- Role of Clearing Corporation: Responsible for clearing and settlement of all trades in the F&O segment of the exchange.
- Legal Principle of Novation: Clearing Corporation becomes the central counterparty for all trades on the derivatives platform.
- Guarantee of Settlement: Acts as a legal counterparty and guarantees financial settlement of trades.
- Key Activities: The clearing and settlement process includes three main activities: Clearing, Settlement, and Risk Management.
- Collaboration: Clearing Corporation conducts these activities with the assistance of Clearing Members and Clearing Banks.
Clearing Members :
- Types of Clearing Members:
- Self-Clearing Member: Clears and settles only their trades or their clients’ trades.
- Trading Member–cum–Clearing Member: Clears and settles their own trades and those of other trading members and custodial participants.
- Professional Clearing Member: Clears and settles trades executed by trading members.
- Key Functions of Clearing Members:
- Clearing: Computes obligations and determines positions for settlement.
- Settlement: Executes the actual settlement process.
- Risk Management: Sets position limits, monitors them, and manages risks using upfront deposits and margins.
- Clearing Banks:
- Clearing members must have a separate account with a designated clearing bank for the F&O segment.
- Eligibility Norms for Clearing Members:
- Minimum net worth of Rs. 300 lakhs (Rs. 100 lakhs for self-clearing members).
- Security deposit of Rs. 50 lakhs with the clearing corporation.
- Additional deposit of Rs. 10 lakhs for every additional trading member they support.
Clearing Mechanism :
- Open Position Calculation:
- A clearing member’s (CM) open position is the sum of open positions from all trading members (TMs) and custodial participants (CPs) clearing through them.
- A TM’s open position includes proprietary and client open positions.
- Order Identification:
- Orders are classified as proprietary (Pro) or client (Cli) at the time of entry.
- Proprietary positions are calculated on a net basis (Buy – Sell).
- Client positions are aggregated by summing individual client net positions.
- Example:
- For CM ‘A’ with TMs ‘PQR’ and ‘XYZ’, positions are calculated as follows:
- PQR:
- Proprietary position: 2,000 (Net: Buy 5,000 – Sell 3,000).
- Client 1 and Client 2: 1,000 and 2,000, respectively.
- Total Long Position: 5,000.
- XYZ:
- Proprietary position: -1,000 (Net: Buy 1,000 – Sell 2,000).
- Client 1 and Client 2: 1,000 and -1,000, respectively.
- Total Long Position: 1,000; Short Position: 2,000.
- Final Clearing Member Position:
- Long Position: 6,000 (PQR: 5,000; XYZ: 1,000).
- Short Position: 2,000 (XYZ).
Interoperability of clearing corporations :
- Background:
- Previously, Indian stock exchanges had their own clearing corporations, requiring traders to be members of each exchange and its clearing corporation.
- This led to inefficiencies, including maintaining separate collateral and margin deposits for multiple exchanges, increasing trading costs.
- SEBI’s Initiative:
- SEBI proposed interoperability among clearing corporations in 2018, which was implemented in 2019.
- Trades on any exchange can now be cleared and settled by any clearing corporation.
- Benefits:
- Cost Reduction: Traders maintain margins with a single clearing corporation, lowering costs and improving capital allocation.
- Operational Efficiency: Brokers comply with one clearing corporation, simplifying processes.
- Continuity: Ensures trade settlement during disruptions or technical glitches.
- Healthy Competition: Encourages competitive pricing and improved services among clearing corporations.
- Example:
- A unified margin computation for positions across exchanges (e.g., netting long and short positions) reduces collateral requirements.
Settlement Mechanism :
- Settlement Overview
- Since October 2019, individual securities futures and options are physically settled upon expiry; index futures and options remain cash-settled.
- Futures Contracts
- Mark-to-Market (MTM) Settlement:
- Adjusts daily margins based on market price changes.
- Profits/losses calculated using trade price, daily settlement price, and squared-off positions.
- Daily settlement price is based on a 30-minute volume-weighted average or a theoretical formula.
- Final Settlement:
- On expiry, all positions are matched for cash or physical delivery based on regulations.
- Stock futures are physically settled; index futures are cash-settled.
- Options Contracts
- Daily Premium Settlement:
- Option premiums are exchanged on a T+1 basis.
- Final Exercise Settlement:
- Index options (European-style) are cash-settled based on intrinsic value.
- Stock options are physically settled; ITM options are assigned randomly to opposing positions.
- Examples
- For futures: Long/short positions must settle differences between trade price and settlement price, either in cash or securities.
- For options: ITM options require delivery or receipt of securities or cash based on strike price and market price.
- Net Settlement Mechanism
- Aligns cash and derivatives segment on expiry, allowing obligations to offset for efficiencies.
- Net settlement is limited to specific trading and clearing combinations, excluding institutional investors.
Risk Management :
- Risk Management Overview: Exchanges and Clearing Corporations manage derivatives risk through a comprehensive risk containment mechanism.
- Capital Adequacy: Membership requires stringent capital adequacy, ensuring the financial strength of members.
- Initial Margin Requirements: Clearing corporations charge an upfront initial margin for open positions, specifying daily margin requirements and using Value-at-Risk (VaR) for margining.
- MTM Settling: Open positions are settled on a Mark-To-Market (MTM) basis at the end of each day.
- Real-Time Monitoring: Clearing corporation’s online system monitors open positions in real-time and sets limits based on effective deposits, with alerts triggered when limits are reached.
- Violation Monitoring: Clearing members (CMs) are monitored for Initial Margin and Exposure Margin violations, while trading members (TMs) are monitored for Initial Margin and position limit violations.
- Trading Terminal for CMs: CMs use a trading terminal to monitor TMs’ open positions, with limits set by CMs to control trading.
- SPAN® System: The margining and position monitoring are carried out online using SPAN® system, which computes margins based on regulator-defined parameters.
Margining and mark to market under SPAN :
- SPAN Overview: SPAN (Standard Portfolio Analysis of Risk) is a risk management and margining tool adopted by Indian exchanges, developed by CME. It helps calculate initial margins on market participants’ positions by determining potential one-day losses.
- Risk Array Concept: SPAN evaluates risk using a “risk array,” which represents the possible value changes in derivatives over a single trading day.
- Margining System:
- Initial Margin: Collected by clearing corporations based on SPAN, considering a 99% confidence level for one-day potential loss. For futures, this may extend to two days.
- Premium Margin: Additional margin required for premium settlement in options.
- Assignment Margin: Charged for obligations on assigned options positions.
- Intraday Crystallized Losses (ICMTM): ICMTM is calculated for trades that close open positions, based on weighted average prices, and adjusted in real-time against clearing member assets.
- Delivery Margins: Applied to positions that may be delivered upon expiry, based on in-the-money long options positions, increasing incrementally as expiry approaches.
- Exposure Margins: Derived from the Capital Market segment’s VaR and Extreme Loss Margins, applied to client-level obligations.
- Short Option Minimum Charge: SEBI discontinued this charge in February 2020 for deep-out-of-the-money options.
- Net Option Value: The difference between long and short option positions, updated intraday and added to clearing members’ liquid net worth.
- Client Margin Reporting: Clearing corporations inform members of client margin liabilities, and brokers must report margins collected to prevent misappropriation of client securities.
- Peak Margin Obligation: SEBI’s peak margin regulations ensure brokers collect the highest margin during the day, avoiding excessive intraday leverage. The regulations were phased in to adapt to the new framework.
- Cross Margining: Allows margin offsets between cash and derivatives segments, benefiting clients with positions that offset across segments.
- Early Pay-in of Securities and Funds: Early pay-ins exempt positions from delivery margins.
- Pledge/Repledge Mechanism: A new system, effective from September 2020, mandates brokers to pledge client securities to prevent misuse and ensure the securities are used for the client’s margin obligations.
- Collateral Segregation and Reporting: A system introduced to ensure visibility of client collateral at every level, with clear segregation and daily reporting by brokers, clearing members, and the clearing corporation.
Position limits :
- Position Limits in Derivatives Exchanges: Position limits restrict the number of derivatives contracts a trader or client can own to prevent market manipulation.
- Types of Position Limits:
- Client-Level Position Limit: Restricts the total open position in a security to the higher of 1% of its free float market capitalization or 5% of the open interest in all derivative contracts.
- Trading Member-wise Position Limit: Limits trading members to either Rs. 7500 crores or 15% of the total open interest in index futures or options.
- Market-Wide Position Limit (MWPL): Set at 20% of the free float of a security for futures and options contracts. Once open interest exceeds 60% of MWPL, alerts are triggered.
- Reporting Requirements: A trader or group owning 15% or more of open interest in a specific index must report it to the exchange.
- Monitoring and Enforcement:
- Violations of position limits (client-level, trading member, MWPL) are penalized.
- Intraday monitoring of position limits will start in April 2025, with at least four snapshots taken throughout the day.
- Violations are checked at the end of the trading day for MWPL, and penalties are imposed for exceeding limits.
- Additional Rules for FPIs and NRIs: Separate rules for Foreign Portfolio Investors, Mutual Funds, and Non-Resident Indians as per SEBI regulations.
- Penalties for Violations: The clearing member is penalized for violations, and penalties are imposed for trading beyond allowed positions in individual securities or indices.
Violations and Penalties :
- Violations and Penalties: Non-compliance with rules by clearing or trading members leads to penalties.
- Common Violations:
- Failure to meet initial margin, settlement, or securities delivery obligations.
- Exposure margin, position limit, and client margin reporting violations.
- Misuse of member/client collaterals and deposits.
- Market wide position limit violations.
- Consequences:
- Clearing Corporation may recommend withdrawal of membership rights and trading facilities.
- Outstanding positions of violating members may be closed out.
- Additional actions include imposing penalties, collecting deposits, invoking guarantees, and disposing of securities.
Settlement of running account of Client’s funds lying with the TM:
- SEBI mandates brokers to settle client funds on a monthly or quarterly basis as per the client’s preference to prevent misuse.
- Trading Members (TM) must settle client accounts monthly or quarterly, considering End of Day (EOD) obligations on all Exchanges.
- Stock exchanges will issue an annual calendar for settlement dates at the start of each financial year.
- For clients with a credit balance and no transactions in 30 days, the full credit balance must be returned by the TM on the upcoming settlement date.
- If the client trades after 30 days but before the next settlement, the account will continue to be settled according to the client’s chosen cycle (monthly or quarterly).
Settlement Guarantee Fund and Investor Protection Fund:
- Core Settlement Guarantee Fund (Core SGF):
- Clearing corporations must maintain a Core SGF for each trading segment (e.g., Cash, F&O).
- Its purpose is to guarantee settlement in case a clearing member defaults.
- Investor Protection Fund (IPF):
- The IPF compensates investors if a defaulting member’s assets are insufficient to cover claims.
- It also promotes investor education, awareness, and research.
- Managed by a registered Trust.
- Recent SEBI Measures for Investor Protection and Market Stability:
- Upfront Collection of Option Premium (from Feb 1, 2025): All option premiums must be collected upfront to reduce leverage and risks.
- Removal of Calendar Spread Benefits (from Feb 1, 2025): No margin offsets on expiry day for contracts expiring the same day to address basis risks.
- Intraday Monitoring of Position Limits (from Apr 1, 2025): Exchanges to monitor position limits with four random intraday snapshots.
- Revision of Index Derivatives Contract Sizes (from Nov 20, 2024): Minimum contract size for new index derivatives will reflect a market value of ₹15–₹20 lakhs.
- Rationalization of Weekly Index Derivatives (from Nov 20, 2024): Only one weekly expiring derivative per benchmark index will be offered by each exchange.
- Additional Tail Risk Coverage (from Nov 20, 2024): An additional 2% extreme loss margin on short options on expiry days due to speculative activity.
Cyber Security & Cyber Resilience framework (CSCRF) for Stock Brokers /
Depository Participants:
- Need for Cyber Security & Resilience: Rapid technological advancements in the securities market highlight the need for robust cyber security and resilience to protect data integrity and privacy.
- Importance for Stock Brokers & Depository Participants: These entities must have a strong cyber security framework to protect services related to securities holders.
- SEBI’s CSCRF Notification: SEBI introduced a detailed Cyber Security and Cyber Resilience Framework (CSCRF) for SEBI Regulated Entities (REs), effective from January 1, 2025.
- Objective of CSCRF: The CSCRF aims to address cyber threats, align with industry standards, promote efficient audits, and ensure compliance by SEBI regulated entities.
- Market Infrastructure Institutions (MIIs): The framework applies to Stock Exchanges, Depositories, Clearing Corporations, KYC Registration Agencies (KRAs), and Qualified Registrars and Transfer Agents (QRTAs).
- Cyber Resilience Definition: Cyber resilience refers to the ability to prepare for, respond to, and recover from cyber-attacks while maintaining operations.
- Five Cyber Resilience Goals:
- Anticipate: Be prepared for potential cyber-attacks.
- Withstand: Continue critical business functions during an attack.
- Contain: Isolate trusted functions during a cyber-attack to prevent further damage.
- Recover: Restore business functions to normal after an attack.
- Evolve: Adapt business functions and cyber capabilities to minimize the impact of future attacks.