Clearing and Settlement on Commodity Exchanges

Commodity Exchanges

Clearing and Settlement on Commodity

Exchanges

Risks in Commodity Markets

• Exchange traded futures contracts risk of non performance is assumed by Exchange Clearing House

• It becomes the counter party to all trades and guarantees their settlement

• Following are benefits in trading on the exchange

• Liquidity, Absence of counter-party risk, Price Discovery


• Since future contracts are standardised, they can be freely traded

• Contracts are liquid and can be freely traded• This permits holders to offset position and not ask for

delivery• The financial integrity is guaranteed by exchange

through clearing house• Hence risks to both buyers and sellers is eliminated• Electronic trading and large volumes minimises price

manipulation resulting in better prices


• Certain risks which can arise are:• Credit risk: Defaults are practically non-existent

because of the exchange guarantee• Market risks arising out of adverse movement

of price• Legal risk arising out of certain activities not

being permitted by regulatory framework• Operational risks arising out of internet,

electrical or any other problems

Commodity Clearing House

• The Clearing House keeps record of all trade and acts as third party on all buy and sell transactions

• All exchange members must report all transactions to the Clearing House after each day of trading

• The Clearing House than ensures financial settlement from each buyer and seller

• The Clearing House also ensures that participants keep cash deposits called margin with it


• Once a contract is processed by the Clearing House, the buyer and seller of the contract will have a contract with the clearing house instead of the counter party with which the contract was made

• This ensures easy reversal of future market position without need of the original party with which the contract was entered

• Another key element is the bank or network of banks through which money settlements are effected


• An exchanges clearing house may be an in house department or separate legal entity

• Single clearing house provides clearing services to more than one exchange

• NCDEX uses services of NSDL (National Securities Depository Ltd)

• Clearing House acts as central counter party to all trades on the exchange

• Clearing houses counter parties are its clearing agents• They generally are a sub set of the exchanges members


• Other trade counter parties, both non- clearing exchange members and non members of the exchange must become clients of one of the clearing members either directly or through another intermediary

• Clearing house has a principal –to –principal relationship with its clearing members

• Thus it looks to clearing members for performance of trade on their own account

• And of trade on the account of their client

Commodity Clearing House• A buyer or seller through a broker places an order• Matched trades are presented to clearing house for clearing through

a clearing member• Market contracts presented to the clearing house are registered• Upon registration of each market contract, two new contracts (open

contracts) are created in place of, and on identical terms with, each market contract

• The clearing house becomes buyer to the seller and seller to the buyer under the open contracts

• As counter party to all open contracts the clearing house undertakes to perform the contractual financial obligations

• This is done through its risk management systems and procedures as well as funds held for the purpose


• The shareholders of the clearing house are required to provide performance bonds- margin money

• They contribute to a guarantee fund to ensure that clearing house will meet all commitments

• As central counter party, the clearing house is exposed to the risk that one or more clearing members will default on their contractual obligation

• A common set of safeguards are utilised by clearing house to limit likelihood of defaults by clearing members

• It has to be ensured that if defaults occur than the clearing house has the required resources


These include:• Financial and operational requirements for membership of

the clearing house• Margin requirements designed to limit the build up of

exposure by periodically settling gains and losses• Close out of position (of client, or of member) in reaction

to a default• Maintenance of clearing house resources to cover losses

that exceed the value of the defaulting member’s margin and to provide liquidity during the time it takes to collect the value of margin


• Clearing houses matches transactions, reconciles sales and purchases and does daily settlements

• Responsible for risk management of its members, inspection and surveillance, collection of margins etc

• It monitors net worth requirements of its members• It ensures performance of every contract, it interposes itself

between the two counter parties• Novation is the practice by which the exchange becomes the

counter party for all trades taking place under it• Clearing houses interpose between buyers and sellers as legal

counter-party• Hence the only risk faced by participants is of clearing house default


• New contracts on the first day of are assigned a base rate by the exchange

• The base rate is calculated by polling spot prices prevailing for the commodity in the most active physical markets or mandis

• If they are not actively trade traded in spot markets in India than international prices are used as benchmarks

• A daily settlement (or closing) price is worked out for each contract based on the average of the last few trades of the trading day

• Due-date rate is calculated based on the average of the last 1, 3 or 5 days closing price (this depends on the commodity)

• This rate is calculated by the exchange based on the average of the last few days closing prices in the spot market of the commodity and the futures contract, whichever is higher

Margins

• The aim of margin money is to minimize the risk of default by either counter party

• The amount of initial margin is so fixed as to ensure that the probability of loss on account of worst possible price fluctuation, which cannot be met by the amount of ordinary/initial margin is very low

• The Exchanges fix rates of ordinary/initial margin keeping in view need to balance high security of contract and low cost of entering into contract

• Different margins payable on futures contracts are: i. ordinary/initial margin, ii. mark-to-market margin, iii. special margin, iv volatility margin and v. delivery margin.

Margins

Initial / Ordinary Margin• It is the amount to be deposited by the market

participants in his margin account with clearing house before they can place order to buy or sell a futures contracts

• This must be maintained throughout the time their position is open and is returnable at delivery, exercise, expiry or closing out

Margins

• Value at Risk ( VaR)system is used for calculating this margin

• This margin is calculated on the basis of variance observed in daily price of the commodity over a specified period

• It is typically 5-10% of the contract value at the time of buying it

• The margin is different for each commodity• It estimates the level of loss over a given time period that

is expected to be exceeded only 1% of the time• The amount of initial margin is fixed so as to ensure that it

covers price movements more than 99% of the time

Margins

Maintenance margin• This is set at a level slightly less than the initial

margin• It is the minimum amount of margin that is

required to be held relative to the futures position held

• It is the lowest amount an account can reach before needing to be replenished

Margins

• Mark-to-market margins (MTM or M2M or valan) are payable based on closing prices at the end of each trading day

• These margins will be paid by the buyer if the price declines and by the seller if the price rises

• This margin is worked out on difference between the closing/clearing rate and the rate of the contract (if it is entered into on that day) or the previous day's clearing rate

• The Exchange collects these margins from buyers if the prices decline and pays to the sellers and vice versa

Margins

• Collecting mark-to-market margin on a daily basis reduces the possibility of accumulation of loss, particularly when futures price moves only in one direction

• Hence the risk of default is reduced• Also, the participants are required to pay less upfront

margin - which is normally collected to cover the maximum, say, 99.9%, of the potential risk during the period of mark-to-market, for a given limit on open position

• Alternatively, for the given upfront margin the limit on open position would have to be reduced, which has the effect of restraining the trade and liquidity

Margins

• The exchange may impose Volatility margin when there are wild fluctuations in rate

• Tender margin is imposed when the contract enters into tender period at the end of its life cycle

• This margin is applicable on both outstanding buy and sell side, which continues upto the marking of the delivery or the expiry of the contract which ever is earlier

• It is calculated at the rate specified for the respective commodity multiplied by the net open position held by a member in the expiring contract

Margins

• On entry into the delivery position, just prior to contract expiry, traders holding position are required to post Delivery period margin

• It is applicable to each open contract in addition to initial margin and maintenance margin

• It is app, 25% of the contract value but can vary and is mentioned in the contract specifications given by the exchange

NMCE

• For efficient clearing & settlement of trades, NMCE has an automated clearing and settlement system with HDFC Bank as its Clearing Bank

• The software automatically calculates Initial Margins using VAR (Value At Risk) and MTM (Mark to Market) margins on a daily basis

• In the same way, members’ positions are also computed on a daily basis

• The information regarding pay-ins and pay-outs arising in calculations of positions of members is transferred at the end of trading hours electronically, using flat files for the clearing banks and members

• The objective of NMCE is to organize trading in such a way that possibility of defaults is almost eliminated

NMCE

To achieve this, NMCE has adopted various means as follows: - Exposure Limits :• Exchange provides facility in the system enabling the TCMs to select

the commodities in which the TM can trade and also fix the trading limits for each TM. TCM can also monitor the position of TMs online.

Initial Margin :• The initial margin (IM) is levied on all open positions (Buy or sell

positions) of the members and their clients. The IM percentage on each commodity varies depending upon its market volatility. The margin so calculated is reduced from the total margin of the member available with the exchange and accordingly further exposure is given on the balance amount. As the IM increases, the exposure shall decrease

NMCE

Mark to Market (MTM) Margins :• MTM is a mechanism devised by the exchanges to prevent the

possibility of the potential loss accumulating to the level where the participants might willingly or unwillingly commit default

• All trades done on the exchange during the day and all open positions for the day are marked to closing price for the respective delivery/contract and notional gain or loss is worked out

• Such loss/gain is debited/credited to respective member’s account at the end of each day. The outstanding position of the members is then carried forward the next day at the closing price

NMCE

• Special Margins :have primarily been introduced not as a risk management tool, but to act as a speed-breaker for sharply rising or falling price

• It is applied when price reaches a particular level above/below the previous day’s closing price

• Delivery Margins :are applicable to the contracting parties (both, buyer and seller) from the 12th day of the contract maturity month.

• Price Bands: Daily Cap & Life Time Cap: have been imposed on all commodities to prevent extreme volatility and unhealthy practices of cornering the market

NMCE

Final Settlement:• On the expiry of the futures contracts, the settlement is by the way of delivery• The delivery is at seller’s option during last three days of the contract expiry

date• The pay-in/pay-out for delivery is by way of debit to the buyer and credit to

the seller to the relevant Clearing Member’s clearing bank account on T+3 day (T=date of allocation of delivery)

• On due date if seller fails to tender delivery or fails to square-off his position then the highest price of the contract during its currency is taken for cash settlement in marking all undelivered outstanding position to final settlement price

• Resulting profit/loss settled in cash• Final settlement loss/profit amount is debited/credited to the relevant

Clearing Member’s clearing bank account on T+1 day. (T=expiry day)

NMCE

• On-Line Surveillance: includes the monitoring of prices, volume & volatility in various series and its analysis using various methods like real time graphs, queries, alerts etc.

• Off-Line surveillance: includes margining requirements, procedures in respect of exception handling, position monitoring, exposure limits, investigation techniques & disciplinary action procedures

ICEX

• ICEX provides risk management solutions to protect their traders and investors against adverse market conditions. The exchange identifies and evaluates the risks through Risk Preventive Measures

Risk Preventive measures:• Margining System:• Initial Margin• Additional margin• Regulatory margin• Long Margin / Short margin• Tender and Delivery Period Margin

ICEX

• Position Limit:• Client Wise• Member Wise• Near and Far Month Position Limits

• Daily Price Range ( DPR Limit)• Mark to Market of Positions on Daily basis

MCX

• MCX follows a comprehensive and stringent margining system for all future contracts traded on the Exchange platform

• Actual margining and position monitoring is done on an on-line basis

• For the purpose of computing and levying the margins, MCX uses SPAN® (Standard Portfolio Analysis of Risk) system which follows a risk-based and portfolio-based approach

• The Initial Margin requirement is based on a worst-case loss scenario of portfolio at client level to cover VaR (value at Risk) over a one day horizon, subject to a minimum Base Margin defined by FMC for the respective commodity

MCX

• The SPAN Risk Parameter File (RPF) is generated by the Exchange periodically at pre-defined timings and RPF files so generated are provided to the members using the FTP service and on the Exchange website

• In addition to SPAN margins, MCX levies Additional margins and/ or Special margins whenever deemed necessary considering the volatility and price movement in the commodities. Such margins are also levied as per the directions of FMC

• Tender Period margins and Delivery Period Margins are levied on contracts nearing expiry to ensure non default in commodity delivery

Trade Guarantee fund

The main objectives of Trade Guarantee fund are:• To guarantee settlement of bonafide transactions of the members

of the Exchange• thereby, to inculcate confidence in the minds of market

participants' • To protect the interest of the investors• All the members of the Exchange are required to make initial

contribution towards trade guarantee fund of the Exchange• All associates of the exchange are required to make an initial

contribution towards the Trade Guarantee fund of the exchange.• Commodity exchanges rarely touch this fund because of the

excellent system put in place to prevent defaults

Daily Price Limit/ Circuit Breakers

• Daily Price Limit: The maximum price movement allowed above or below the previous session’s settlement price

• All commodity exchanges have procedures for serious market volatility

• The price limit does not stop trading in futures but prohibits trading at prices outside pre-set limit during price volatility

Circuit Breakers:• Volatility may be moderated after a price limit triggers a

trading interruption by use of circuit breakers• It restores financial confidence by providing market

participants with a cooling of period

Open Position

Maximum allowable open position:Commodity Exchanges fix maximum number of lots for each clearing member to transact based on the margin deposited

This sets the maximum quantity allowed to keep as an open position

Settlement Process

A commodity futures contract can be settled by either by cash or delivery of the commodity depending upon:

• Terms of the Trade• Demands of the Buyer• Rules of the Exchange• Globally deliveries are only 2% of the total volume of

exchange• Remaining contracts are settled at the settlement price

arrived at by the exchange between the buyer and seller

Documents

Clearing and Settlement on Commodity Exchanges