Foundation — Clearing, the entities involved, and how open positions are computed

Think of it like this

Key terms in this chapter

Automatic exercise

On expiry, all open long in-the-money option contracts are exercised without instruction and assigned on a random basis to open short positions of the same strike and series.

Back testing

The daily comparison of margins collected against actual price changes in the contracts cleared, used to check whether the margining model is behaving as intended.

Calendar spread charge

The reduced margin on a futures position hedged by an offsetting position in a different expiry month, computed on the delta of the portfolio in each month and available till the near month expires.

Capped additional contribution

The last call on non-defaulting members before pay-out haircuts, limited to the lower of twice their primary Core SGF contribution or 20% of the segment's Core SGF in derivatives (10% in equity and debt).

Cash component and non-cash component

Liquid assets split into cash-like collateral and other collateral. Cash must be at least half, so any non-cash in excess of the cash component is simply not counted as a liquid asset at all.

Central counterparty

The clearing corporation once it has novated every trade. It guarantees settlement, nets payments, monitors participants and provides independent legal enforcement so buyers and sellers never have to sue each other.

Cheapest-to-deliver (CTD) bond

The bond every futures seller prefers to deliver, because the conversion factor stays fixed during the delivery month while bond prices move. The futures price ends up tracking the CTD bond's cash price.

Clearing

The process of determining obligations, after which those obligations are discharged by settlement. It is carried out through multilateral netting, leaving each clearing member with either a pay-in or a pay-out.

Clearing bank

An empanelled bank at which every clearing member maintains a clearing account used exclusively for clearing and settlement. The clearing corporation instructs it to debit on pay-in and credit on pay-out.

Client Unpaid Securities Pledgee Account

The account into which unpaid securities are auto-pledged after being transferred to the client's demat account. If not invoked or released within seven trading days of pay-out, the pledge is auto released.

Conversion factor

For physical delivery, the price of the deliverable security per rupee of principal on the first calendar day of the delivery month, computed to yield 7% with semi-annual compounding.

Core Settlement Guarantee Fund

A per-segment fund used to complete settlement when a clearing member fails, without disturbing the normal settlement process. It is managed by the clearing corporation's Regulatory Oversight Committee.

Custodial participant

A client eligible to trade through multiple trading members while clearing and settling through a single clearing member, identified by a unique custodian participant code linked to that clearing member.

Default waterfall

The order in which resources absorb a default — the defaulter's own monies, insurance, the clearing corporation's 5% skin in the game, the Core SGF, further CC resources, other segments' funds, capped member contributions, and finally a haircut to pay-outs.

EWMA volatility

The Exponential Weighted Moving Average estimate of daily return volatility used in margining, with the decay parameter lambda fixed at 0.995 and returns measured logarithmically.

Extreme Loss Margin (ELM)

A margin charged in addition to initial margin — 0.25% for G-Sec interest rate derivatives, 0.015% for 91-day T-Bill futures and 0.50% for MIBOR futures, with 0.01% on calendar spreads.

FPI net long cap

No FPI may hold a net long position above Rs 1,800 crore, all FPIs together may not exceed Rs 5,000 crore, and an FPI's gross short may never exceed its long in government securities and interest rate futures.

Gross open position (long and short)

For limit monitoring, long counts long futures, long calls and short puts; short counts short futures, short calls and long puts — because a short put behaves like a long position and a long put like a short one.

Inter-CC collateral

Collateral clearing corporations hold with each other under interoperability — margins under the SEBI risk framework, plus additional capital based on the linked CC's credit risk, on which no exposure is granted.

Interoperability among clearing corporations

A framework letting a clearing member choose its clearing corporation regardless of the exchange where a trade was executed, through peer-to-peer links. It applies to all products except commodity derivatives, and excludes IFSC clearing corporations.

Invoice price

The amount a buyer pays the seller on physical delivery: [(final settlement price × conversion factor) + accrued interest] × contract amount / 100, the contract amount being Rs 2,00,000.

Liquid Net Worth

Total liquid assets deposited towards initial margin and capital adequacy, less initial margin and extreme loss margin on total gross open positions. It must never fall below Rs 50 lakh.

Margin on consolidated crystallized obligation

A margin on the net payable amount at client level — intraday from closed-out futures and premium, and at end of day from all futures and options positions. It replaced net buy premium, assignment margin and futures final settlement margin.

Margin pledge

The only permitted way for a client to give securities as collateral, created in the depository system. Title transfer to the broker's demat account is prohibited, since an off-market transfer changes ownership.

Mark to market settlement

The daily revaluation of open positions to the daily settlement price, settled in cash on T+1 for futures and adjusted against liquid assets for options, with positions carried forward at the new settlement price.

Minimum Required Corpus (MRC)

The Core SGF corpus, fixed monthly and reviewed by the 15th of each month, set as the higher of the average of the preceding month's daily worst-case stress losses and the previous MRC.

Net Option Value

The difference between long and short option positions valued at the last closing price, added to the clearing member's liquid net worth. It is why option gains and losses are never settled in cash.

Novation

The act of a clearing corporation interposing itself between both parties of every trade as the legal counterparty to both, so that it becomes buyer to every seller and seller to every buyer.

Pay-in and pay-out

Pay-in is the first phase, where the clearing member brings money or securities to the clearing corporation. Pay-out is the second, where the clearing corporation pays money or delivers securities back.

Peak margin

The highest client margin requirement across at least four random intraday snapshots. The higher of the peak shortfall and the end-of-day shortfall is what attracts penalty for short collection.

Position limits

The maximum exposure levels the entire market and each trading member or investor may reach. They are always specified in number of lots and computed from the previous day's end-of-day open interest.

Price scan range

The price move SPAN simulates, based on 6 sigma subject to a minimum — 1.75% for G-Sec interest rate derivatives, 0.065% for 91-day T-Bills and 5.50% for MIBOR.

Professional Clearing Member (PCM)

A clearing member with clearing rights but no trading rights, clearing trades executed by trading members and custodial participants. SEBI registered custodians and recognised banks may become PCMs.

Reverse stress test

A periodic test designed to identify the market conditions and scenarios under which margins, the Core SGF and other resources would prove insufficient — the question of what would actually break the system.

Risk reduction mode

The state a broker is forced into when 90% of collateral is utilised — all unexecuted orders cancelled, only IOC orders allowed, position-increasing orders margin-checked. Normal mode resumes below 85%.

Running account settlement

Where a client authorises the broker in writing to hold funds, settlement must occur within a maximum gap of 30 or 90 days by the client's choice, by actual payment into the client's bank account and never by journal entry.

Self-clearing member

A member with both trading and clearing rights who clears only his own trades, on his own account or for his clients — but never for custodial participants.

Settlement

A two-way process involving the transfer of funds and securities on the settlement date. For cash settled ETIRD it happens on T+1, typically before market hours the next day.

SPAN margin

The scenario-based initial margin system developed by the Chicago Mercantile Exchange. It generates 16 what-if scenarios and margins the entire portfolio at once rather than each position separately.

The netting rule for open positions

Positions are netted only within one client or the proprietary book in one contract. Client positions are added across clients, and trading members' counter positions are added at clearing member level — never offset.

Upstreaming and downstreaming accounts

Client funds are received into the Up Streaming Client Nodal Bank Account and paid out only from the Down Streaming Client Nodal Bank Account, so that one client's money is never used to settle another's.

Value at Risk (VaR)

A measure of the maximum likely price change over a given horizon at a given confidence level. Initial margin uses 99% VaR over one day, or two days where mark to market cannot be collected before the next session.

Vintage allocation

The rule for assigning physical deliveries — long positions are allocated starting with the highest vintage, and within a single vintage, on a random basis.