A Clearing Corporation is a critical financial market infrastructure that acts as the central counterparty to all transactions in a market. In the Indian derivatives market, NSCCL (NSE Clearing Ltd.) fulfills this role. Its core function is to ensure that all trades executed on the exchange are settled smoothly and without the risk of a counterparty default. This is achieved through a process called novation.
Novation: This is a legal process where the Clearing Corporation steps in between the original buyer and seller. It becomes the buyer to every seller and the seller to every buyer. This guarantees the trade will be settled, regardless of the financial status of the original counterparty. This process effectively removes counterparty risk from the equation.
NSCCL's key roles include:
Guaranteeing Settlement: By acting as the central counterparty, NSCCL assumes the credit risk of both parties.
Margin Collection: It collects various forms of margins from members to serve as a financial buffer against potential defaults.
Netting: It calculates the net obligations of each clearing member at the end of the day, simplifying the settlement process by reducing the number of transactions.
Final Settlement: It facilitates the final exchange of cash or underlying assets on the contract's expiry.
7.2 Clearing Members
Clearing members are entities responsible for fulfilling the obligations of their clients and themselves to the Clearing Corporation. They are crucial for the efficient flow of trades and settlement. There are three primary types of clearing members:
Trading-cum-Clearing Member (TCM): A TCM is a member who can trade on the exchange and is also authorized to clear and settle trades. They can clear for their own proprietary trades and for the trades of their clients. This is the most common type of clearing member.
Professional Clearing Member (PCM): A PCM is a specialist clearing entity. They do not have a trading terminal and are prohibited from trading on their own account. Their sole business is to clear and settle trades for other trading members who may not have clearing capabilities.
Self-Clearing Member (SCM): An SCM is a member who only clears and settles trades that they have executed on their own behalf. They do not clear for any other trading members or clients. This model is often adopted by large proprietary trading firms.
7.3 Settlement Types
The settlement of derivative contracts is a multi-layered process designed to manage risk in a structured way.
A. Daily Settlement (Mark-to-Market - MTM)
Daily MTM settlement is a fundamental risk management practice for futures contracts. At the end of each trading day, every open futures position is valued against the day's closing price. The difference between the previous day's closing price and the current day's closing price (or trade price for new positions) is calculated as the profit or loss. This profit is credited to the clearing member's margin account, while any loss is debited. This ensures that no large, unpaid losses accumulate, which significantly reduces the risk of default.
B. Final Settlement
Final settlement takes place on the expiry day, which is the last Thursday of the contract month. On this day, the futures price is expected to converge with the underlying asset's spot price. The settlement mechanism depends on the type of derivative:
Index Derivatives: All index futures and options (e.g., Nifty 50, Bank Nifty) are cash-settled. The difference between the final settlement price and the strike price (for options) or the last trading price (for futures) is paid in cash.
Stock Derivatives: Since October 2019, all stock futures and options are physically settled. This means that if a contract expires in-the-money, the buyer must take delivery of the underlying shares, and the seller must deliver them. This requires the parties to have a Demat account and sufficient shares or funds.
C. Options Settlement
Options contracts are settled in a specific way based on their expiration status:
An in-the-money (ITM) option is automatically exercised by the Clearing Corporation on the expiry day.
An out-of-the-money (OTM) option, having no intrinsic value, simply expires worthless.
Index options are always cash-settled, while stock options are physically settled.
7.4 Settlement Cycle 🔄
The complete settlement process follows a well-defined cycle:
Trade Execution: The initial phase where an order is matched on the trading system.
Clearing: The post-trade phase where the Clearing Corporation calculates the net positions and obligations of each member.
Settlement: The final phase where funds and/or securities are actually transferred to fulfill the obligations.
7.5 Margins in Settlement
Margins are a crucial element of the risk management system, acting as a financial cushion. Various types of margins are collected from members:
Initial Margin (SPAN): This is the primary margin collected from both the buyer and seller of a derivatives contract. It is calculated using the SPAN (Standard Portfolio Analysis of Risk) system, a portfolio-based margining system that assesses the risk of the entire portfolio.
Exposure Margin: This is an additional margin collected by the Clearing Corporation to cover potential losses not covered by the Initial Margin.
MTM Margin: The daily profit/loss settlement amount for futures contracts. If a member's MTM loss exceeds their available margin, they must deposit additional funds.
Premium Margin: The full premium amount paid by the buyer of an option to the seller is also collected by the Clearing Corporation as a form of margin.
7.6 Default Handling 🛡️
In the rare event that a clearing member defaults on their obligations, NSCCL follows a pre-defined hierarchy to manage the situation and ensure market integrity. The funds are used in this order:
Margins of the Defaulting Member: The initial and other margins deposited by the defaulting member are the first to be utilized to cover the losses.
Defaulting Member's Contribution to the SGF: The member's contribution to the Settlement Guarantee Fund (SGF).
Settlement Guarantee Fund (SGF): If the defaulting member's margins and contributions are insufficient, the Settlement Guarantee Fund (SGF), which is a pool of funds contributed by all clearing members, is used as the primary safety net.
NSCCL's Own Funds: In an extreme scenario, NSCCL would use its own funds to complete the settlement.
Note: NSCCL's objective is to complete the settlement at all costs to prevent systemic risk and maintain confidence in the market. The Settlement Guarantee Fund is the cornerstone of this risk management framework.