Chapter 8: Clearing and Settlement — Complete Study Notes (Part 2 of 3)
8.3 Settlement Procedure Overview
All futures and options contracts traded on the Futures and Options (F&O) segment of the National Stock Exchange (NSE) are cash settled through the exchange of cash. Because the underlying stock index (such as Nifty 50) cannot be physically delivered, index futures and index option contracts are required to be settled in cash. Furthermore, regulatory guidelines mandate that individual stock options and stock futures contracts are also settled in cash.
The clearing corporation, National Securities Clearing Corporation Limited (NSCCL), computes net settlement obligations for each Clearing Member (CM) across all their affiliated Trading Members (TMs) and constituents/clients for mark-to-market (MTM) cash flows, option premiums, and final exercise settlements.
8.3.1 Settlement of Futures Contracts
Futures contracts undergo two distinct types of cash settlements:
- Mark-to-Market (MTM) Settlement: Executed continuously at the end of each trading day.
- Final Settlement: Executed on the last trading day (expiry day) of the futures contract.
| Settlement Mechanism | Timing | Key Features |
|---|---|---|
| Daily Mark-to-Market (MTM) Settlement | Daily → T+1 | • Continuous daily cash settlement• Calculated using the Daily Settlement Price• Settled on a T+1 basis |
| Final Settlement | Expiry Day → T+1 | • Occurs on the Expiry Day• Calculated using the Final Settlement Price• Settled on a T+1 basis |
Daily Mark-to-Market (MTM) Settlement Mechanism
At the close of every trading day, all open futures positions of each Clearing Member are marked-to-market using the daily settlement price of the respective contract series. Daily MTM profits or losses are calculated under three specific scenarios:
- Un-squared Trades Executed During the Day: Profit or loss is calculated as the difference between the trade execution price and the current day's settlement price.
- Brought Forward Positions from Previous Days: Profit or loss is calculated as the difference between the previous day's settlement price and the current day's settlement price.
- Trades Executed and Squared Up During the Day: Profit or loss is calculated as the difference between the buy trade price and the sell trade price.
Numerical Illustration: Computation of MTM at End of Day (Table 8.6)
To understand how daily MTM cash flows are calculated across different position types, consider a clearing participant with brought-forward and intra-day positions when today's settlement price for the futures contract is Rs. 105:
Position Breakdown
- Brought Forward Position: 100 units brought forward from previous day @ Rs. 100.
- Intra-day Executed Trades: Bought 200 units @ Rs. 100 and Sold 100 units @ Rs. 102.
- Open Position Remaining: 100 units bought during the day @ Rs. 100 (not squared up).
MTM Calculations
- Brought Forward MTM Profit: (Rs. 105 - Rs. 100) * 100 units = Rs. 500 Profit.
- Intra-day Closed Position MTM Profit: (Rs. 102 - Rs. 100) * 100 units = Rs. 200 Profit.
- Open Intra-day Position MTM Profit: (Rs. 105 - Rs. 100) * 100 units = Rs. 500 Profit.
- Total Net MTM Cash Flow: Rs. 500 + Rs. 200 + Rs. 500 = Rs. 1200 Profit.
Table 8.6: Daily MTM Settlement Summary
| Trade Details | Quantity Bought / Sold | Settlement Price (Rs.) | MTM Profit / Loss (Rs.) |
|---|---|---|---|
| Brought Forward from Previous Day | 100 @ 100 | 105 | +500 |
| Traded During Day (Squared Up) | Bought 200 @ 100, Sold 100 @ 102 | 102 | +200 |
| Open Position (Not Squared Up) | 100 @ 100 | 105 | +500 |
| Total Daily MTM Cash Flow | - | - | +1200 Profit |
Pay-in and Pay-out of Daily MTM Settlement
- Cash Flow Routing: Clearing Members who incur an MTM loss must pay the loss amount in cash to NSCCL. NSCCL collects these loss funds and passes them on to Clearing Members who earned MTM profits.
- Settlement Timeline: Pay-in and pay-out of MTM amounts take place on the day following the trade day (T+1 basis).
- Responsibility Hierarchy: CMs are responsible for collecting daily MTM losses from TMs and clients clearing through them. TMs must collect/pay MTM amounts from/to their clients by the next day.
- Position Reset: After daily MTM settlement calculations are completed, all open positions are reset to the daily settlement price, which serves as the open position price for the next trading day.
Theoretical Settlement Price Formula
When a futures contract is not traded on a specific day, or is not traded during the last half hour of trading, NSCCL computes a theoretical settlement price using the cost of carry model:
Theoretical Futures Settlement Price = Spot Price * e^(r * T)
Where:
- Spot Price (S) = Closing value of the underlying index or security in the cash market.
- r = Cost of financing (continuously compounded risk-free interest rate).
- T = Time till expiration expressed in years.
- e = Exponential constant (approximately 2.71828).
Final Settlement for Futures Contracts
- Timing: Executed on the expiry day of the futures contract after the close of trading hours.
- Process: NSCCL marks all open futures positions of a Clearing Member to the final settlement price.
- Settlement Flow: The resulting profit or loss is debited or credited to the Clearing Member's designated clearing bank account on the day following the expiry date (T+1 basis).
Determination of Futures Settlement Prices
- Daily Settlement Price: Closing price of the futures contract, calculated as the weighted average price of the contract during the last half hour of trading on the F&O segment of NSE.
- Final Settlement Price: Closing price of the relevant underlying index or security in the Capital Market (cash) segment of NSE on the last trading day of the contract.
8.3.2 Settlement of Options Contracts
Options contracts undergo two separate types of cash settlements:
- Daily Premium Settlement.
- Final Exercise Settlement.
| Settlement Mechanism | Timing | Key Features |
|---|---|---|
| Daily Premium Settlement | T+1 | • Premium is paid by the buyer and received by the seller• Premiums are netted across contracts for each client• Cash settlement takes place on a T+1 basis |
| Final Exercise Settlement | Expiry Day → T+1 | • Applies to ITM options on expiry• Automatic exercise is carried out by NSCCL• Settlement is cash settled on a T+1 basis |
Daily Premium Settlement
- Obligation & Entitlement: The buyer (holder) of an option is obligated to pay the full option premium. The seller (writer) of an option is entitled to receive the option premium.
- Client-Level Netting: Premium payable and receivable amounts are netted to compute the net premium payable or receivable for each client across all option contracts.
- Settlement Timeline: Daily option premium settlement is completed in cash on a T+1 basis.
Final Exercise Settlement and Exercise Process
- Style of Options: Index options and individual stock options traded on NSE are European style.
- Automatic Exercise: On the expiration day, all open long positions in in-the-money (ITM) option contracts existing at the close of trading hours are automatically exercised by NSCCL. Option buyers do not need to submit manual exercise notices.
- Random Assignment: Open long ITM options exercised by NSCCL are automatically assigned to open short positions in option contracts of the same series on a random basis.
- Cash Settlement Flow: The long ITM option buyer receives the exercise settlement value per unit from the short option seller.
Exercise Settlement Value Formulas
The exercise settlement price is the closing price of the underlying index or security in the cash market segment on the expiry day. Exercise settlement values per unit are calculated as follows:
- Call Option Exercise Settlement Value = Closing Price of Security on Exercise Day - Strike Price
- Put Option Exercise Settlement Value = Strike Price - Closing Price of Security on Exercise Day
All final option exercise settlements are effected by payment in cash and debited or credited to the Clearing Member's designated clearing bank account on T+1 day (where T is the exercise/expiry date).
Special Facility for Settlement of Institutional Deals (Custodial Participants - CPs)
NSCCL provides a specialized facility to institutional investors, Foreign Institutional Investors (FIIs), and Mutual Funds to execute trades through any Trading Member while settling through their own designated Clearing Member.
| Stage | Process | Details |
|---|---|---|
| 1. Order Entry | Unique CP Code via TM | Order is entered through the NEAT Trading Workstation using the unique CP Code through the Trading Member (TM). |
| 2. Trade Confirmation | NSCCL Trade Confirmation System | NSCCL receives and confirms the trade. |
| 3. Custodian Confirmation | Custodian CM — T-Day | Trade is confirmed online by the Custodian Clearing Member (CM) on T-Day. |
| 4. Settlement Responsibility | Shift to Custodian CM | Upon confirmation, settlement responsibility shifts to the Custodian CM. |
Operational Workflow for Custodial Participants (CPs)
- Registration & Unique CP Code: To utilize this facility, an institutional client must register with NSCCL through its designated Clearing Member (custodian) and obtain a unique Custodial Participant (CP) code allotted by NSCCL.
- Order Entry Requirement: All orders executed on behalf of a CP by any Trading Member must explicitly capture the unique CP code in the specified field on the trading workstation at the time of order entry.
- Online Trade Confirmation:
- Trades executed under a CP code must be confirmed online by the CP's designated Clearing Member on trade day (T day) within the timeframe specified by NSE.
- Liability Rule: Until the trade is confirmed by the CP's Clearing Member, the trade is treated as a trade of the executing Trading Member, and settlement responsibility rests with the TM's Clearing Member.
- Shift of Responsibility: Once confirmed by the CP's Clearing Member, that Clearing Member becomes solely responsible for clearing and settling the institutional deal.
- FII Compliance: FIIs and their sub-accounts are permitted to trade on the F&O segment only after obtaining a unique CP code from NSCCL and complying with prescribed position limits and reporting procedures.
Key Takeaways & Exam Points
- Mandatory Cash Settlement: All derivative contracts (index futures, index options, stock futures, stock options) on the NSE F&O segment are settled in cash.
- Daily MTM Settlement: Computed at the end of every trading day and settled in cash on a T+1 basis. All open positions are reset to the daily settlement price daily.
- Futures Settlement Pricing: Daily settlement price is the weighted average price during the last 30 minutes of trading. Final settlement price is the closing price of the underlying asset in the cash market on expiry day.
- Theoretical Futures Settlement Formula: Theoretical Price = Spot Price * e^(r * T).
- Options Exercise Mechanism: European style with automatic exercise of all long in-the-money (ITM) options on expiration day. Assignment to short positions is done on a random basis.
- Single-Line Exercise Value Formulas:
- Call Option = Closing Price - Strike Price.
- Put Option = Strike Price - Closing Price.
- Custodial Participant (CP) Facility: Allows institutional entities to trade via any TM and clear/settle via their chosen custodian CM using a unique CP code. Unconfirmed CP trades remain the liability of the executing TM's CM.