CHAPTER 4 - Trading, Clearing and Settlement Systems

The 3 principal F&O exchanges in India (BSE, NSE and MSEI) provide a fully automated screen-based trading platform for index futures, index options, stock futures and stock options. The levels of liquidity are different with NSE being the most liquid and MSEI being the least liquid. Their trading systems support an order driven market and also provide complete transparency of trading operations. Derivative trading is similar to that of trading of equities in the cash market segment, except that the security characteristics and specifications are different.

Clearing Members

Broadly speaking there are three types of clearing members

1. Self-clearing member: They clear and settle trades executed by them only, either on their own account or on account of their
2. Trading member–cum–clearing member: They clear and settle their own trades as well as trades of other trading
3. Professional clearing member: They clear and settle trades executed by trading members.

Both trading-cum-clearing member and professional clearing member are required to bring in additional security deposits in respect of every trading member whose trades they undertake to clear and settle.

Five important entities in the trading system

1. Trading Members: are members of Stock Exchanges (SEBI registered) who are authorized to trade either on behalf of their clients or on their own account (proprietary trades). As per SEBI regulations, every trading member has a unique TM-ID.
    
2. Trading cum Clearing Members (TCM): is a Clearing Member (CM) who is also a Trading Member (TM) of the exchange. Most large brokers are TCMs. Such TCMs can clear and settle their own proprietary trades, their client trades as well as trades of other TMs and even Custodial Participants.
    
3. Professional Clearing Member (PCM): Professional clearing member clears the trades of associate Trading Member and institutional clients. PCM is not a Trading Member of the exchange and hence is not authorized to execute trades; they can only clear. Typically banks or FPI custodians become PCM to clear their client trades
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4. Self-Clearing Member (SCM): A Self Clearing Member is also a Trading Member on the exchange. Such SCMs can clear and settle their own proprietary trades and their client trades but cannot clear and settle trades of other TMs (unlike TCMs)
    
5. Participants: Participant is a client of a trading member. Clients may trade through various trading members but settle through a single clearing member. Interoperability allows seamless transfer of margins and positions across clearing members.

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 Clearing Corporation designated clearing bank for F&O segment.

Clearing Member Eligibility Norms

Net worth of at least Rs.300 lakhs. The net worth requirement for a Clearing Member who clears and settles only deals executed by him is Rs. 100 lakhs. Deposit of Rs. 50 lakhs to clearing corporation which forms part of the security deposit of the Clearing Member. Additional incremental deposits of Rs.10 lakhs to clearing corporation for each additional TM, in case the Clearing Member undertakes to clear and settle deals for other TMs.

Order types, order conditions and order matching rules

There are different types of orders that any client can place on the F&O trading system. Broadly, orders can be classified into two condition based order sets viz. Orders based on Time condition and Orders based on Price condition.

Orders based on Time condition

• Day order: is an order which is valid for a single day i.e. the day on which it is entered. Day orders not executed during the day are automatically cancelled by the system at the end of the day.

• Immediate or cancel (IOC) order: has to be executed as soon as the order is released into the trading system. Any unmatched order will be immediately cancelled. At times part of the order is matched and the unmatched portion of the order is cancelled.

Orders based on Price condition

• Limit order: is an order to buy or sell a contract at a specified price. The user specifies the limit price while placing the order and the system executes the order at or at better price than the limit price (lower for buy order and higher for sell order). Limit order is a good option when executing orders in a volatile market.

• Market order: is an order to buy or sell at the best available price in the market. Unlike the limit order, the market order gets executed at the best possible in the market subject to availability of volumes. Markets orders work well in trending markets.

• Stop-loss order: is an order to buy (or sell) a security once the price of the security moves above (or drops below) a trigger price. The stop-loss order gets activated only when the trigger price is reached / crossed. Stop loss orders are an important means of risk management for short-term traders.

How are stocks selected for inclusion in F&O?

SEBI has laid out a well-designed format and a set of criteria for inclusion of stocks in the F&O eligible list.

Eligibility conditions for inclusion in F&O

• The stock must rank in the top-500 stocks in terms of average daily market capitalization and average daily traded value in last six months on rolling basis
• The stock’s median quarter-sigma order size (MQSOS) over last six months shall not be less than Rs.1 million. MQSOS shall mean the order value required to cause a change in the stock price equal to one-quarter of a standard deviation
• The market wide position limit (MWPL) in the stock shall not be less than Rs.300 crores. The MWPL of open position (in terms of the number of underlying stock) on futures and option contracts on a particular underlying stock will be 20% of the number of shares held by non-promoters (free-float).

Eligibility conditions for continuance in F&O

• The stock’s MQSOS over last six months shall not be less than Rs. 5 lakhs
• The MWPL of the stock shall not be less than Rs. 200 crores
• The stock’s average monthly turnover in derivatives segment in last three months shall not be less than Rs. 100 crores

If a stock fails to meet these retention criteria for 3 consequent months, no fresh month contract shall be issued on that stock.

How are Indices selected for inclusion in F&O

Exchange can introduce derivative contracts on an index if weightage of constituent stocks of the index, which are individually eligible for derivatives trading, is at least 80%. No single ineligible stock in the index shall have a weightage of more than 5% in the index.  Exchange will verify whether the index continues to meet the aforesaid eligibility criteria on a monthly basis. If the index fails to meet the eligibility criteria for three consecutive months, then no fresh contract shall be issued on that index.

Adjustment of F&O contracts for corporate actions

Since most corporate actions change the number of shares held, it impacts F&O contracts. F&O makes adjustments for bonus, stock splits, consolidation and extraordinary dividends. In case of options, the new strike price is arrived at by dividing the old strike price by the adjustment factor as under. The new market lot will be arrived at by multiplying the old market lot by the adjustment factor.

Adjustment factor for bonus

If Ratio is (A: B) then the Adjustment factor will be - (A+B)/B

Adjustment factor for stock split

If Ratio is (A: B) then the Adjustment factor will be - A/B

How to adjust F&O contacts in case of Dividends?

Only extraordinary dividends are adjusted in F&O. Dividends less than 10% of the market value of the underlying stock is deemed to be ordinary dividend and no adjustment in the Strike Price will be made. For extra-ordinary dividends, above 10%, the Strike Price will be adjusted proportionately.

Clearing and Settlement of F&O trades

The Clearing Corporations (NSCCL for NSE and ISCCL for BSE) are responsible for clearing and settlement of all trades executed on the F&O Segment. Clearing refers to calculating the net amount receivable / payable and settlement is ensuring that the credits and debits of cash and stocks are done into TM account. The Clearing Corporation acts as a legal counterparty to all trades on this segment and also guarantees their financial settlement. This guarantee is backed by the settlement guarantee fund (SGF). Clearing and settlement activities are accomplished with the help of Clearing Members and Clearing Banks.

Clearing mechanism

Clearing process begins with calculating open positions and obligations of clearing members. Trading Members (TMs) identify orders as either proprietary (PRO) or client (CLI). Proprietary positions are calculated on net basis (buy - sell) for each contract and that of clients are arrived at by summing together net positions of each individual client. A TM’s open position is the sum of proprietary open position, client open long position and client open short position. Let us consider a clearing member ‘A’ with trading members clearing through him ‘PQR’ and ‘XYZ’.

In the above case, the clearing member’s open position will be calculated as under:

Settlement of F&O trades:

SEBI has given the stock exchanges the flexibility to offer any of these options:

• Cash settlement (settlement by payment of differences) for both stock options and stock futures; or
• Physical settlement (settlement by delivery of underlying stock) for both stock options and stock futures; or
• Cash settlement for stock options and physical settlement for stock futures; or
• Physical settlement for stock options and cash settlement for stock futures.

Eligibility criteria for membership on F&O segment:

• No additional net-worth is required for self-clearing members. However, a net-worth of Rs. 300 Lakhs is required for TM-CM and PCM.
• Additional Rs. 25 Lakhs is required for clearing memberships (SCM, TM-CM). In addition, the clearing member is required to bring in IFSD of Rs. 2 Lakhs and CSD of
• 8 Lakhs per trading member he undertakes to clear and settle.

Requirements for professional clearing membership:

Final Settlement of futures and options contracts

There is a slight difference between the final settlement of futures and that of options. Here is how.

Final Settlement of futures

On the F&O expiration day (last Thursday of the month), after close of trading hours, the clearing corporation marks all positions of a clearing member to the final settlement price. The resulting profit or loss is settled in cash. Final settlement loss/profit amount is debited/ credited to the relevant clearing member’s clearing bank account on the day following expiry day of the contract. All long positions are automatically assigned to short positions in option contracts with the same series on a random basis (since longs are equal to shorts).

Settlement of Options Contracts on Index and Stocks

Options contracts have two types of settlements; Daily premium settlement and Final settlement.

• Daily Premium Settlement

In options contract, buyer of an option pays premium while seller receives premium. The amount payable and receivable as premium are netted to compute the net premium payable or receivable amount for each client for each option contract. CMs with premium payable positions are required to pay the premium amount to the clearing corporation which in turn passes on to the members who have premium receivable position. The pay-in and pay-out of the premium settlement is on T+1 day (T=Trade day).

• Final Exercise Settlement

All the in the money stock options contracts shall get automatically exercised on the expiry day. All the unclosed long / short positions are automatically assigned to short/ long positions in option contracts with the same series, on the random basis. Profit/ loss amount for options contract on index and individual securities on final settlement is credited / debited to the relevant clearing members clearing bank account on the day after expiry day. Open positions, in option contracts, cease to exist after their expiration day.

Trading Member wise Position Limits Index Futures Contract:

The trading member position limits in equity index futures contracts is higher of Rs.500 Crores or 15% of the total open interest in the market in equity index futures contracts.

This limit would be applicable on open positions in all futures contracts on a particular underlying index.

Index Options Contract:

The trading member position limits in equity index option contracts is higher of Rs.500 Crores or 15% of the total open interest in the market in equity index option contracts.

This limit would be applicable on open positions in all option contracts on a particular underlying index.

Futures and Option contracts on individual securities:

For stocks having applicable market-wise position limit (MWPL) of Rs. 500 Crores or more, the combined futures and options position limit is 20% of applicable MWPL or Rs. 300 Crores, whichever is lower. Further stock futures position cannot exceed 10% of applicable MWPL or Rs. 150 Crores, whichever is lower.

For stocks having applicable market-wise position limit (MWPL) less than Rs. 500 Crores, the combined futures and options position limit would be 20% of applicable MWPL. Further futures position cannot exceed 20% of applicable MWPL or Rs. 50 Crores whichever is lower. The Clearing Corporation shall specify the trading member-wise position limits on the last trading day of the month which shall be reckoned for the purpose during the next month.

To illustrate, if the MWPL of a stock is 300 Crores, the combined futures and option position limit is 20% of applicable MWPL i.e. 60 Crores and the futures position cannot exceed 20 % of the MWPL i.e. 20% of 60 Crores in this case or 50 Crores whichever is lower.

Client level position limits

The gross open position for each client, across all the derivative contracts on an underlying, should not exceed 1% of the free float market capitalization (in terms of number of shares) or 5% of the open interest in all derivative contracts in the same underlying stock (in terms of number of shares) whichever is higher.

Disclosure for Client Positions in Index based contracts

Any person or persons acting in concert who together own 15% or more of the open interest on a particular underlying index is required to report this fact to the Exchange

Clearing Corporation - Failure to do so shall be treated as a violation and shall attract appropriate penal and disciplinary action in accordance with the Rules, Byelaws and Regulations of Clearing Corporation.

Penalties

A penal charge will be levied on the amount in default as per the by-laws relating to failure to meet obligations by any Clearing Member. The following penal charges are levied for failure to pay funds/ settlement obligations:

Any violations by the custodial participants shall be treated in line with those by the trading member and as a result action shall be initiated against the concerned clearing member.

Short Reporting of Margins in Client Margin Reporting Files

The following penalty shall be levied in case of short reporting by trading/clearing member per instance.

If short/non-collection of margins for a client continues for more than 3 consecutive days, then penalty of 5% of the shortfall amount shall be levied for each day of continued shortfall beyond the 3rd day of shortfall.

If short/non-collection of margins for a client takes place for more than 5 days in a month, then penalty of 5% of the shortfall amount shall be levied for each day, during the month, beyond the 5th day of shortfall.

Notwithstanding the above, if short collection of margin from clients is caused due to movement of 3% or more in the Nifty (close to close) on a given day, (day T), then, the penalty for short collection shall be imposed only if the shortfall continues to T+2 day.

All instances of non-reporting are treated as 100% short reporting for the purpose of levy of penalty.

Penalty and penal charges for margin/limit violation

Penalty for margin / limit violation is levied on a monthly basis based on slabs as mentioned below or such other amount as specified by the Clearing Corporation from time to time.

Instances as mentioned above refer to all disablements during market hours in a calendar month. The penal charge of 0.07% per day is applicable on all disablements due to margin violation anytime during the day.

FII/Mutual Fund position limit violation

In case of violation of FII/ Mutual Fund limits a penalty of Rs. 5,000/- would be levied for each instance of violation.

Client wise/NRI/sub account of FII/scheme of MF position limit violation

In case of open position of any Client / NRI / sub-account of FII / scheme of MF exceeding, the specified limit following penalty would be charged on the clearing member for each day of violation:

1% of the value of the quantity in violation (i.e., excess quantity over the allowed quantity, valued at the closing price of the security in the normal market of the Capital Market segment of the Exchange) per client or Rs.1,00,000 per client, whichever is lower, subject to a minimum penalty of Rs.5,000/- per violation / per client.

When the client level/NRI/sub-account of FII/scheme of mutual fund violation is on account of open position exceeding 5% of the open interest, a penalty of Rs.5,000 per instance would be levied to the clearing member.

Market wide Position Limit violation

At the end of each day during which the ban on fresh positions is in force for any security, when any member or client has increased his existing positions or has created a new position in that security the client/trading members will be subject to a penalty 1% of the value of increased position subject to a minimum of Rs.5000 and maximum of Rs.100000. The positions, for this purpose, will be valued at the underlying close price.

The following penalty shall be levied in case of short reporting by trading/clearing member per instance.