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