Clearing and Settlement of Futures and Options

National Securities Clearing Corporation Limited (NSCCL) undertakes clearing and settlement of all trades executed on the futures and options (F&O) segment of the NSE. It also acts as legal counterparty to all trades on the F&O segment and guarantees their financial settlement.

Clearing Entities

Clearing and settlement activities in the F&O segment are undertaken by NSCCL with the help of the following entities:

• Clearing members: In the F&O segment, some members, called self clearing members, clear and settle their trades executed by them only either on their own account or on account of their clients. Some others called trading member–cum–clearing member, clear and settle their own trades as well as trades of other trading members (TMs). Besides, there is a special category of members, called professional clearing members (PCM) who clear and settle trades executed by TMs. The members clearing their own trades and trades of others, and the PCMs are required to bring in additional security deposits in respect of every TM whose trades they undertake to clear and settle.
• Clearing banks: Funds settlement takes place through clearing banks. For the purpose of settlement all clearing members are required to open a separate bank account with NSCCL designated clearing bank for F&O segment.

The Clearing and Settlement process comprises of the following three main activities:

1. Clearing
2. Settlement
3. Risk Management

Settlement Mechanism

All futures and options contracts are cash settled, i.e. through exchange of cash. The underlying for index futures/options of the Nifty index cannot be delivered. These contracts, therefore, have to be settled in cash. Futures and options on individual securities can be delivered as in the spot market. However, it has been currently mandated that stock options and futures would also be cash settled. The settlement amount for a CM is netted across all their TMs/clients, with respect to their obligations on MTM, premium and exercise settlement.

Settlement of Futures Contracts

Futures contracts have two types of settlements, the MTM settlement which happens on a continuous basis at the end of each day, and the final settlement which happens on the last trading day of the futures contract.

1. MTM Settlement: All futures contracts for each member are marked-to-market (MTM) to the daily settlement price of the relevant futures contract at the end of each day. The profits/losses are computed as the difference between:

1. The trade price and the day’s settlement price for contracts executed during the day but not squared up.
2. The previous day’s settlement price and the current day’s settlement price for brought forward contracts.
3. The buy price and the sell price for contracts executed during the day and squared up.

2. Final Settlement for Futures On the expiry day of the futures contracts, after the close of trading hours, NSCCL 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 hank account on the day following expiry day of the contract.

Settlement Prices for Futures

Daily settlement price on a trading day is the closing price of the respective futures contracts on such day. The closing price for a futures contract is currently calculated as the last half an hour weighted average price of the contract in the F&0 Segment of NSE. Final settlement price is the closing price of the relevant underlying index/security in the capital market segment of NSE, on the last trading day of the contract. The closing price of the underlying Index/security is currently its last half an hour weighted average value in the capital market segment of NSE.

Settlement of Options Contracts

Options contracts have three types of settlements, daily premium settlement, exercise settlement, interim exercise settlement in the case of option contracts on securities and final settlement.

1. Daily premium settlement: Buyer of an option is obligated to pay the premium towards the options purchased by him. Similarly, the seller of an option is entitled to receive the premium for the option sold by him. The premium payable amount and the premium receivable amount are netted to compute the net Premium payable or receivable amount for each client for each option contract.
2. Exercise settlement: Although most option buyers and sellers close out their options positions by an offsetting closing transaction, an under-standing of exercise can help an option buyer determine whether exercise might be more advantageous than an offsetting sale of the option. There is always a possibility of the option seller being assigned an exercise. Once an exercise of an option has been assigned to an option seller, the option seller is bound to fulfill his obligation (meaning, pay the cash settlement amount in the case of a cash-settled option) even though he may not yet have been notified of the assignment.
3. Interim exercise settlement: Interim exercise settlement takes place only for option contracts on securities. An investor can exercise his in-the-money options at any time during trading hours, through his trading member. Interim exercise settlement is effected for such options at the close of the trading hours, on the day of exercise. Valid exercised option contracts are assigned to short positions in the option contract with the same series (i.e. having the same underlying, same expiry date and same strike price), on a random basis, at the client level. The CM who has exercised the option receives the exercise settlement value per unit of the option from the CM who has been assigned the option contract.
4. Final exercise settlement: Final exercise settlement is effected for all open long in–the–money strike price options existing at the close of trading hours, on the expiration day of an option contract. All such long positions are exercised and automatically assigned to short positions in option contracts with the same series, on a random basis. The investor who has long in–the–money options on the expiry date will receive the exercise settlement value per unit of the option from the investor who has been assigned the option contract.

Exercise Process

The period during which an option is exercisable depends on the style of the option. On NSE, index options are European style, i.e. options are only subject to automatic exercise on the expiration day, if they are in–the–money. As compared to this, options on securities are American style. In such cases, the exercise is automatic on the expiration day, and voluntary prior to the expiration day of the option contract, provided they are in–the–money. Automatic exercise means that all in–the–money options would be exercised by NSCCL on the expiration day of the contract. The buyer of such options need not give an exercise notice in such cases. Voluntary exercise means that the buyer of an in–the–money option can direct his TM/CM to give exercise instructions to NSCCL. In order to ensure that an option is exercised on a particular day, the buyer must direct his TM to exercise before the cut-off time for accepting exercise instructions for that day. Usually, the exercise orders will be accepted by the system till the close of trading hours. Different TMs may have different cut–off times for accepting exercise instructions from customers, which may vary for different options. An option, which expires unexercised, becomes worthless. Some TMs may accept standing instructions to exercise, or have procedures for the exercise of every option, which is in–the–money at expiration. Once an exercise instruction is given by a CM to NSCCL, it cannot ordinarily be revoked. Exercise notices given by a buyer at anytime on a day are processed by NSCCL after the close of trading hours on that day. All exercise notices received by NSCCL from the NEAT F&O system are processed to determine their validity. Some basic validation checks are carried out to check the open buy position of the exercising client/TM and if option contract is in–the–money. Once exercised contracts are found valid, they are assigned.

Assignment Process

The exercise notices are assigned in standardized market lots to short positions in the option contract with the same series (i.e. same underlying, expiry date and strike price) at the client level. Assignment to the short positions is done on a random basis. NSCCL determines short positions, which are eligible to be assigned and then allocates the exercised positions to any one or more short positions. Assignments are made at the end of the trading day on which exercise instruction is received by NSCCL and notified to the members on the same day. It is possible that an option seller may not receive notification from its TM that an exercise has been assigned to him until the next day following the date of the assignment to the CM by NSCCL.

Exercise Settlement Computation

In case of index option contracts, all open long positions at in–the–money strike prices are automatically exercised on the expiration day and assigned to short positions in option contracts with the same series on a random basis. For options on securities, where exercise settlement may be interim or final, interim exercise for an open long in–the–money option position can be effected on any day till the expiry of the contract. Final exercise is automatically effected by NSCCL for all open long in–the–money positions in the expiring month option contract, on the expiry day of the option contract. The exercise settlement price is the closing price of the underlying (index or security) on the exercise day (for interim exercise) or the expiry day of the relevant option contract (final exercise). The exercise settlement value is the difference between the strike price and the final settlement price of the relevant option contract. For call options, the exercise settlement value receivable by a buyer is the difference between the final settlement price and the strike price for each unit of the underlying conveyed by the option contract, while for put options it is difference between the strike price and the final settlement price for each unit of the underlying conveyed by the option contract. Settlement of exercises of options on securities is currently by payment in cash and not by delivery of securities. It takes place for in-the-money option contracts.

The exercise settlement value for each unit of the exercised contract is computed as follows:

Call options – closing price of the security on the day of exercise – Strike price

Put options – Strike price – Closing price of the security on the day of exercise

For final exercise the closing price of the underlying security is taken on the expiration day the exercise settlement by NSCCL would ordinarily take place on 3rd day following the day of exercise. Members may ask for clients who have been assigned to pay the exercise settlement value earlier.

Special Facility for Settlement of Institutional Deals

NSCCL provides a special facility to Institutions/Foreign Institutional Investors (FIIs)/Mutual Funds etc. to execute trades through any TM, which may be cleared and settled by their own CM. Such entities are called custodial participants (CPs). To avail of this facility, a CP is required to register with NSCCL. Through his CM. A unique CP code is allotted to the CP by NSCCL. All trades executed by a CP through any TM are required to have the CP code in the relevant field on the trading system at the time of order entry. Such trades executed on behalf of a CP are confirmed by their

Own CM (and not the CM of the TM through whom the order is entered), within the time specified by NSE on the trade day though the on-line confirmation facility. Till such time the trade is confirmed by CM of concerned CP, the same is considered as a trade of the TM and the responsibility of settlement of such trade vests with CM of the TM. Once confirmed by CM of concerned CP, such CM is responsible for clearing and settlement of deals of such custodial clients. FIIs have been permitted to trade in all the exchange traded derivative contracts subject to compliance of the position limits prescribed for them and their sub-accounts, and compliance with the prescribed procedure for settlement and reporting. A FTI/a sub-account of the FIT, as the case may be, intending to trade in the F&O segment of the exchange, is required to obtain a unique Custodial Participant (CP) code allotted from the NSCCL. FIIs/sub–accounts of FIIs which have been allotted a unique CP code by NSCCL are only permitted to trade on the F&O segment. The FII/sub–account of FTI ensures that all orders placed by them on the Exchange carry the relevant CP code allotted by NSCCL

Risk Management

NSCCL has developed a comprehensive risk containment mechanism for the F&O segment. The salient features of risk containment mechanism on the F&O segment are:

1. The financial soundness of the members is the key to risk management. Therefore, the requirements for membership in terms of capital adequacy (net worth, security deposits) are quite stringent.
2. NSCCL charges an upfront initial margin for all the open positions of a CM. It specifies the initial margin requirements for each futures/options contract on a daily basis. It also follows value-at-risk (VAR) based margining through SPAN. The CM in turn collects the initial margin from the TMs and their respective clients.
3. The open positions of the members are marked to market based on contract settlement price for each contract. The difference is settled in cash on a T+1 basis.
4. NSCCL’s on-line position monitoring system monitors a CM’s open positions on a real-time basis. Limits are set for each CM based on his capital deposits. The on-line position monitoring system generates alerts whenever a CM reaches a position limit set up by NSCCL. NSCCL monitors the CMs for MTM value violation, while TMs arc monitored for contract-wise position limit violation.
5. CMs are provided a trading terminal for the purpose of monitoring the open positions of all the TMs clearing and settling through him. A CM may set exposure limits for a TM clearing and settling through him. NSCCL assists the CM to monitor the intra-day exposure limits set up by a CM and whenever a TM exceed the limits, it stops that particular TM from further trading.
6. A member is alerted of his position to enable him to adjust his exposure or bring in additional capital. Position violations result in withdrawal of trading facility for all TMs of a CM in case of a violation by the CM.
7. A separate settlement guarantee fund for this segment has been created out of the capital of members.

The most critical component of risk containment mechanism for F&O segment is the margining system and on-line position monitoring. The actual position monitoring and margining is carried out on–line through Parallel Risk Management System (PRISM). PRISM uses SPAN(R) (Standard Portfolio Analysis of Risk) system for the purpose of computation of on-line margins, based on the parameters defined by SEBI.

NSCCL–SPAN

The objective of NSCCL–SPAN is to identify overall risk in a portfolio of all futures and options contracts for each member. The system treats futures and options contracts uniformly, while at the same time recognizing the unique exposures associated with options portfolios, like extremely deep out–of–the–money short positions and inter–month risk. Its over–riding objective is to determine the largest loss that a portfolio might reasonably be expected to suffer from one day to the next day based on 99% VAR methodology. SPAN considers uniqueness of option portfolios. The following factors affect the value of an option:

1. Underlying market price
2. Strike price
3. Volatility (variability) of underlying instrument
4. Time to expiration
5. Interest rate

As these factors change, the value of options maintained within a portfolio also changes. Thus, SPAN constructs scenarios of probable changes in underlying prices and volatilities in order to identify the largest loss a portfolio might suffer from one day to the next. It then sets the margin requirement to cover this one–day loss. The complex calculations (e.g. the pricing of options) in SPAN are executed by NSCCL. The results of these calculations are called risk arrays. Risk arrays, and other necessary data inputs for margin calculation are provided to members daily in a file called the SPAN risk parameter file. Members can apply the data contained in the risk parameter files, to their specific portfolios of futures and options contracts, to determine their SPAN margin requirements. Hence, members need not execute a complex option pricing calculation, which is performed by NSCCL. SPAN has the ability to estimate risk for combined futures and options portfolios, and also re–value the same under various scenarios of changing market conditions.