An important part of trading in currencies is the efficacy and the efficiency of the clearing and settlement process. Clearing identifies the pay in and pay out of various parties to the trade; and settlement actually executes such clearings and ensure that debits are collected and credits are paid. This may appear to be quite simple and straight forward but behind the scenes there is a vast machinery of technology, matching and manpower that is working in ensuring that the clearing and settlement happens in a smooth and seamless way.
Clearing and settlement are done by clearing members (CM). Without a robust clearing and settlement mechanism the exchange functioning will come to standstill. In the context of currency futures, it is the stock exchanges and the clearing corporations of the exchange that take on the responsibility of clearing and settlement. Here is what you need to know about clearing and settlement process.
Clearing Members (CM) registered with the clearing corporation have the responsibility of clearing and settlement of all deals executed by Trading Members (TM), who clear and settle such deals through them. Primarily, the CM performs the following key functions:
Types of Clearing Members and eligibility norms
Typically, your currency broker will be a TM-CM (Trading Member cum Clearing Member). A Clearing Member who is also a TM can clear and settle own proprietary trades, clients' trades as well as trades of other TMs and Custodial Participants (CPs). Professional Clearing Member (PCM) is a CM who is not a TM. PCMs are generally banks and / or custodians. They clear and settle trades for TM's as well as of the Custodial Participants.
The eligibility norms for clearing members includes a minimum net worth of Rs.10 crores and a deposit of Rs. 50 lakhs which forms part of the security deposit of the CM.
A Clearing Member's open position is arrived at by aggregating the open position of all the Trading Members (TM) and all custodial participants (CP) clearing through the CM. A TM's open position in turn includes his proprietary open position and clients’ open positions. This is the graded matrix to identify the open position pay in and pay outs and executes the settlement of trades. Remember, in the currency derivatives segment, all trades are necessarily settled in cash only. Unlike commodities, there is no concept of settlement against delivery in case of currency futures. Here is how the clearing process flow works.
Proprietary / Clients’ Open Position
At the time of entering orders in the trading system, the trading members (TMs) are required to identify them as proprietary (if they are own trades) or client (if entered on behalf of clients). The trader / dealer executing the order need to appropriately select “PRO / CLI” indicator provided in the order entry screen and accordingly the trade will be classified for settlement purposes. The proprietary positions are calculated on net basis (buy - sell) and client positions are calculated on gross of net positions of each client i.e., a buy trade is off-set by a sell trade and a sell trade is off-set by a buy trade.
Open positions for the proprietary trades / positions of the trading member are calculated separately from client position. Let us look at an illustration to understand this point better.
For a CM - XYZ, with TMs clearing through him being (ABC and PQR)
|Proprietary Position||Client 1||Client 2||Net Member
|ABC||USDINR contract January||4||2||2||3||1||2||4||2||2||Long 6|
|PQR||USDINR contract January||2||3||(1)||2||1||1||1||2||(1)||Long 1 Short 2|
XYZ’s open position for USDINR January contract is:
|Member||Long Position||Short Position|
|Total for XYZ||7||2|
As we can see in the above calculation, for the purpose of clearing and settlement, the determination of pay in is done by netting the position of each of the clients but on an overall basis they continue to be gross positions. For example, Client 1 net long is not netted against Client 2 net short and vice versa.
Settlement is the next step after clearing. In clearing, as explained above, the net receivable and payables on a CM levels, TM level and client level are identified. The onus is on the respective members at the higher level of the hierarchy grade to collect the requisite margin and deposit with the clearing corporation. The settlement is the final step. Once the obligations are identified as per the clearing mechanism, the settlement ensures that the actual debits and credits are executed at a CM level. Then the respective TMs take it up at a client level. Let us now look in detail at how the settlement process works.
Settlement of daily mark to market positions is carried out on T+1 day basis. Final Settlement is carried out on T+2day basis. Members with a funds pay-in obligation are required to have clear funds in their primary clearing account on or before 8.30 am on the settlement day. The payout of funds is credited to the primary clearing account of the clearing members thereafter.
Daily Settlement Price for mark to market settlement of futures contracts
Daily settlement price for futures contracts is the closing price of such contracts on the trading day. The closing price for a futures contract shall be calculated on the basis of the last half an hour weighted average price of such contract or such other price as may be decided by the relevant authority from time to time.
What about the settlement of unexpired future contract which are not traded in the last half hour? What is the price to use as the benchmark in such cases? Here you can use the theoretical daily settlement price. What exactly is that? Theoretical daily settlement price for unexpired futures contracts, which are not traded during the last half an hour on a day, shall be the price computed as per the following formula:
Futures settlement price - F0 = S0 e(r-r) fT
F0 = Theoretical futures price
S0 = Value of the underlying
r = Cost of financing (using continuously compounded interest rate)
rf = Foreign risk free interest rate
T = Time till expiration
e = 2.71828
Rate of interest (r) may be the relevant MIFOR rate or such other rate as may be specified by the Clearing Corporation from time to time.
Foreign risk free interest rate is the relevant LIBOR rate or such other rate as may be specified by the Clearing Corporation from time to time.
Final Settlement Price for mark to market settlement of futures contracts
Final settlement price for a futures contract for the various currencies shall be as mentioned below, or as may be specified by the relevant authority from time to time
|Final settlement price||RBI reference rate||RBI reference rate||Exchange rate published by RBI in its Press Release captioned RBI reference Rate for US$ and Euro||Exchange rate published by RBI in its Press Release captioned RBI reference Rate for US$ and Euro|
Broadly, there is the daily MTM settlement that is done for futures and options on currency. This daily MTM settlement is to mark up the currency position to the latest price and ensure that any shortfalls in margins are collected before the commencement of the next trading day in the currency market. Let us look at this process in greater detail.
Daily Mark-to-Market Settlement
The positions in the futures contract for each member are marked-to-market to the daily settlement price of the futures contracts at the end of each trade day. Remember, that in case of long futures and short futures the above principle will apply. However, in case of long put and long call options, there is only the initial margin settlement that is done on the day of the transaction. Since the maximum loss of the long call and long put position on currencies is limited to the premium paid, there is no need for daily mark to market settlement in case of long options. However, short options i.e. in the event of sale of calls or puts, the MTM margining will be exactly like long futures and short futures except that the seller of the call or put option will get the credit for the premium received on the option sold. The margin requirement reduces to that extent.
The profits / losses are computed as the difference between the trade price or the previous day’s settlement price, as the case may be, and the current day’s settlement price. The CMs who have suffered a loss are required to pay the mark-to-market loss amount to the clearing corporation, which is then passed on to the members who have made a profit. This is known as daily mark-to-market settlement. The transfer of obligations and payments happens seamlessly based on the gradation in the exchange clearing hierarchy.
Theoretical daily settlement price for unexpired futures contracts, which are not traded during the last half an hour on a day, is currently the price computed as per the formula for theoretical pricing, which has been explained in detail earlier. After daily settlement, all the open positions are reset to the daily settlement price. Clearing members (CMs) are responsible to collect and settle the daily mark to market profits / losses incurred by the TMs and their clients clearing and settling through them. The pay-in and pay-out of the mark-to-market settlement is on T+1 day (T = Trade day). The mark to market losses or profits are directly debited or credited to the CMs clearing bank account. Then the respective funds get passed on to the TMs and to their trading clients.
Final Settlement of currency futures and options contracts
On the expiry of the futures contracts, the Clearing Corporation marks all positions of a CM to the final settlement price and the resulting profit / loss is settled in cash. Remember, there is no physical or delivery settlement in currency futures and options and all positions in rupee pairs and also in cross currency pairs. All these are necessarily settled in cash only. The final settlement profit / loss will be computed as the difference between trade price and the previous day’s settlement price, as the case may be, and the RBI reference rate of such futures contract on the last trading day.
Final settlement loss/ profit amount is debited/ credited to the relevant CMs clearing bank account on T+2 day (T = last trading day). Open positions in futures contracts cease to exist after their last trading day.
Defaults and shortfalls are two different things. While the VAR margin takes care of 99% of the cases, there could be extreme black swan situations where there may be a shortfall despite margining. In such cases, the clearing corporation being the counter party to the trade, steps in and honours the trade on the part of the defaulter. Then the clearing corporation will arrange to collect the requisite funds from the member who has caused this loss. In the event of shortfalls, the clearing corporation and the TM / CM are authorized to terminate open positions without recourse to the trader and liability for the losses so incurred, in any.