable amount for each client
for each option contract.
Settlement of Options Contracts on Index or Individual
Securities

Final Exercise Settlement

•All the in the money stock options contracts shall get automatically
exercised on the expiry day.
•All the unclosed long/ short positions are automatically assigned to
short/ long positions in option contracts with the same series, on the
random basis.
Risk Management

For the F&O segment, a comprehensive risk containment

mechanism has been developed by clearing corporation.
The salient features of risk containment measures on the F&O
segment are:
•Stringent requirements of capital adequacy for membership
(Financial strength of a member) helps in risk management.
•Clearing corporation charges an upfront initial margin for all the
open positions of a Clearing Member (CM). It specifies the initial
margin requirements for each futures/ options contract on a daily
basis and also follows Value-At-Risk (VAR) based margining.
Risk Management

• Clearing member collects initial margin from the trading members

(TMs) and their respective clients.
• The open positions of the members are settled on an MTM basis
for each contract at the end of the day. The difference is settled in
cash on a T+1 basis.
• Clearing corporation’s on-line position monitoring system monitors
a CM’s open position on a real-time basis. Clearing corporation
monitors the CMs for Initial Margin violation, Exposure margin
violation, while TMs are monitored for Initial Margin violation and
position limit violation.
Risk Management

• Clearing corporation monitors the CMs for Initial Margin violation, Exposure
margin violation, while TMs are monitored for Initial Margin violation and
position limit violation.
• Clearing corporation assists the CM to monitor the intraday limits set up by a
CM and whenever a TM exceed the limits, it stops that particular TM from
further trading.
• The most critical component of risk containment mechanism for F&O
segment is the margining system and on-line position monitoring. The actual
position monitoring and margining is carried out on-line through Parallel Risk
Management System (PRISM) using SPAN® (Standard Portfolio Analysis of
Risk) system for the purpose of computation of on-line margins, based on the
parameters defined by SEBI
NSCCL-SPAN

• SPAN evaluates overall portfolio risk by calculating the worst possible loss that a
portfolio of derivative and physical instruments might reasonably incur over a
specified time period (typically one trading day.)
• This is done by computing the gains and losses that the portfolio would incur under
different market conditions.
• At the core of the methodology is the SPAN risk array
• It is a set of numeric values that indicate how a particular contract will gain or lose
value under various conditions.
• Each condition is called a risk scenario.
• The numeric value for each risk scenario represents the gain or loss that that
particular contract will experience for a particular combination of price (or
underlying price) change, volatility change, and decrease in time to expiration.
NSCCL-SPAN

• The objective of the NSCCL-SPAN is to identify the overall risk in the portfolio
containing all the futures and options contracts for each member.
• The system treats futures and options contracts uniformly.
• Its overriding objective is to determine the largest loss that a portfolio might
reasonably be expected to suffer from one day to the next day, based on the
99 percent VaR methodology.
NSCCL-SPAN

• The complex calculations (e.g., the pricing of options) in the SPAN are
executed by the NSCCL.
• The members can apply the data contained in the Risk Parameter files to
their specific portfolios of futures and options contracts, to determine their
SPAN margin requirements.
• The SPAN has the ability to estimate the risk for combined futures and
options portfolios, and also to revalue the same under various scenarios of
changing market conditions.
• The NSCCL generates six risk parameter files for a day, taking into account
prices and volatilities at various time intervals.
Position Limits:

• Clearing Members are subject to the following position

limits in addition to initial margins requirements.
Market Wide Position Limits (for Derivative Contracts on
Underlying Stocks)
• At the end of each day the Exchange disseminates the aggregate open
interest across all Exchanges in the futures and options on individual scrips
along with the market wide position limit for that scrip and tests whether the
aggregate open interest for any scrip exceeds 95% of the market wide
position limit for that scrip.
• If so, the Exchange takes note of open positions of all client/ TMs as at the
end of that day in that scrip, and from next day onwards the client/ TMs
should trade only to decrease their positions through offsetting positions till
the normal trading in the scrip is resumed.
• The normal trading in the scrip is resumed only after the aggregate open
interest across Exchanges comes down to 80% or below of the market wide
position limit.
Trading Memberwise Position Limit

Index Futures
•The trading member position limits in equity index futures / options
contracts is higher of
 Rs.500 crores or
 15% of the total open interest in the market in equity index
futures contracts.
•This limit is be applicable on open positions in all futures / Options
contracts on a particular underlying index.
Value At Risk: (VaR)

• A statistical technique used to measure and quantify the level of

financial risk within a firm or investment portfolio over a specific time
frame.
• Value at risk is used by risk managers in order to measure and
control the level of risk which the firm undertakes.
• Value at Risk is measured in three variables: the amount of potential
loss, the probability of that amount of loss, and the time frame.
• VaR has been called the "new science of risk management”.
• VAR answers the question, "What is my worst-case scenario?" or
"How much could I lose in a really bad month?"
• A VAR statistic has three components:
 a time period,
 a confidence level and
 a loss amount (or loss percentage).
Keep these three parts in mind as we give some examples of variations of
the question that VAR answers:
• What is the most I can - with a 95% or 99% level of confidence -
expect to lose in dollars over the next month?
• What is the maximum percentage I can - with 95% or 99%
confidence - expect to lose over the next year?
• There are three methods of calculating VAR:
 the historical method,
 the variance-covariance method and
 the Monte Carlo simulation.
• 1. Historical Method
• The historical method simply re-organizes actual historical returns,
putting them in order from worst to best. It then assumes that history will
repeat itself, from a risk perspective.

• The Variance-Covariance Method

• This method assumes that stock returns are normally distributed. In other words, it
requires that we estimate only two factors - an expected (or average) return and a
standard deviation - which allow us to plot a normal distribution curve.
• we use the familiar curve instead of actual data. The advantage of the normal curve
is that we automatically know where the worst 5% and 1% lie on the curve.
• The most critical component of risk containment
mechanism for F&O segment is the margining system
and online position monitoring. The actual position
monitoring and margining is carried out on-line through
Parallel
• Risk Management System (PRISM). PRISM uses
SPAN(r) (Standard Portfolio Analysis of Risk) system for
the purpose of computation of on-line margins, based on
the parameters defined by SEBI.