Clearing Versus Settlement Versus Risk Management

Quite often we tend to equate clearing, settlement and risk management as a single activity. While, these 3 are related quite intricately, each of them is a discipline by itself. To begin with, clearing is about computing open positions and net obligations of clearing members. Settlement is the actually pay-in and pay-out of the shares being delivered to the buying member and cash being credited into the bank account of the selling member. Clearing and settlement is a relationship between the clearing corporation, clearing bank and the clearing members. The actual credit to the individual accounts is done by the trading member. Risk management is a continuous process and entails managing the risks pertaining to volatility and exposure of clients.

Clearing means computing open positions and obligations of clearing members in the trading system. Whereas, settlement means actual pay-in or pay-out to settle the contract. The open positions computation is used to arrive at daily mark to market margin requirement and maintaining exposure norms. The settlement could be of mark to market settlement which happens on daily basis or could be final settlement which happens at the expiry of the contract.

Understanding The Clearing Mechanism

Having understood the concept of clearing, let us turn to the mechanism of clearing in the Currency Derivatives segment. Clearing is undertaken by the Clearing Corporation (affiliated to the exchange) with the help of clearing members and clearing banks.

The clearing mechanism involves determining open positions and obligations of clearing members (TCM / CM / PCM). The open positions of Clearing Members (TCM / CM / PCM) are arrived at by aggregating the open positions of all the TMs and all custodial participants clearing through them. Let us now look at the open position of the TM. The TM's open position is the aggregate of their proprietary open position and clients' open positions. While proprietary positions are calculated on net basis (buy-sell) for each contract, client positions are arrived at by grossing all the (buy-sell) positions of each individual client. You must note that positions are only netted for each client and not netted across clients.

Illustration 1: This illustration on USDINR lots for Aug-19 contracts will help to understand this better.

	TM prop deals	Client Alpha	Client Beta	Client Theta
Day 1	Buys 40, sells 60	Buys 20, sells 10	Buys 30, sells 10	Buys 10, sells 20
Day 2	Buys 40, sells 30	Buys 10, sells 30	Buys 20, sells 10	Short 20

From the Clearing Corporation perspective, the net open position for each of the specific client / prop can be consolidated as under.

Net Position Calculation	TM Prop deals	Client Alpha	Client Beta	Client Theta
Net position at end of Day 1 for carry forward to Day 2	Short 20	Long 10	Long 20	Short 10
For trades done on Day 2	Long 10	Short 20	Long 10	Short 20
Net position at the end of Day 2	Short 10	Short 10	Long 30	Short30

What is important to note in the above table is that the Prop Deals are netted while the clients will be netted individually. Alpha positions will not be netted against Client Beta for instance. Each client open position is calculated individually.

Understanding The Settlement Mechanism

Currency futures contracts are, by default, cash settled. That means just the profits / losses are adjusted to the client account. This applies to Rupee Currency Futures and also to Cross Currency Futures. The settlement amount for a Clearing (TCM / CM / PCM) is netted across all their TMs and clients. Currency futures have two types of settlements you should be aware of.

Mark-to-Market (MTM) Settlement

All futures contracts for each member are marked to market to the daily settlement price of the relevant futures contract at the end of each day. The profits/losses could be computed differently for different types of positions. MTM is positive if the price movement is in your favour and negative if price movements are against you. For example, if you are long on USDINR future and if the dollar appreciates then it results in positive MTM whereas if the dollar weakens it results in negative MTM.

Final settlement for Currency Futures

On the last trading day of the futures contracts, after the close of trading hours, the Clearing Corporation marks all positions of a CM 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 CM's clearing bank account on T+2 working day following last trading day of the contract (contract expiry day). The final settlement price is the RBI reference rate for the last trading day of the futures contract. All open positions are marked to market on the final settlement price for all the positions which gets settled at contract expiry. Such marked to market profit / loss shall be paid to / received from clearing members.

How Is Risk Management Handled In Currency Futures

Managing risk in the Currency Futures segment is more about pre-empting a crisis rather than managing a crisis. It is therefore a containment mechanism and the best form of containment is through adequate capitalization. Currency Futures risk management broadly covers, inter alia, the following.

Ensuring financial soundness of members in terms of capital adequacy (net worth, security deposits) etc is the starting point.
Collection of upfront / initial margin all open measure helps to cover the position for wild price movement in 99% of the cases. The Value at Risk (VAR) approach is adopted.
All open positions of members are marked to market based on contract settlement price for each contract on a daily basis and settled in cash on T+1 day.
Open currency futures positions are monitored online and real time at multiple levels including internal risk management teams, stock exchange, SEBI and RBI.
Clearing members also have access to a trading terminal with real time information on risk levels of clients clearing through them. CM helps to monitor intraday limits.
A comprehensive system of trader alerts at critical points enables trading members to unwind positions or bring additional capital. Penalties for margin violations are severe.
Separate settlement guarantee funds for this segment have been created by exchanges.

How Margins Are Used To Manage Risk

Margining system for currency futures trading adopts the SPAN (Standard Portfolio Analysis of Risk) methodology, and margins are computed on a real time basis. Broadly, different types of margins are collected for the purpose of risk management.

Initial Margin and Extreme Loss Margins

Initial margin is a kind of security deposit for allowing exposure limits. Initial Margins are based on a worst case loss of a portfolio of an individual client across various scenarios of price changes. The scenarios are computed so as to cover 99% Value at Risk (VAR) over a one-day horizon. Initial margin is deducted from the liquid net worth of the clearing member on real-time basis. Now brokers have to also collect exposure margins / extreme loss margins (ELM) at the time of initiating the currency futures trade itself. The clearing member’s liquid net worth after adjusting for the initial margin and extreme loss margin requirements must be at least Rs. 50 lakhs at all points in time.

Calendar spread margins

Here a concessional margin is applied due to the long/short nature of the transaction having an in-built risk management focus. A currency futures position at one maturity which is hedged by an offsetting position at a different maturity is treated as a calendar spread. The benefit for a calendar spread continues till expiry of the near-month contract.

Mark-to-Market margins (MTM)

The MTM gains and losses are settled in cash before the start of trading on T+1 day. If MTM obligations are not collected before start of the next day, clearing corporation collects correspondingly higher initial margin to cover the potential for higher losses.

More than the margins, it is the enforcement that actually manages the risk. The client margins (initial margin, ELM, calendar-spread margin, and MTM) are mandatorily collected and reported to the Exchange; which imposes stringent penalty on members who do not collect margins from their clients. The Exchange also conducts regular inspections to ensure margin collection from clients.

Module III

CHAPTER 5 - Clearing, settlement and risk management in currency futures