Clearing, Settlement and Risk Management

Chapter 7: Clearing, Settlement and Risk Management

NISM Series IV — Interest Rate Derivatives | ~10% weightage | ~40 questions

What this chapter is about

The clearing and settlement chapter for IRD. Same novation/CC/MTM framework as Series I and VIII but with bond-specific additions: conversion factor, cheapest-to-deliver bond, delivery vs payment, buy-in, delivery margin, and the physical settlement process for single bond futures. Core SGF, liquid networth, and interoperability rules are also tested.

Clearing Corporation — the central counterparty

Acts as central counterparty to ALL trades via NOVATION — becomes buyer to every seller and seller to every buyer. Provides settlement guarantee for exchange-traded derivatives.

Exchange = separate legal entity from Clearing Corporation

Role of Clearing Corporation = settlement guarantee Role of Exchange = facilitate trading (not settle)

Three supporting entities: 1. Depositories — handle securities settlement (debit/credit of bonds) 2. Clearing Banks — handle funds settlement (pay-in and pay-out) 3. Clearing Members — responsible for settling obligations

Clearing Bank Account

Used EXCLUSIVELY for payments to/from Clearing Corporation. Cannot be used for general banking.

Rules:

• CC can directly raise debit WITHOUT prior permission of clearing member
• Closure requires prior permission of CC (Clearing Corporation)
• Cannot be closed or shifted without CC's prior approval

MTM and Settlement

Daily MTM settlement: Cash settled before start of trading the next day (T+1)

Final settlement: T+1 (next working day after last trading day) for IRDs

• T-bill futures: final settlement = next working day after last Wednesday
• Bond futures: settlement day = next working day after last Thursday

Settlement method:

• T-bill futures: always CASH
• Notional bond futures (current): always CASH
• Single bond futures: can be PHYSICAL (delivery of actual bond) or cash

Physical Settlement of Bond Futures — unique to IRD

When bond futures are physically settled:

Deliverable bonds: Seller can deliver ANY of the specified deliverable bonds (not any bond the seller holds — must be from the approved list).

Conversion Factor (CF):

• Makes different deliverable bonds equivalent in value to the notional bond
• Different for DIFFERENT deliverable bonds (each bond has its own CF)
• Different for DIFFERENT delivery months for the same bond (changes as remaining maturity changes)
• For SAME delivery month, CF does NOT change during the delivery month
• It is a PRACTICAL APPROXIMATION — not a perfect adjustment

Why conversion factor exists: Every bond in the deliverable basket has different coupon and remaining maturity, so direct comparison to the notional bond price isn't fair. CF standardizes them.

Cheapest to deliver (CTD) bond: Every futures seller prefers to deliver the cheapest-to-deliver bond because:

• CF is fixed during the delivery month
• Bond prices change during trading hours
• The seller can choose whichever deliverable bond maximizes their profit

Delivery process:

• Last trading day: seller notifies CC of INTENT TO DELIVER (notice of intent by close of last trading day)
• Delivery margin collected on DAY OF INTENT (last trading day)
• Day of Delivery: seller delivers bonds, buyer pays cash
• Settlement: DvP (Delivery versus Payment)

Short delivery (seller fails to deliver):

• If short delivery on SETTLEMENT DAY → auctioned same day → called "BUY-IN"
• If seller fails to notify Intent to Deliver → auctioned on FIRST BUSINESS DAY after Day of Intention → called "AUCTION SETTLEMENT"

Core Settlement Guarantee Fund (Core SGF)

• Clearing Corporation contributes ≥50% of MRC (Minimum Required Corpus) from OWN funds
• Stock Exchange contributes ≥25% of MRC (note: different from S1 where it's CC 50%)
• Remaining up to 25% from Clearing Members

Interoperability

Interoperability allows a Clearing Member to choose ONE Clearing Corporation to clear/settle trades across MULTIPLE exchanges.

Applies to: ALL products including IRDs and Currency Derivatives. Does NOT apply to: Commodity Derivatives

Basis Risk and Yield Curve Spread Risk

Basis Risk: Arises because futures contracts are standardized: 1. Contract amount is standardized (multiples of Rs 2L only — can't match odd amounts) 2. Expiry date is standardized (last Wed/Thu — may not match actual exposure date) Both create mismatch = basis risk

Basis risk = differential price changes between cash and futures prices

Yield Curve Spread Risk: Arises when term structure shift is NON-PARALLEL (steepening or flattening). Example: 10Y rate changes 0.30% but 15Y rate changes only 0.10% — if hedging 15Y exposure with 10Y futures, the hedge is imperfect.

No yield curve spread risk when shift is PARALLEL (all tenors change by same amount).

Risk measures for Bond Futures

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

• VaR (1 Day, 99%) = Rs 17 means: over next 1 day, loss will not exceed Rs 17 in 99 out of 100 cases.

SPAN Margining: Portfolio-based margining system. Applied between TMs and their clients.

Extreme Loss Margin (ELM): Implemented by Clearing Corporation. Collected from liquid assets in real time.

Trap Alert

Trap 1: "Seller can deliver any bond they hold" — FALSE Must deliver from the approved list of DELIVERABLE bonds. Can choose whichever one is cheapest for them.

Trap 2: "CF is same for same bond across different delivery months" — FALSE CF changes across delivery months for same bond (remaining maturity changes month to month).

Trap 3: "CF is different during the delivery month" — FALSE CF does NOT change DURING the delivery month (stays fixed). This is why seller prefers CTD.

Trap 4: "Buy-in = when seller fails to notify Intent to Deliver" — FALSE Buy-in = when there is a short delivery on SETTLEMENT DAY. Auction settlement = when seller fails to notify Intent to Deliver (next business day auction).

Trap 5: "CC provides trade guarantee, so does Exchange" — FALSE CLEARING CORPORATION provides the trade guarantee (via settlement guarantee fund). Exchange only facilitates trading.

Trap 6: "Core SGF: Stock Exchange contributes 50%" — FALSE CC contributes ≥50% | Stock Exchange contributes ≥25%

Trap 7: "Basis risk and yield curve spread risk are the same" — FALSE Basis risk = mismatch in amount/date. Yield curve spread risk = non-parallel yield curve shifts.

Must-remember rules

• CC provides trade guarantee | Exchange facilitates trading — separate legal entities
• Clearing bank account: CC can debit without permission | closure needs CC permission
• Final settlement: T+1 working day after last trading day (both T-bill and bond)
• T-bill and notional bond futures: CASH settlement
• Single bond futures: can be PHYSICAL
• Deliverable bonds: seller chooses which (must be from approved list)
• CF: different for different bonds | different for different months | SAME within delivery month
• CF is practical approximation (not perfect)
• Seller prefers CTD because CF is fixed during month but prices change
• Intent to Deliver: seller notifies CC by close of LAST TRADING DAY
• Delivery margin: collected on DAY OF INTENT (last trading day)
• Buy-in: short delivery on settlement day (same day auction)
• Auction settlement: failure to notify intent (next business day)
• Core SGF: CC ≥50% | Exchange ≥25% | Clearing Members rest
• Interoperability: all products EXCEPT commodity derivatives
• Basis risk: standardization of contract | Yield curve spread risk: non-parallel shifts
• SPAN: TM-client level | ELM: CC implements, real-time from liquid assets
• DvP: simultaneous exchange, eliminates settlement risk

Quick revision — 60 second scan

• CC = trade guarantee | Exchange = trading platform (separate legal entities)
• Clearing bank: CC can debit without consent | close = CC permission needed
• MTM: T+1 | Final: T+1 after last trading day
• Physical settlement: seller delivers from approved list, chooses CTD
• CF: different per bond and per month, fixed within month
• Buy-in = settlement day short delivery | Auction = failed intent notification
• Core SGF: CC ≥50%, Exchange ≥25%
• Interoperability: excludes commodity derivatives
• Basis risk = standardization | Yield curve spread = non-parallel shifts