Chapter 7: Clearing, Settlement and Risk Management

Clearing Corporation: Clearing and Settlement Process

Introduction:

• Clearing Corporation: An entity separate from the Exchange, governed by SEBI’s Stock Exchange and Clearing Corporation Regulations, 2012.
• Clearing Corporation’s role: Facilitate settlement of trades executed on the Exchange platform.
• Key responsibilities: Margin collection, payment and delivery mechanism, and guaranteeing settlement.

Clearing and Settlement Process:

1. Trade execution by the trading system
2. Clearing Corporation’s involvement begins
3. Clearing Corporation collects margins from traders
4. Clearing Corporation verifies trade details
5. The netting process to determine obligations
6. Clearing Corporation guarantees settlement
7. Payment and delivery mechanism initiated
8. Settlement completion and confirmation

Distinction between Exchange and Clearing Corporation:

• Regulatory aspects: Governed by SEBI’s Stock Exchange and Clearing Corporation Regulations, 2012.
• Member compliance: Separate governance norms for Exchange and Clearing Corporation.
• Settlement mandate: SEBI requires Exchange trades to be settled through a clearing corporation, either in-house or outsourced.

Clearing and Settlement Process in Commodity Trading

1. Clearing and Settlement Overview:
   Clearing involves updating and reconciling trade obligations/payments, while settlement matches buy and sell instructions, transferring commodity ownership against funds. Delivery-versus-payment (DVP) is used, with commodities settled on a netting basis and funds settled at the member level.
2. Clearing and Settlement Process Steps:

3. Clearing and Settlement Functions:

3.1 Pre-Trading Session:

• Uploading member margin limits to the trading system
• Uploading obligation and margin files to the bank
• Verifying margins, etc.

3.2 Intra-Trading Session:

• Tracking funds collection against margins/obligations
• Processing increase/release margin requests of members, etc.

3.3 Post-Trading Session:

• Calculation of clearing members’ positions based on open interest (outstanding positions) at the client level
• Trade processing
• Report generation
• Updating margins and Management Information System (MIS)

Clearing and Settlement Example:

• Members A and B are clearing members of the exchange.
• X is a client of member A, and Y is a client of member B.
• X buys a gold futures contract (1 kg) at Rs 50,000 per 10 grams from Y.
• Margin requirement: 5% of the contract value.
• Closing price: Rs 50,100 per 10 grams.
• Clearing corporation calculates Mark-to-Market (MTM) pay-in and pay-out.
• Y incurs a notional loss of Rs 10,000, which becomes the pay-in amount on T+1.
• X earns a notional profit of Rs 10,000, which becomes the pay-out amount on T+1.

Delivery Process in Commodity Futures Trading

Overview:

• Each commodity futures contract enters the delivery period from the specified expiry month.
• Delivery logic varies based on the contract specifications.
• Three delivery options: Compulsory delivery, Both option, and Seller’s option.
• Delivery period resembles the cash market rather than the futures market.

Physical Delivery Process:

Compulsory Delivery:

• Both buyer and seller with open positions during the tender/delivery period are obligated to take/give delivery.
• The remaining open interest after the expiry date is settled through physical deliveries.
• Short positions not squared off require the seller to give certified physical delivery, and the buyer pays the settlement price.

Both Option to Deliver:

• Delivery is executed only when both buyers and sellers agree.
• If no intention for delivery is given, open positions are cash settled at the Due Date Rate (DDR), which is the average of spot prices in the last few days of the futures contract.

Entities Involved in the Clearing and Settlement Process:

• Clearing members maintain settlement accounts with designated clearing banks for fund movements.
• Clearing banks communicate fund flow status to the clearing house.
• Warehouses play a crucial role in the physical delivery of commodities.
• Commodity exchanges set criteria for warehouses and empanel warehouse service providers (WSPs).
• WSPs arrange storage facilities based on exchange criteria.
• SEBI prescribes norms for WSPs, including accreditation, compliance, net worth criteria, and staff training.
• WSPs need to comply with Know Your Depositor (KYD) policies.
• Warehouses must comply with assaying and quality testing requirements.
• Clearing corporations monitor accredited warehouses and appraise WSPs’ performance.
• Participants submit requests to clearing corporations for depositing goods in accredited warehouses.
• SEBI emphasizes the importance of accurate weighing, sampling, inspection, and grading of commodities.
• Clearing corporations ensure transparency in the accreditation of assayers.
• Electronic-Registry for Warehouse Receipts enables multiple transfers without physical movement of goods.
• The E-Registry maintains information related to the original depositor, charges, stocks, quality, and expiry dates.

Premium/Discount:

• Quality specification of a commodity indicates the minimum acceptable criteria for valid delivery.
• Quality variations in delivered goods are generally accepted, with adjustments to the contracted prices in the form of premium or discount.
• A discount is applied when the quality falls below certain specifications, resulting in a decrease in the contracted price.
• The discount amount is calculated based on the decrease in quality, with a specified discount percentage for each unit or part thereof.
• A premium is applied when the quality exceeds the specified criteria, resulting in an increase in the contracted price.
• The premium amount is calculated based on the increase in quality, using a specified premium formula.

Example for Discount:

• Castor seed futures contract specifies a quality range for oil content (45% to 47%).
• If the oil content falls below 47% but within 45%, a discount is applied.
• For every 1% decrease in oil content or part thereof, a discount of 2% or part thereof is applied.
• Example: Contracted price = Rs 6000 per ton, quality content = 46%.
• Discount calculation: Discounted price = Contracted price * (100% – discount percentage).
• Contracted price at a discount = Rs 6000 * (100% – 2%) = Rs 5880.

Example for Premium:

• Gold futures contract specifies a quality requirement of .995 fineness.
• If a higher quality of .999 fineness is delivered, a premium is applied.
• Premium calculation: Price = Contract rate * (higher fineness / specified fineness).
• Example: Contract rate = Rs 25,000 per 10 grams, delivered fineness = .999.
• Premium calculation: Gold price = Rs 25,000 * (.999 / .995) = Rs 25,100.50.
• The buyer will pay Rs 25,100.50 instead of the original contract price of Rs 25,000 per 10 grams.

Penalty for Seller’s Delivery Default and Buyer’s Default:

SEBI Guidelines:

• SEBI has set guidelines and procedures for imposing penalties in case of delivery defaults to strengthen deterrent measures and ensure compensation to the non-defaulting party.
• The following delivery default norms were prescribed by SEBI through a circular dated March 23, 2021.

Penalty on Seller (in case of delivery default):

• Agri-commodities futures contracts: 4% of Settlement Price + replacement cost.
• Replacement cost: Difference between settlement price and the average of three highest spot prices of the last five succeeding days after the commodity pay-out date. If the average price is higher than the settlement price, the replacement cost is positive; otherwise, it is zero.
• Non-agri commodities futures contracts: 3% of Settlement Price + replacement cost.
• Replacement cost: Difference between settlement price and the higher of the last spot price on the commodity pay-out date and the following day. If the spot price is higher than the settlement price, the replacement cost is positive; otherwise, it is zero.

Flexibility of Penalties:

• Clearing Corporations/Exchanges have the flexibility to increase or decrease penalties for specific commodities based on the situation, in consultation with SEBI.

Norms for Penalty Apportionment:

• At least 1.75% of Settlement Price is deposited in the Settlement Guarantee Fund (SGF) of the Clearing Corporation.
• Up to 0.25% of Settlement Price may be retained by the Clearing Corporation for administration expenses.
• The remaining amount (1% of Settlement Price for non-agri goods or 2% of Settlement Price for agri goods) plus replacement cost is given to the entitled buyer.

Penalty on Defaulting Buyers:

• Default penalty on defaulting buyers was introduced from May 2021, as per the circular dated March 23, 2021.
• The Clearing Corporation reviews the loss incurred by the non-defaulting party (seller) and, at its sole discretion, levies a penalty on the defaulting buyer.
• The penalty imposed on the defaulting buyer should not exceed the overall cap of delivery margins collected from the buyer by the clearing corporations.

Deliveries in the Case of Physical Delivery:

• Delivery Locations: Contract specifications clearly indicate the approved warehouses at the designated delivery centers where physical deliveries are made. These delivery centers are specified by the Exchange for each commodity.

Staggered Delivery:

• Staggered Delivery Mechanism: Sellers have the option to indicate their intention to deliver on any day during the last 10 days before the contract expiry.
• Random Allocation: The trading system of the exchange randomly allocates a corresponding buyer to the seller who intends to deliver.
• Delivery Timeframe: The buyer must take the delivery on T+2 (two trading days after the transaction day) from the delivery center specified by the seller.
• Benefits: Staggered delivery helps ensure confirmation of delivery in the near-month contract and helps control price volatility.
• Settlement Price: For deliveries made during the staggered period (up to one day prior to expiry), the settlement price is determined based on the last available spot price displayed by the Exchange for the respective contract.

Risk Management for Exchange Traded Commodity Derivatives:

1. Counterparty Risk:
   • Replacement-cost risk: Cost associated with replacing the original trade due to a counterparty’s failure to honor the contract.
   • Principal risk: Risk of non-receipt of goods/funds by a buyer/seller who has fulfilled their payment/delivery obligation. Addressed through central counterparties and the principle of Novation.
2. Market Integrity and Surveillance related risks:
   • Risks of price rigging, cartelling, and cornering stocks to create artificial prices.
   • Exchanges and regulators maintain strong surveillance to ensure fair price discovery and market integrity.
   • Members are required to implement adequate risk management and due diligence to prevent market failures.
3. Operational Risk:
   • Risk of loss resulting from internal process failures, system outages, connectivity issues, and other operational issues.
   • Measures taken to address information technology-related issues, trading terminal shutdowns, and disaster recovery.
4. Legal Risk:
   • Uncertainty due to legal actions, contract interpretation, and compliance with regulations.
   • Additional complexities related to the delivery of stocks of specified quality and compliance with relevant laws and regulations.
5. Systemic Risk:
   • Risk of default by one party leading to defaults by other parties, causing a failure in the system.
   • Mitigated through margining rules, capital adequacy standards, settlement guarantee funds, and legal provisions for settlement activities.

Position Limits and Computation of Open Position:

Position Limits:

• Set at client and member levels to prevent manipulation of short-term price movements.
• Numerical limits established for agricultural and non-agricultural commodities as per regulatory guidelines.

Computation of Open Position:

• Open position: Quantity of commodity to be squared off before expiry or settled either through delivery or price difference.
• Open position limit based on higher of Buy or Sell positions.
• At client level, open position is calculated as the net level per commodity.
• At member level, higher of buy and sell positions from each client are grossed up to determine the open position.

Table Example for Computation of Open Position:

Salient Features of Risk Containment Measures:

Capital Adequacy Requirements:

• Commodity exchanges and regulatory authorities stipulate capital adequacy and net worth requirements for clearing members.
• Net worth computation considers assets specific to broking business while excluding certain assets.
• Deposits collected from members serve as an additional defense and can be used towards margin requirements.

On-Line Monitoring:

• Real-time monitoring and surveillance system implemented by commodity exchanges.
• Alerts and pre-set limits notify members as they approach specified levels.
• Micro-details of members’ positions can be checked if necessary.
• On-line surveillance generates alerts on price/volume movements not in line with past trends.
• Rumors in the media are tracked and verified with companies for price-sensitive information.

Off-line Surveillance Activity:

• Inspections and investigations conducted to ensure compliance with exchange rules and regulations.
• Inspections verify if investors’ interests are being compromised by trading members.

Margin Requirements:

• Need-based margin requirements imposed by commodity exchanges.
• Margin amounts adjusted to discourage undesirable and speculative trades.

Circuit Filters (DPR / DPL):

• Circuit filters, such as Daily Price Range (DPR) or Daily Price Limit (DPL), define the maximum price range for daily trading.
• Used as a risk management tool in highly volatile markets.
• Circuit filters provide limits and a cooling-off time to restrict volatility.

Position Limits:

• Client level and member level limits set to prevent concentration risk and market manipulation.
• Avoids large positions that can manipulate short-term price movements.

Settlement Guarantee Fund (SGF):

• Acts as a buffer for residual risk and operates as an insurance mechanism.
• Utilized to complete settlement in the event of a trading member’s default.
• Provides confidence to market participants that settlement will be completed.

Investor Protection Fund (IPF):

• Separate fund used for investor education, awareness, and client/investor claims.
• Covers defaults by members when dues exceed deposited margins.
• Governed by separate rules and regulations outlined by regulatory authorities.

Table Example for Circuit Filters (DPR / DPL):

Margining Mechanisms:

Additional Procedures for Other Commodity Products

Raising of Bill for Delivery

Once the delivery obligations are assigned to the seller, the seller will raise a bill on the buyer using the Final Settlement Price. The bill will include the appropriate Goods and Services Tax (GST) levied on the Final Settlement Price.

It’s important to note that even though the trades may have occurred at different rates on the trade date, the bills are raised based on the Final Settlement Price. Any differences between the traded rates and the Final Settlement Price were already adjusted during the daily mark-to-market (MTM) obligations.

By raising the bill at the Final Settlement Price, both parties ensure that the delivery transaction is settled accurately and in accordance with the determined price.