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Margins are one of the most efficient and effective forms of risk management in currency trading. Margins are collected from the currency trader at a specified formula for long futures, short futures and selling of options. For buying options only the premium margins are collected since the losses are limited to the premium paid.
The Clearing Corporations of the NSE and the BSE have developed a comprehensive risk containment mechanism for the Currency derivatives segment. The most critical component of a risk containment mechanism is the online position monitoring and margining system. The actual margining and position monitoring is done on-line, on an intra-day basis. Initial margining is done based on the concept of SPAN (Standard Portfolio Analysis of Risk) system, which is a portfolio based approach to margining and gives you the benefit of risk mitigating factors. We shall understand this aspect later when we discuss margining in the case of calendar spreads.
The clearing corporation at the NSE and the BSE collects initial margin up-front for all the open positions of a Clearing Member (CM) based on the margins computed by Clearing-SPAN. A CM is in turn required to collect the initial margin from the Trading Members (TMs), who are the SEBI registered brokers. Similarly, a TM is required to collect upfront margins from his clients who are actual participants in the currency futures market. That is how the graded escalation of margin collection goes on.
Initial margin requirements are based on 99% value at risk (VAR) over a one day time horizon. However, in the case of futures contracts, where it may not be possible to collect mark to market settlement value before the commencement of trading, the initial margin is computed over a two-day time horizon, applying the appropriate statistical formula. The methodology for computation of Value at Risk percentage is as per the recommendations of SEBI from time to time.
Following is the methodology for collection of Initial margin from a member:
Extreme loss margin:
Clearing members are subject to extreme loss margins in addition to basic SPAN margins. The applicable extreme loss margin on the mark to market value of the gross open positions is as follows or as may be specified by the relevant authority from time to time.
|Futures: 1% of the value of gross open position|
|Options: 1.5% of the value of gross open position (For short option positions)||0.3% of the value of gross open position||0.5% of the value of gross open position||0.7% of the value of gross open position|
For the purpose of SPAN Margin, the Clearing Corporation at the BSE and the NSE specifies various parameters from time to time:
|Currency Pairs||Price scan range||Minimum margins|
|USDINR||Three & a half standard deviations (3.5 sigma)||1.00%|
|EURINR||Three & a half standard deviations (3.5 sigma)||2.00%|
|GBPINR||Three & a half standard deviations (3.5 sigma)||2.00%|
|JPYINR||Three & a half standard deviations (3.5 sigma)||2.30%|
Calendar spread margin:
A currency futures position in one expiry month which is hedged by an offsetting position in a different expiry month would be treated as a calendar spread. The benefit for a calendar spread would continue till expiry of the near month contract and after that the normal margining rules will apply. The margins are lower in case of calendar spreads as the offsetting long/short position across two different months reduces the overall risk. The calendar spread margin shall be as follows:
Rs.400 for spread of 1 month
Rs.500 for spread of 2 months
Rs.800 for spread of 3 months
Rs.1000 for spread of 4 months or more
Rs.700 for spread of 1 month
Rs.1000 for spread of 2 months
Rs.1500 for spread of 3 months or more
Rs.1500 for spread of 1 month
Rs.1800 for spread of 2 months
Rs.2000 for spread of 3 months or more
Rs.600 for spread of 1 month
Rs.1000 for spread of 2 months
Rs.1500 for spread of 3 months or more
The initial and extreme loss margin is payable upfront by Clearing Members. Initial margins and extreme loss margins can be paid by members in the form of cash or other approved instruments like Bank Guarantees, Fixed Deposit Receipts, approved Securities, government securities etc. The list is constantly updated and made available to the members. Appropriate haircuts are also defined for each category.
Clearing members who are clearing and settling for other trading members can specify the maximum collateral limit towards initial margins and extreme loss margins for each trading member and custodial participant clearing and settling through them. Such limits can be set up by the clearing member, through the facility provided on the trading system up to the time specified in this regard. Such collateral limits once set are applicable to the trading members / custodial participants for that day, unless otherwise modified by clearing member.
Non-fulfilment of either whole or part of the margin obligations will be treated as a violation of the Rules, Bye-Laws and Regulations of Clearing and may attract penalty as specified by the Clearing Corporation from time to time. In addition the Clearing may at its discretion and without any further notice to the clearing member, initiate other disciplinary action, inter-alia including, withdrawal of trading facilities and / or clearing facility, close out of outstanding positions, imposing penalties, collecting appropriate deposits, invoking bank guarantees / fixed deposit receipts, etc.
A long position on options is basically buying a call or put option. When you buy a call or put option, the premium is paid up front. The premium is the maximum loss that the buyer of the option can incur under the worst of circumstances. Hence there is no need to collect any further margins from the buyer of the option. For buying options, the trader is required to deposit the upfront margin at the time of trade itself. Options settlement happens on T+1 basis and hence the same day payment of such margins becomes essential. Once the premium margin is paid, the buyers of call and put options do not have to worry about SPAN margins, ELMs or MTM margins. Even additional margins are not applicable to the buyer of the options.
A short position in an option refers to selling an option. You can sell a call or put option depending on your view of the market. Typically, traders will sell USDINR call options when they do not expect the USDINR to strengthen above a point. Their total income is the premium but their losses can be unlimited in case the price moves against them. Similarly, traders will sell USDINR put options when they do not expect the USDINR to weaken below a point. Their total income is the premium received but their losses can be unlimited in case the price moves against them.
In terms of margining, the seller of the option is subjected to all the regular margins that a buyer of seller of the futures is subjected to. This includes the SPAN margin, the extreme loss margin (ELM), the MTM on a daily basis and any additional margins from time to time. The only difference is that the margin requirement in the case of the seller of the option is adjusted to the extent of the premium received when debiting to the trading account. To that extent, the seller of the option pays lower margins compared to the trader who is long or short on futures of a similar contract.
One of the basic differences between forward contract and futures contracts is that forwards carry counter party risk. That means, if one of the parties to the contract defaults on his side of the obligation, then the other party is put in a tight spot and may have to adopt a prolonged legal route. That problem is solved in case of exchange traded futures, In this case, the Clearing Corporation guarantees each trade by becoming the counterparty to every trade on the currency futures and options segment. For if X is buying USDINR futures and Y is selling USDINR futures, then they don’t deal with each other directly. In fact, X buys from the Clearing Corporation and Y actually sells to the Clearing Corporation. The Clearing Corporation in this case acts as the counterparty and also the guarantor of the trade. If one party defaults, the Clearing Corporation will honour the other side of the trade so that exchange mechanism is not impacted. Then the exchange will recover the losses from the defaulter. That raises a very fundamental question; on what basis does the clearing corporation give such a guarantee. Any such guarantee has to be backed by a large pool of funds. That is where the Settlement Guarantee Fund (SGF), also called TGF, comes in handy. Let us look at this concept of SGF in greater detail.
The Clearing Corporation has set up the Settlement Guarantee Fund (SGF) through the contributions of its trading members. The SGF is intended primarily to guarantee completion of settlement up to the normal pay-out for trades executed in the regular market and will not act as guarantee for company objection cases i.e. replacement of bad paper or payment of its equivalent financial value. It only guarantees good trades in the normal course of business. The SGF / TGR therefore ensures that the settlement is not held up on account of failure of trading members to meet their obligations and all market participants (trading members, custodians, investors etc.) who have completed their part of the obligations are not affected in any manner whatsoever.
That is normally not required. The traders have their margins and the exchange adjusts the loss to the defaulting member’s margin account. The SGF is purely a financial backing to give confidence to the market and the participants that in a worst case situation there is a corpus to fall back upon. As a result, the investor is not affected in case the counter trading member fails to meet his obligation since the Clearing Corporation of the NSE and the BSE guarantees the net settlement obligations. The Clearing Corporation guarantees completion of settlement through the Settlement Guarantee Fund.
All contracts in the currency futures market: in the case of rupee pair futures, rupee pair options, cross currency pair futures and cross currency pair options are all necessarily settled in cash only. The settlement takes place in the following forms.
Daily Mark-to-Market Settlement
The positions in the futures contracts for each member are marked-to-market to the daily settlement price of the futures contracts at the end of each trade day. 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 clearing which is passed on to the members who have made a profit. This is known as daily mark-to-market settlement. Theoretical daily settlement price for unexpired futures contracts, which are not traded during the last half an hour on a day, is currently price computed as per a pre-defined formula.
After the 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.
On the expiry of the Currency futures contracts, Clearing marks all positions of a CM to the final settlement price and the resulting profit / loss is settled in cash. The final settlement profit / loss is 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 the 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.
There is no concept of delivery settlement in currency futures trading at this point of time.