Commodity Exchanges - International Commodity Management - Lecture Slides, Slides of International Management

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Commodity Exchanges

Clearing and Settlement on Commodity

Exchanges

Risks in Commodity Markets

• Exchange traded futures contracts risk of non

performance is assumed by Exchange Clearing

House

• It becomes the counter party to all trades and

guarantees their settlement

• Following are benefits in trading on the

exchange

• Liquidity, Absence of counter-party risk, Price

Discovery

Risks in Commodity Markets

• Certain risks which can arise are:
• Credit risk: Defaults are practically non-

existent because of the exchange guarantee

• Market risks arising out of adverse movement

of price

• Legal risk arising out of certain activities not

being permitted by regulatory framework

• Operational risks arising out of internet,

electrical or any other problems

Commodity Clearing House

• The Clearing House keeps record of all trade and

acts as third party on all buy and sell transactions

• All exchange members must report all

transactions to the Clearing House after each day

of trading

• The Clearing House than ensures financial

settlement from each buyer and seller

• The Clearing House also ensures that participants

keep cash deposits called margin with it

Commodity Clearing House

• An exchanges clearing house may be an in house department or separate legal entity
• Single clearing house provides clearing services to more than one exchange
• NCDEX uses services of NSDL (National Securities Depository Ltd)
• Clearing House acts as central counter party to all trades on the exchange
• Clearing houses counter parties are its clearing agents
• They generally are a sub set of the exchanges members

Commodity Clearing House

• Other trade counter parties, both non- clearing

exchange members and non members of the

exchange must become clients of one of the

clearing members either directly or through

another intermediary

• Clearing house has a principal –to –principal

relationship with its clearing members

• Thus it looks to clearing members for

performance of trade on their own account

• And of trade on the account of their client

Commodity Clearing House

• The shareholders of the clearing house are required to provide performance bonds- margin money
• They contribute to a guarantee fund to ensure that clearing house will meet all commitments
• As central counter party, the clearing house is exposed to the risk that one or more clearing members will default on their contractual obligation
• A common set of safeguards are utilised by clearing house to limit likelihood of defaults by clearing members
• It has to be ensured that if defaults occur than the clearing house has the required resources

Commodity Clearing House

These include:

• Financial and operational requirements for membership of the clearing house
• Margin requirements designed to limit the build up of exposure by periodically settling gains and losses
• Close out of position (of client, or of member) in reaction to a default
• Maintenance of clearing house resources to cover losses that exceed the value of the defaulting member’s margin and to provide liquidity during the time it takes to collect the value of margin

Commodity Clearing House

• New contracts on the first day of are assigned a base rate by the exchange
• The base rate is calculated by polling spot prices prevailing for the commodity in the most active physical markets or mandis
• If they are not actively trade traded in spot markets in India than international prices are used as benchmarks
• A daily settlement (or closing) price is worked out for each contract based on the average of the last few trades of the trading day
• Due-date rate is calculated based on the average of the last 1, 3 or 5 days closing price (this depends on the commodity)
• This rate is calculated by the exchange based on the average of the last few days closing prices in the spot market of the commodity and the futures contract, whichever is higher

Margins

• The aim of margin money is to minimize the risk of default by either counter party
• The amount of initial margin is so fixed as to ensure that the probability of loss on account of worst possible price fluctuation, which cannot be met by the amount of ordinary/initial margin is very low
• The Exchanges fix rates of ordinary/initial margin keeping in view need to balance high security of contract and low cost of entering into contract
• Different margins payable on futures contracts are: i. ordinary/initial margin, ii. mark-to-market margin, iii. special margin, iv volatility margin and v. delivery margin.

Margins

• Value at Risk ( VaR)system is used for calculating this margin
• This margin is calculated on the basis of variance observed in daily price of the commodity over a specified period
• It is typically 5-10% of the contract value at the time of buying it
• The margin is different for each commodity
• It estimates the level of loss over a given time period that is expected to be exceeded only 1% of the time
• The amount of initial margin is fixed so as to ensure that it covers price movements more than 99% of the time

Margins

Maintenance margin

• This is set at a level slightly less than the initial

margin

• It is the minimum amount of margin that is

required to be held relative to the futures

position held

• It is the lowest amount an account can reach

before needing to be replenished

Margins

• Collecting mark-to-market margin on a daily basis reduces the possibility of accumulation of loss, particularly when futures price moves only in one direction
• Hence the risk of default is reduced
• Also, the participants are required to pay less upfront margin - which is normally collected to cover the maximum, say, 99.9%, of the potential risk during the period of mark- to-market, for a given limit on open position
• Alternatively, for the given upfront margin the limit on open position would have to be reduced, which has the effect of restraining the trade and liquidity

Margins

• The exchange may impose Volatility margin when there are wild fluctuations in rate
• Tender margin is imposed when the contract enters into tender period at the end of its life cycle
• This margin is applicable on both outstanding buy and sell side, which continues upto the marking of the delivery or the expiry of the contract which ever is earlier
• It is calculated at the rate specified for the respective commodity multiplied by the net open position held by a member in the expiring contract