Trading systems, clearing, settlement and risk management

The exam's objective on "clearing, settlement, risk management and operations" is worth a large block of marks and is mostly rules. The good news is that the rules form a chain: an order enters the system, becomes a trade, is novated to the clearing corporation, margined, marked to market daily and settled at expiry. Follow the chain and the questions answer themselves.

The trading system and order types

Derivatives trade on the exchange's screen-based, order-driven system (NEAT-F&O on NSE, BOLT on BSE) from 9:15 am to 3:30 pm, with orders matched on price-time priority: best price first, and among equal prices, the earliest order. Each contract is identified by underlying, instrument type (FUTIDX, FUTSTK, OPTIDX, OPTSTK), expiry and, for options, strike and type (CE for call, PE for put).

• Limit order: executes at the stated price or better. Market order: executes at the best available price immediately.
• Stop-loss order: stays dormant until a trigger price is touched, then enters the book as a limit or market order.
• Time conditions: Day (valid for the session) and IOC (immediate or cancel: whatever is not filled at once is cancelled).
• Price bands and dynamic price ranges limit how far a single order can move a contract; there is no daily circuit on index futures, but orders outside the operating range are rejected.

Every trade generates a contract note to the client within 24 hours, showing price, brokerage, taxes and the trade's unique identifiers. The client's trades are tagged with a unique client code; proprietary trades of the broker are tagged separately.

Clearing: novation and the clearing corporation

Once a trade matches, the clearing corporation (NSE Clearing for NSE, ICCL for BSE) steps in through novation: the original contract between buyer and seller is replaced by two contracts, one between the clearing corporation and the buyer and one between the clearing corporation and the seller. Neither party now cares who was on the other side. The clearing corporation manages this risk with margins, a core settlement guarantee fund funded by itself, the exchange and clearing members, and the right to close out defaulters.

Clearing is done through clearing members: a trading-cum-clearing member clears its own and its clients' trades; a professional clearing member (typically a bank or custodian) clears for trading members but does not trade; a self-clearing member clears only its own trades. Each clearing member keeps a liquid net worth and deposits with the clearing corporation, as specified by it.

Margins

Margins are collected upfront, before a position is taken, at the client level, and passed up through the clearing member to the clearing corporation.

• Initial margin (SPAN): computed by the Standard Portfolio Analysis of Risk system, which revalues the whole portfolio across 16 scenarios of price and volatility and takes the worst one-day loss at 99% confidence. It recognises offsets within a portfolio, so a long and a short in correlated contracts attract less than the sum of their individual margins. Parameters are updated several times a day.
• Exposure margin: a flat percentage of contract value collected in addition to SPAN, as specified by the clearing corporation; higher for stocks than for indices.
• Premium margin: the option buyer pays the full premium, which is settled on T+1 and is the buyer's only margin obligation.
• Assignment margin: collected from option writers on expiry for the settlement obligation on options assigned to them.
• Delivery margin: collected on stock derivative positions in the last days before expiry, since they will result in physical delivery.

Brokers must collect the full upfront margin from each client before the trade and report client-wise margins to the exchange daily. The exchange also captures peak margin snapshots during the day; if the client's margin at any snapshot was short, a penalty is levied on the broker, which may be passed on. A broker may not fund a client's margin and may not use one client's funds for another's margin.

Settlement

Futures are settled twice. The daily mark-to-market settlement uses the daily settlement price, the closing price of the futures contract computed as the weighted average of the last half hour of trading. The gain or loss is paid in cash on T+1. The final settlement on expiry uses the final settlement price, which is the closing price of the underlying index or stock in the cash market on the last trading day. Index futures and options are cash settled. Since October 2019, all single-stock futures and options are physically settled: an open stock futures position at expiry becomes an obligation to deliver or receive shares at the final settlement price, and an ITM stock option becomes a delivery obligation at the strike. Delivery passes through the cash segment's settlement cycle.

Options settle in two steps: the premium on T+1 when the trade happens, and the exercise value on expiry. All ITM options are exercised automatically; OTM options lapse. For index options the exercise settlement value is the intrinsic value at the final settlement price, paid in cash.

Position limits and surveillance

Limits stop one participant from cornering a contract. They are set at four levels and revised by SEBI and the exchanges from time to time:

1. Client level: a cap on gross open positions in a stock's derivatives, as a percentage of market-wide position limit and of open interest, as notified.
2. Trading member level: a cap on the member's total open positions across clients, as a share of market-wide open interest.
3. Market-wide position limit for a stock: a percentage of its non-promoter (free-float) shares, as notified. When open interest crosses 95% of this limit the stock enters a ban period, during which only position-reducing trades are allowed.
4. FPI, mutual fund and SIF limits: separate caps for institutional categories at scheme and entity level.

Exchanges monitor positions in real time, can call for additional margins on concentrated positions, and square off a client whose margin is not replenished. For a distributor, the practical rule is that a client cannot hold a stock F&O position beyond the limits however much margin they have, and that a ban period can trap a client in an unwanted position until it is reduced.