Clearing & Settlement of Derivatives

Value-at-Risk (VaR) and Expected Shortfall (ES) are tools that give a forecast about the level of potential loss a portfolio will incur, usually applied for financial risk management. To put it simply, where VaR gives the threshold of loss in a specific confidence level, Expected Shortfall is meant to take one step further, estimating the actual magnitude of losses beyond the threshold. Understanding these concepts helps investors and risk managers to get an idea of the risks emanating from the use of such derivative instruments, which brings us to the very important role that clearing and settlement play in ensuring that these risks are managed properly.

The concepts of clearing and settlement are central to making derivatives trading smooth and secure. Clearing and settlement in India need to be understood in terms of how these processes function.

What Are Derivatives?

Derivatives are the financial instruments whose value is determined by the price or value of an underlying stock, commodity, or an index. Examples include futures and options contracts, which are commonly traded on Indian exchanges like the NSE and BSE.

Why Are Clearing & Settlement Important?

Clearing and settlement ensure that derivative trades go through smoothly, with both sides fulfilling their obligations.

• Clearing ensures that both sides to a trade are verified and matched.
  
• Settlement is a process of exchanging cash or securities after the trade.
  

These all procedures are very important to reduce risks, such as defaults and for market integrity.

The Clearing & Settlement Process

In India, clearing and settlement of derivative trades are performed by independent clearing corporations associated with the exchanges. The main two players in this field are - National Securities Clearing Corporation Limited for NSE and Indian Clearing Corporation Limited for BSE.

1. Role of Clearing Corporations

Clearing corporations serve as central counterparty (CCP) clearing members. If one party defaults on their obligation, the CCP steps in. This reduces the counterparty risk and ensures problem-free trade completion.

2. Matching and Confirmation

After a trade has been made, the clearinghouse matches the buyer's and seller's orders. If everything is okay, the transaction proceeds to the settlement stage. For instance, if you purchase a futures contract, the clearinghouse will ensure that the seller also holds a position.

3. Margin Requirements

Pre-settlement, a margin is deposited by both counterparties to cover the possible inability to fulfill the obligation. In India, the level of margin would depend upon the volatility of the underlying asset, and would be specified by the clearinghouse with a view to maintaining risk management in the market.

4. Settlement of Contracts

Derivative contracts are settled mostly on a T+1 basis for futures and T+2 for options, where 'T' is the date of the transaction. On the date of settlement, the buyer and seller are helped by the house in the transferring of cash or assets. For example, if you are the seller of a futures contract, you will receive the corresponding cash credit.

5. Physical vs. Cash Settlement

Most of the derivative contracts in India are cash-settled, meaning no actual asset is transferred. The parties, however, settle on the basis of market price at the expiry of the contract. Some contracts may, however, require physical settlement where the actual asset (like shares) is exchanged.

Regulatory Oversight

The clearing and settlement process is regulated by the Securities and Exchange Board of India (SEBI), which ensures that the systems are robust, transparent, and up to global standards. SEBI oversight protects investors and protects the integrity of the market.

Conclusion

Clearing and settlement reduce the risk and enhance market confidence by matching trades, maintaining margins, and completing transactions safely. While clearing and settlement provide a strong foundation for derivatives trading, there are several challenges that market participants face in managing these complex instruments. From liquidity risks to regulatory compliance, navigating the derivatives landscape requires a deep understanding of market dynamics. In the next section, we’ll explore the key challenges in derivatives trading and discuss best practices that can help mitigate these risks and enhance trading strategies.