Introduction to Clearing and Settlement System

1Novation and the clearing corporation

The clearing corporation clears and settles every F&O trade. Under the legal principle of novation, it steps in as the central counterparty to every trade (buyer to every seller and seller to every buyer), so neither side faces the other's credit risk, and it guarantees financial settlement. Its work has three parts, clearing, settlement and risk management, carried out with clearing members and clearing banks.

Remember

• Novation: the clearing corporation becomes counterparty to both sides.

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2Clearing members and clearing banks

Three types:

• Self-clearing member: clears only its own trades and its clients' trades.
• Trading member cum clearing member: clears its own trades and those of other TMs and custodial participants.
• Professional clearing member: clears trades of TMs (and institutions) without trading itself.

Clearing-cum-trading members and PCMs must bring an extra security deposit for each TM they clear for.

A clearing member's three jobs: clearing (working out each TM's obligations), settlement, and risk management (setting TM position limits based on deposits and monitoring them continuously).

Funds move through clearing banks: every clearing member opens a separate F&O account with a bank designated by the clearing corporation.

Eligibility:

• Net worth ₹300 lakh (₹100 lakh for one that clears only its own deals);
• ₹50 lakh deposit with the clearing corporation;
• ₹10 lakh extra for each additional TM cleared.

Remember

• Net worth ₹3 crore (₹1 crore if self-clearing); deposit ₹50 lakh; ₹10 lakh per extra TM.

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3Working out open positions

A TM's open position = its proprietary position (netted: buy − sell) + its clients' positions. Each client is netted separately, but clients are not netted against each other: client longs and client shorts are added up separately. A clearing member's open position is the total of its TMs' longs and shorts.

Example TM PQR: proprietary net long 2,000; client 1 net long 1,000; client 2 net long 2,000 → PQR long 5,000. TM XYZ: proprietary net short 1,000; client 1 net long 1,000; client 2 net short 1,000 → XYZ long 1,000 and short 2,000. Their clearing member's position = long 6,000, short 2,000.

Example One client buys 800 contracts and another sells 900. The member's open position is 800 + 900 = 1,700 contracts, not 100.

Remember

• Proprietary: net. Clients: each netted, then longs and shorts summed separately.

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4Interoperability of clearing corporations

Each exchange used to have its own clearing corporation, so members trading on several exchanges kept collateral with several clearing corporations. SEBI's interoperability framework (proposed in 2018, live in 2019) lets a trade on any exchange be cleared by any clearing corporation. A broker can choose one clearing corporation for all its trades.

Benefits:

• Lower costs and better use of capital: margins and collateral sit in one place, and positions on different exchanges net off.
• Resilience: if one exchange or its link to its clearing corporation fails, trades can be routed to another.
• Simpler compliance and competition among clearing corporations.

Example Long 10 lots of a stock's May futures on NSE and short 6 lots of the same contract on BSE → net long 4 lots, margined accordingly.

Remember

• Interoperability: one clearing corporation for trades on all exchanges.

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5Settlement of futures

Since October 2019, stock futures and options open at expiry settle by physical delivery; index derivatives settle in cash.

Daily mark-to-market (MTM): profit or loss is the difference between:

• trade price and the day's settlement price (new positions not squared off);
• previous and current settlement prices (positions brought forward);
• buy and sell prices (positions opened and closed the same day).

Losers pay, gainers receive, and positions are reset to the settlement price for the next day. MTM is always cash settled, with pay-in and pay-out before trading starts the next day through clearing bank accounts.

• Daily settlement price: the volume-weighted average price of the last 30 minutes of the futures contract across exchanges. If it did not trade in that half hour, a theoretical price F = S × e^(rt) is used.
• Final settlement price: the volume-weighted average price of the last 30 minutes of the underlying across exchanges on the last trading day. Long positions are randomly assigned to shorts in the same series.

Cash-settled futures (index): all positions are marked to the final settlement price on expiry and settled in cash on T+1.

Physically settled futures (stocks): settled on T+1 (T = expiry). Long futures become a buy (receive shares); short futures become a sell (deliver shares), at the final settlement price. The last day's MTM is settled in cash too.

Example Long 1 lot (1,500 shares) of a stock future at expiry; final settlement price ₹475, previous day's ₹482. The client must pay 1,500 × 475 = ₹7,12,500 and take delivery on T+1, and also pays MTM of (482 − 475) × 1,500 = ₹10,500. A client short the same lot delivers 1,500 shares, receives ₹7,12,500 and is credited the ₹10,500.

Remember

• Daily settlement price: last 30 minutes' VWAP of the futures contract.
• Stock F&O at expiry: physical delivery on T+1. Index F&O: cash.

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6Settlement of options

Daily premium settlement: buyers pay and sellers receive premium, netted per client per contract, through the clearing bank on T+1.

Final exercise settlement: all in-the-money options are exercised automatically on expiry (all Indian options are European) and assigned at random to short positions in the same series.

• Index options settle in cash at the intrinsic value, on T+1.

Formula Call settlement value = closing price − strike; put settlement value = strike − closing price

Example Index call, strike 17,500; index closes at 17,800; lot 50 → (17,800 − 17,500) × 50 = ₹15,000 in cash on T+1.

• Stock options settle by physical delivery at the strike price:
  • long ITM call → buy (receive shares); short assigned call → sell (deliver shares);
  • long ITM put → sell (deliver shares); short assigned put → buy (receive shares).

Example Long 1 lot (1,500) of a ₹475 call; stock closes at ₹510 → pay 475 × 1,500 = ₹7,12,500 and receive 1,500 shares. Long a ₹475 put with the stock at ₹410 → deliver 1,500 shares and receive ₹7,12,500.

Net settlement of cash and F&O on expiry: a client's cash-market obligations and physical F&O obligations in the same stock on expiry can be netted, if the client uses the same TM-CM in both segments (not available to institutions).

Example Long a ₹110 put; the client buys the shares at ₹101 on expiry day. Instead of paying ₹101, receiving the shares and then delivering them for ₹110, the client simply receives ₹9, with no movement of shares.

Remember

• ITM options are exercised automatically.
• Physical option settlement is at the strike price.

7Risk management

The risk containment system rests on:

• capital adequacy rules for members;
• upfront initial margin on all open positions, set daily using value at risk (VaR), collected from clients by TMs and from TMs by CMs;
• daily MTM settlement;
• online position monitoring in real time, with limits for each CM based on its deposits and alerts as limits approach. CMs are monitored for initial and exposure margin violations; TMs for initial margin and position limit violations;
• CMs set limits for their TMs, and a TM exceeding its limit is stopped from trading.

The core of the system is margining and online monitoring using SPAN.

Remember

• Margins are collected upfront.

8Margins under SPAN

SPAN (Standard Portfolio Analysis of Risk) was developed by the Chicago Mercantile Exchange. It estimates the largest loss a portfolio could reasonably suffer over one day and sets initial margin to cover it, treating futures and options together. It builds a risk array: the gain or loss on each position under a set of market scenarios over one trading day.

• Initial margin: computed to client level. Collected on a gross basis per client for client positions and net for proprietary positions. Based on 99% VaR over one day, but over two days for futures, because MTM may not be collected before the next day's trading.
• Premium margin: the premium due, charged until premium pay-in is complete.
• Assignment margin: the net exercise settlement value due on assigned positions, until pay-in.
• Intraday crystallised losses (ICMTM): losses on positions closed during the day, futures only, part of initial margin, blocked against the member's liquid assets in real time and released after MTM pay-in.
• Delivery margins: on stock derivatives that will settle by delivery, levied on potential deliverable positions (or ITM long options) from four days before expiry, in steps of 20%, 40%, 60% and 80% at the end of expiry − 4, − 3, − 2 and − 1. Early pay-in of shares or funds exempts the position.
• Exposure margin: on top of initial margin; for delivery obligations, cash-market VaR and extreme loss rates apply.
• Short option minimum charge: abolished in February 2020.
• Net option value: long option value minus short option value at current prices, added to the clearing member's liquid net worth. Option MTM is not settled in cash.

Client margin reporting: members report margins collected from each client; short or non-collection is penalised. Securities given as margin must be through a margin pledge in the depository system to a separate Client Securities Margin Pledge Account, not by transfer or power of attorney (since September 2020). The TM re-pledges to the CM, and the CM to the clearing corporation; title stays with the client, and the securities can support only that client's positions. TMs and CMs report client-level collateral daily, and clients can see it on exchange portals.

Peak margin (July 2020): clearing corporations send at least four snapshots a day of each client's margin requirement. The broker is penalised for the higher of the shortfall at end of day and at the peak. Since August 2022, the snapshots (and from February 2023, the end-of-day check) use the beginning-of-day margin parameters, so a client who had enough margin at the start is not penalised for intraday rises.

Example Beginning-of-day margin for a position is ₹10,000 and the client keeps ₹11,000. Volatility pushes the requirement to ₹12,000 intraday. Under the current rules there is no short-margin penalty, because the beginning-of-day figure applies all day.

Cross margining: offsetting positions across the cash and derivatives segments get margin benefit, for all categories of participants. With the same CM, client details go through the Collateral Interface for Members (CIM); with different CMs, agreements are needed.

Example Two traders each sell futures with 6% initial margin and lot 50: 20 lots at 4,500 and 17 lots at 4,550. Margin = 0.06 × (20 × 50 × 4,500 + 17 × 50 × 4,550) = 2,70,000 + 2,32,050 = ₹5,02,050.

Remember

• SPAN: one-day worst likely loss; built by CME.
• Futures initial margin uses a two-day horizon.
• Client margins are gross; proprietary margins net.

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9Position limits

Position limits stop anyone from cornering a stock or index through derivatives.

Client level (stock derivatives): gross open position across all derivatives on a stock must not exceed the higher of 1% of free-float market cap or 5% of open interest (in number of shares, per exchange). Anyone (alone or acting in concert) holding 15% or more of open interest in an index must report it.

Trading member level:

• Index futures and index options (each separately): higher of ₹7,500 crore or 15% of total market OI in that product.
• Stock F&O combined: 20% of the MWPL per exchange, fixed on the last trading day of the month for the next month.

Market-wide position limit (MWPL): 20% of the non-promoter (free-float) shares. An alert is shown above 60%. Above 95% of MWPL (across exchanges), no fresh positions from the next day (the stock is in the ban period); normal trading resumes only once OI falls to 80% or below.

Index derivatives (PAN level, on FutEq basis):

• Index options: net end-of-day ₹1,500 crore, gross ₹10,000 crore.
• Intraday monitoring: net ₹5,000 crore, gross ₹10,000 crore, checked with at least four random snapshots a day, including one between 2:45 and 3:30 p.m.
• Index futures (gross notional): higher of 15% of index futures OI or ₹500 crore for FPI Category I, mutual funds, proprietary TMs and clients; 10% (or ₹500 crore) for most FPI Category II; 5% (or ₹500 crore) for individual, family office and corporate FPI Category II.

Exceeding a limit: a client cannot take fresh positions and must reduce; the exchange penalises the CM, which recovers it from the TM or client. TM limits are checked through the day; MWPL at day end. Adding to a position in a banned stock attracts a penalty, collected on T+1.

Remember

• MWPL = 20% of free float. Ban above 95%; resume at 80%.
• Client stock limit = higher of 1% of free float or 5% of OI.

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10Violations and penalties

Penalties apply for failing initial margin, settlement or delivery obligations, minimum deposits, exposure margin and position limits (including MWPL), misusing client collateral, violating exercised positions, and short or non-reporting of client margin. The clearing corporation can have the exchange withdraw membership rights and trading facilities without notice, close out open positions, impose penalties, collect deposits, invoke bank guarantees or sell securities.

Remember

• Close-out of positions by the clearing corporation is final and binding.

11Settling client running accounts

To stop misuse of client funds, brokers must settle each client's running account monthly or quarterly, as the client chooses, on dates in an annual calendar issued jointly by the exchanges. A client with a credit balance who has not traded for 30 calendar days gets the full balance back on the next monthly settlement date, whatever their chosen cycle.

Remember

• No trade for 30 days → funds returned at the next monthly settlement.

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12Guarantee and protection funds, and SEBI's 2024–26 measures

• Core Settlement Guarantee Fund (Core SGF): kept by each clearing corporation, for each segment, to complete settlement if a clearing member defaults.
• Investor Protection Fund: run by a trust set up by each exchange to compensate investors when a defaulting member's assets are not enough, and to fund investor education, awareness and research.

SEBI's measures for equity index derivatives:

• Option premium collected upfront from buyers (from 1 February 2025).
• No calendar spread margin benefit on expiry day for contracts expiring that day (from 1 February 2025; extended to single stock derivatives from 5 May 2026). Spreads between two later expiries still get the benefit.
• Intraday position limit monitoring with at least four snapshots (from 1 April 2025).
• Minimum contract size ₹15–20 lakh for new index derivatives (from 20 November 2024).
• Weekly expiries on only one benchmark index per exchange (from 20 November 2024).
• Extra 2% extreme loss margin on short options on expiry day (from 20 November 2024).

Remember

• Core SGF guarantees settlement; IPF compensates investors.

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13Cyber security and resilience

SEBI's Cyber Security and Cyber Resilience Framework (CSCRF) applies to regulated entities in phases from 1 January 2025. Market infrastructure institutions under it: stock exchanges, depositories, clearing corporations, KRAs and QRTAs. Cyber resilience is the ability to prepare for, respond to, keep working through and recover from an attack. Its five goals: anticipate, withstand, contain, recover, evolve.

Remember

• Five goals: anticipate, withstand, contain, recover, evolve.