Clearing, Settlement and Risk Management of Currency Futures in India

NSE (National Stock Exchange of India) has witnessed healthy growth in the turnover and open interest positions during its first completed month of currency futures trading in India. NSE commenced currency futures trading in India on 29^th August 2008.

CDX (Currency Derivative Exchange), currency derivative segment of BSE (Bombay Stock Exchange) commenced currency futures trading from 1^st October. BSE on its very first day of trading in currency futures clocked a turn over of about 65,000 contracts, which is approximately Rs. 300 Crores.

With ever-growing global financial crisis, exchange rates are fluctuating widely. INR exchange rate has touched 47 against USD. Currency futures trading in India has generated huge interest among Indian retail investors and traders. There is a strong demand for information gathering about the intricacies of currency futures from small investors and enterprises.

We has published numbers of informative articles on currency futures trading in India. It is our endeavor to post new articles and updates on currency futures in India regularly on this website. This article intends to provide detailed information about clearing, settlement and risk management process of currency futures on National Stock Exchange of India.

Who carries out the process of clearing and settlement?

NSCCL (National Securities Clearing Corporation Limited), a wholly owned subsidiary of NSE acts as the body responsible for carrying out the entire clearing and settlement process. NSCCL, established in August 1995, is the first clearing corporation in India.

What are the primary functions of NSCCL?

• To operate tight risk containment system
• To carry out the Novation (It is a process of replacement of one obligation by another by mutual agreement of both the parties)
• To act as the counter party to all the trades
• To guarantee the final settlement

What is the model of clearing and settlement process?

• Clearing members and clearing banks are the entities that help NSCCL in carrying out the activities of clearing and settlement. There are two types of clearing members.
• Trading cum clearing members (TCM) – TCM clear and settle, their own trades as well as the trades of other trading members (TM)
• Professional clearing members (PCM) – PCM clear the trades executed by trading members
• TCM and PCM have to pay deposit to undertake clearing and settlement of trades of every TM.
• TCM and PCM have to open a separate bank account with NSCCL designated bank for settlement of trades.
• The entire process of clearing and mechanism comprises of three components – clearing, settlement and risk management

How the clearing mechanism takes place?

• NSCCL works out open positions and obligations of clearing members (TCM and PCM) at the end of every business day.
• Daily exposure limits and margin obligations are derived based on net open positions. Net open contracts (Buy – Sell) multiplied by 1000 gives the net open positions in USD terms.

NOTE: The information about the process of calculation of net open position across various members is not covered in this article. Any reader who is interested in knowing this process should post the request in the comments section.

How the settlement mechanism takes place?

• Settlement is done in cash mode payable in INR.
• Daily MTM (Marking to Market) settlement takes place based on DSP (Daily settlement price) which is calculated by taking the weighted average of last half an hour’s trades.
• NSE daily disseminates DSP on its website.
• Daily MTM or profit and loss are calculated by taking the difference of trade price and DSP. If a client has carried forward the position from previous day then MTM is calculated as the difference between previous day’s DSP and current day’s DSP.
• Clearing members with net loss in daily MTM have to pay the amount in cash. Clearing members with net profit will receive the amount in cash. Payment and receipts are to be settled on the basis of T+1 day.
• Clearing members are responsible for collection/payment of daily MTM from/to the trading members, who in turn are responsible for the client’s liabilities.
• At the end of the day all the net positions are carried forward to next day after resetting with respect to the current day’s DSP.
• Final settlement is also done in cash mode in terms of INR.
• Final settlement price is the RBI reference rate on the last trading day of the expiry contract.
• Final profit and loss or MTM of all the net open positions of the clearing members will be on the basis of final settlement price. Settlement takes place on the basis of T+2 days.

How the risk management is carried out in currency futures in India?

Salient features of risk management system of NSCCL:

• Financial soundness of the members is ensured by imposing stringent conditions about capital adequacy. NSCCL enforces the requirement about sufficient net-worth and cash and collateral security deposit.
• NSCCL follows real-time and scientific margining system.
• Net open positions of the members are daily settled in cash based on MTM.
• Members open positions are monitored online and alerts are issued on real time basis in respect of violation of margin and open positions. Whenever any trading member exceeds intra-day limits or violates the margins and open positions then further trading of that member is stopped for the rest of the day and until the compliances are fulfilled.
• NSCCL maintains separate settlement guarantee fund, which is created out of the capital of the members.

Margining System

Trading in currency future and for that matter any derivatives involves highly leveraged trading. Any leveraged trading is capable of generating enormous losses even with minor movement in the price of underlying. Smooth functioning of the market demands perfect margining system.

Most critical component of a healthy margining system requires online monitoring. Margining system of NSCCL monitors online positions on intra-day basis by using PRISM (Parallel Risk Management System). In PRISM, risk of each member is monitored online on real time basis. As and when any member approaches certain limits, alerts are generated and sent online to the members. In case a member exceeds the set limits then further trading of the member is stopped automatically. NSCCL calculates initial margin on portfolio based margining system by using SPAN (Standard Portfolio Analysis of Risk)

NSCCL – SPAN

Main objective of SPAN is to identify the overall risk in the entire portfolio of each member. Main emphasis is on calculating the maximum loss that a portfolio might be expected to suffer from the current day to the next day on the base of 99% VaR (Value at Risk) methodology. SPAN system constructs the probable scenarios in the changes in the price of the underlying presuming various levels of volatility.

Types of Margins

• Initial Margin – NSCCL computes initial margin up to client level on the base of SPAN methodology. Client has to pay the initial margin upfront.
• Extreme Loss Margin – 1% of value of gross open positions of any member is adjusted online and on real-time basis from the liquid assets of the member towards extreme loss margin.
• Client Margins – NSCCL daily communicates to the members about the margin liability of each and every client. Members are responsible for pay-in and pay-out of the margins to clients. Members are also required to submit compliance report to NSCCL