Trading Mechanism in Exchange Traded Interest Rate Derivatives

Chapter 6: Trading Mechanism in Exchange Traded Interest Rate Derivatives

NISM Series IV — Interest Rate Derivatives | ~8% weightage | ~32 questions

What this chapter is about

Same structure as Series VIII CH6 and Series I CH6. Order types, trading members, price bands, position limits, quantity freeze. IRD-specific: price range for bonds/T-bills, minimum age 21 for trading member, SPAN margining applied client-by-client, and proprietary position netting at trading member level.

Market participants in IRD trading

Trading Members (TMs): Members of the Exchange. Can EXECUTE trades only (not settle unless also a clearing member). Can trade for own account + clients.

Clearing Members: Members of Clearing Corporation. Can clear and settle trades.

Trading-cum-Clearing Member: Member of both Exchange and Clearing Corporation. Can execute AND settle trades including for other TMs.

Professional Clearing Member (PCM): Member of Clearing Corporation ONLY. Cannot execute trades. Can ONLY clear and settle trades of other TMs.

Key rule:

• Trading Member = executes trades only
• PCM = settles trades of other TMs only (cannot execute)
• TCCM = both executes and settles

Minimum age for individual trading member: 21 years (per Securities Contracts (Regulation) Rules, 1957)

Order types — same as other modules

Limit price order: Buy at or below / Sell at or above specified price. Executes at favorable price.

Market order: No price specified. System determines price. Price-related condition.

Stop Loss order: Has a trigger price. Activated when market reaches trigger.

• Stop Loss Buy: trigger price is HIGHER than current market offer price
• Stop Loss Sell: trigger price is LOWER than current market bid price
• Stop Loss order (without limit) = more likely to execute than Stop Loss Limit order

IOC (Immediate or Cancel): Execute immediately or cancel. Partial execution allowed.

Day order = Good Till Day (GTD): Valid for the day. Auto-cancelled at EOD if unexecuted.

Good Till Cancelled (GTC): Valid until cancelled.

Passive orders: Unmatched orders sitting in the order book. Active orders = incoming orders seeking to match.

Order priority: Best price first. Same price → earlier time priority. Buy = highest price first; Sell = lowest price first.

Position limits

Definition: Maximum exposure levels for the entire market, trading member, and each client.

Position limits are set at:

• Client level
• Trading member level
• Exchange/market level

Netting of positions:

• Client positions: Long and short in SAME underlying CAN be netted (3 short)
• Client A and Client B positions: CANNOT be netted across clients (added separately)
• Proprietary long and short: netted at trading member level

Example from exam:

• TM Client A: net long 12 | TM Client B: net short 10
• TM reports: long 12 AND short 10 separately (cannot net across clients)
• TM's own proprietary: can net (buy 6, sell 9 = net short 3)

Price bands and operating ranges

Price range = specified percentage above AND below base price

For exchange-traded IRDs:

• The exchange can further tighten (reduce) the range set by SEBI regulations
• Cannot widen (dilute) beyond SEBI's specified range

Example: If SEBI says max 1%, exchange can set 0.5% but NOT 2%.

Overnight MIBOR futures: Operating range = ±5% of base rate

Quantity Freeze:

• NOT a limit on trade size
• A check to prevent erroneous (accidental) order entry
• Orders above Quantity Freeze require TM to separately confirm to Exchange that order is genuine
• TM must confirm the order is without errors before it executes

SPAN Margining

SPAN = Standard Portfolio Analysis of Risk

SPAN considers the entire portfolio of an investor for computing portfolio-wide margin requirements.

Applied between: Trading Members and their CLIENTS (not at CC-clearing member level)

Margins collected on: Client-by-client basis. Netting between clients NOT allowed for margin collection.

Contract-level minimum margin:

• Same for all the days of a contract
• Different for T-bills vs G-Sec bonds
• Same for all G-Sec bond futures (regardless of 6Y, 10Y, 13Y)

T-bill futures initial margin: VaR (99%, 1-day), minimum 0.10% on first day, 0.05% thereafter

G-Sec bond futures initial margin: VaR (99%, 1-day), minimum 2.8% on first day, 1.5% thereafter

Risk management — broker level

90% collateral utilization = risk reduction mode When broker's collateral utilization hits 90%, all unexecuted orders are automatically cancelled.

Delivery versus Payment (DvP): Settlement method that eliminates settlement risk. Both parties simultaneously exchange cash and security — if one fails, other withholds.

Value at Risk (VaR): Maximum likely price change over a given horizon at a given confidence level.

• VaR (1 Day, 99%) of Rs 17 = In the next 1 day, loss will NOT exceed Rs 17 in 99 out of 100 days.

Trap Alert

Trap 1: "PCM can execute and settle trades" — FALSE PCM can ONLY settle trades of other TMs. Cannot execute any trades.

Trap 2: "Client positions can be netted across clients" — FALSE Client A long 12 + Client B short 10 must be reported separately as long 12 AND short 10.

Trap 3: "Quantity Freeze = maximum trade size limit" — FALSE Quantity Freeze is a check against erroneous entries. Not a hard limit. Orders above it just need explicit confirmation.

Trap 4: "Exchange can widen SEBI's price range" — FALSE Exchange can only TIGHTEN, not widen, the regulator's prescribed range.

Trap 5: "SPAN margin is applied between CC and clearing members" — FALSE SPAN is applied between TMs and their CLIENTS.

Trap 6: "T-bill and bond futures have same minimum margin" — FALSE Different: T-bills = 0.10%/0.05% | Bonds = 2.8%/1.5%

Must-remember rules

• TM = execute only | PCM = settle only | TCCM = both
• PCM cannot execute any trades
• Minimum age for individual TM = 21 years (not 18)
• Client positions: netted individually but not across clients
• Proprietary positions: netted at TM level
• Price range: exchange can tighten but NOT widen SEBI limits
• Quantity Freeze = error check (not a hard limit)
• 90% collateral utilization = all unexecuted orders cancelled
• SPAN applied: TM-client level (not CC-clearing member level)
• VaR (1D, 99%) = maximum loss not exceeded in 99 of 100 days
• DvP = eliminates settlement risk (simultaneous exchange)
• T-bill minimum margin: 0.10% first day, 0.05% thereafter
• Bond minimum margin: 2.8% first day, 1.5% thereafter

Quick revision — 60 second scan

• TM: execute | PCM: settle only | TCCM: both
• Min age 21 for individual TM
• Client positions: net each client separately, add across clients (don't net across)
• Proprietary: net at TM level
• Best price priority → time priority
• Quantity Freeze = error check, not limit
• 90% collateral → cancel all pending orders
• SPAN = TM to clients | VaR = max loss at confidence level
• Exchange can tighten but not widen SEBI's price range