Risk Management in Commodity Derivatives

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Questions and Answers

What is the purpose of the Settlement Guarantee Fund (SGF) in exchanges?

The SGF is used to provide settlement guarantees by ensuring that trades are settled even in the case of member defaults.

How do concentration margins contribute to risk management in commodity derivatives contracts?

Concentration margins cover the risk associated with the longer liquidation period of concentrated positions in commodity derivatives.

What defines liquid assets in the context of exchanges, and what is the haircuts rule applicable to them?

Liquid assets include cash equivalents and certain securities, with haircuts ranging from 0% for cash to a maximum of 10% for other liquid assets.

What are the implications of Initial and Extreme Loss Margins within the risk management framework?

Initial margins are required to open positions, while extreme loss margins are intended to cover potential significant losses during market volatility. Signup and view all the answers

What defines the limits for exposure to a single issuer regarding liquid assets in exchanges?

The limit for exposure is determined by fixed percentage-based haircuts or VaR-based haircuts, not to exceed 10%. Signup and view all the answers

What is the minimum Liquid Net-worth requirement for clearing members in the CD segment as specified by SEBI?

INR 50 Lakhs. Signup and view all the answers

What is the Base Minimum Capital (BMC) requirement for trading members engaged in algo trading?

INR 50 Lacs. Signup and view all the answers

What happens to a trading member when 90% of their Liquid Assets for margins/deposits are utilized?

They are mandatorily put in risk-reduction mode. Signup and view all the answers

How much of the Base Minimum Capital is required to be in cash form?

25% of the total BMC. Signup and view all the answers

What occurs to all unexecuted orders when a trading member breaches the 90% collateral utilization level?

All unexecuted orders are cancelled. Signup and view all the answers

What is the consequence for a trading member if there is a repeated shortfall in margin?

The member must be put in square off mode and required to reduce positions. Signup and view all the answers

What is the purpose of the Settlement Guarantee Fund in exchange surveillance policies?

To ensure the financial integrity of transactions by providing a safety net for settlements. Signup and view all the answers

What is required from clearing members who clear and settle non-algo trades?

They must maintain a Base Minimum Capital of INR 25 lakhs. Signup and view all the answers

What is the purpose of Liquid Assets in the risk management framework of stock exchanges?

Liquid Assets are deposited by members to cover various margin and deposit requirements, ensuring financial stability and compliance. Signup and view all the answers

What do Initial Margins (IM) represent in the context of risk management?

Initial Margins represent the Value at Risk margins necessary to cover potential future exposure for at least 99% of days before the close of positions. Signup and view all the answers

How do Extreme Loss Margins (ELM) differ from Initial Margins (IM)?

Extreme Loss Margins are designed to cover losses beyond the scenarios accounted for by Initial Margins, providing an additional safety net. Signup and view all the answers

What is the function of the Settlement Guarantee Fund (SGF)?

The SGF acts as a financial safety mechanism to ensure that obligations are met during the settlement process, protecting the interests of participants. Signup and view all the answers

What requirements must clearing members meet regarding Liquid Net-worth?

Clearing members must maintain a Liquid Net-worth as specified by SEBI, which is the value of their liquid assets after adjusting for applicable margins. Signup and view all the answers

Explain the significance of Mark to Market (MTM) Settlement in trading.

MTM Settlement involves the daily adjustment of open positions based on current market prices, helping to reflect their real-time value. Signup and view all the answers

What role do Additional Margins play in the risk management framework?

Additional Margins are imposed beyond the standard margins to mitigate heightened risks in volatile market conditions. Signup and view all the answers

Describe the purpose of the Delivery Period Margin as outlined in the risk management system.

The Delivery Period Margin is levied on long and short positions marked for delivery to ensure adequate funds are available until the transaction is completed. Signup and view all the answers

Study Notes

Commodity Derivatives - Contract Design, Trading, Surveillance, C & S

Commodity derivatives involve contract design, trading, surveillance, and related compliance.

Session Outline

Essential Components of a Commodity Futures Contract: Covered in the outline.
Principles of Commodity Futures Contract Design: Core concepts in contract design.
Key Parameters to be Considered: Factors influencing product suitability, analysis, approval, and modification.
Product Suitability Analysis: Assessing product suitability using a scorecard approach.
Contract Approval and Modification: Procedures and criteria for contract approval and adjustments.
Evaluation of Performance of a Product: Key performance indicators and assessment criteria.
Modification of an Existing Contract: Process for revising existing contracts.
SEBI Criteria for Eligibility, Retention, and Reintroduction of Derivatives Contracts on Commodities: Regulatory guidelines.
Role of Independent Oversight Committee for Product Design: The oversight committee's function.
Options – Product Design: Specifics of options contract design.

Commodity Derivative Contracts in India

Commodity Futures Contracts: Focuses on price discovery and risk management.
Commodity Options on Futures Contracts: Risk management and delivery through underlying assets.
Options Contracts on Commodities (Spot): Risk management, price for risk management, and delivery on expiry.

Commodity Derivatives Contract Design - Perspectives

Hedgers Perspective: Efficient price discovery and risk management.
Regulator(s) Perspective: Compliance requirements.
Market Perspective: Requirements of stakeholders and efficient price discovery.
Competition Perspective: Arbitrage opportunities and size of the contract.

Principles on Contract Design - IOSCO*

Economic Principles: Price volatility and risk management.
Correlation with Cash Market: Underlying physical commodity and commercial practices.
Promotion of Cash and Convergence: Equivalence and settlement reliability.

Economic Utility

The chance of success or potential for contract performance issues.
Has a large and active cash market.
Experiences substantial cash price volatility.
Subject to regulatory treatment that might interrupt supply and demand.
Satisfies hedging needs.
Tracks assets held by hedgers.

Correlation with the Cash Market

Size and structure of the market.
Historical patterns of production, consumption, and supply.
Quality or grade of the underlying commodity.
Liquidity and cash pricing system.
Vertical integration and consumption patterns.
Price controls and other regulations.

Promotion of Convergence

Convergence is essential for price discovery and risk management.
Few deliveries occur.
Contract terms and conditions should reflect the underlying cash market and avoid impediments to delivery.
Convergence is measured by "basis."
Basis is calculated as Cash - Futures.
A negative number indicates a "weak" basis, while a positive number indicates a "strong" basis.
A compliant contract consistently promotes convergence.

Promotion of Convergence (Physical Delivery)

Contract size and trading unit.
Trading months.
Minimum price fluctuation (“tick”).
Delivery pack/facilities.
Last trading day and delivery period.
Delivery procedures and points.
Delivery instrument.
Price limits.
Reportable levels.
Position limitations.
Position accountability

Promotion of Convergence: Cash Settlement

Guidance from the Commodity Exchange Act (price reflecting the underlying cash market).
Price basis.
Cash settlement procedure.
Determining index reliability, availability, and adequacy of sample size.
Third-party information providers.
Information sharing.

Post Launch

Market Surveillance: Large trader reporting, transaction reporting, cash market familiarity, product terms and conditions, market participants, and delivery process familiarity.
Risk Review: Margin requirements, incorporate into risk modeling for market participants and exchange reporting requirements.

Product Development - Process

Stage #1 (Conceptualization): Market consultation, expert opinion, internal evaluation.
Stage #2 (Feasibility Study): Product parameters, expert opinion.
Stage #3 (Internal Evaluation): Top management evaluation.
Stage #4 (Submission of Proposal): Proposal evaluation, clarifications, discussions with stakeholders.
Stage #5 (Approval & Launch): Market feedback, contract modification, approval.

Product Potential - Key Parameters

Standardization.
Availability of Supply.
Price Control.
Market Size.
Geographical Coverage.
Price Volatility.
Large Number of Buyers/Sellers.
No Market Intervention by Policy Makers.

Product Identification (Sample Scorecard)

Parameters and corresponding weightage for product identification.

Evaluation of Performance of a Product

Parameters for Evaluation: Market feedback, stakeholders participation, price convergence with spot market, geographical spread, traded volume, and liquidity in the market.

Parameters for Performance Review of Commodity Derivative Contract

Background information.
Global scenario, Opening stocks, Production, Consumption, and Closing stocks.
Indian scenario, Opening stocks, Production, Imports, Total supply, Exports, Domestic Consumption, and Closing stocks.
Major changes in the policies.
Trading related parameters, e.g., Monthly and Annual traded volume
Price movements.
Other parameters, e.g., Qualitative and quantitative measure for Hedge effectiveness

Goods Notified Under SCRA

List of goods.

Eligibility Criteria for Allowing Derivative Contracts

Risk Management (correlation with the international market, seasonality, and price volatility).
Trade Factors (global, value chain, and geographical coverage).
Ease-of-doing-Business (no price control, non-applicability of other laws).
Commodity Fundamentals (size of the market, volume of the market, and homogeneity/standardization).

Template on Criteria for Eligibility of Commodity Derivative Products

Parameters for commodity derivative product eligibility.

Criteria for Retention and Reintroduction of Derivative Contracts on Commodities

Criteria for retaining or reintroducing commodity derivative contracts.

Product Advisory Committee (PAC)

Functions: Product design, contract modifications of existing products, review of already approved contracts, overseeing SEBI inspections, assessing resource adequacy, terms of reference.

Role of Regulatory Oversight Committee Regarding Product Design

Oversee product design matters and already approved contracts.
Oversee SEBI inspection observation on product design issues.
Estimate resource adequacy for product design functions (related to commodities).

Options on Commodity Futures (June 13 – 2017)

Eligibility: Average Daily Turnover (Agri/Non-Agri).
Settlement: Long call/put and short call/put positions.
Exercise Style: European.
Strikes: Minimum of three in-the-money (ITM) or out-of-the-money (OTM) and at-the-money (ATM) positions.

Options on Goods

Eligibility: Exchange trading futures contracts on or before launching options contracts.
Settlement: Delivery of goods.
Exercise Style: European or American style.
Strikes: Should have minimum 3 strikes – ITM, OTM and ATM.
Exercise: ATM and 2 CTM - All ITM

Trading Mechanism

Trading features.
Trading workstation.
Order validation.
Order matching.
Order management.
Close price.
Bhavcopy.

Trading Features

Automated screen-based trading.
National reach.
Order-driven trading system.
Transparency, Objective, and Fair order matching system.
Undisclosed trader identity.
Daily turnover limits.
Flexibility in placing orders (Trading Unit, Lot, or weight).
Complete Online Market Information.
Flexible speed and customized portfolio for spot and futures prices.
Square-off facility.

Graphical Illustration

Exchange technology framework. (Includes diagrams)

Trading Workstation

Client-Server architecture.
Server software.
Fault-tolerant system.
Client software under Windows on PC.
CTCL facility.
Resource utilization, Data-Feed, Disaster Recovery site, and replication.

Types of Order

Time conditions: Day order, Good-Till-Cancelled (GTC), Immediate or Cancel (IOC), and Good-Till-Date (GTD).
Price conditions: Limit order, Market order, and Stop Loss Order.

Order Validation

Circuit filter (price range).
Price steps (tick size).
Market lot.
Minimum disclosed quantity.
Time conditions.
Order size.

Order Matching

Price-time priority.
Best Buy/Best Sell order matching.
Quantity fields in units.
Price quotes in Indian rupees.
Unique Order No. / Trade No. with Time Stamp.

Order Matching - Snapshot

Showing diagrams and example data for order matching.

Order Management

Modification and cancellation of orders.
Changes in order parameters.
Implementing time priority for modification.
Cancellation of unexecuted/pending orders.
Prohibiting modification/cancellation of already executed trades.

Order Modification

Modifying order parameters.
Real-time confirmation through TWS messages.
Obligation note transmission.
Deduction of margin.
Contract note issueation.

Close Price

Formula for calculating weighted average prices.
Process when fewer than 10 trades occur.
Default calculation when no trades occur.

Bhavcopy (Daily Price List)

Information available in Bhavcopy (Open, High, Low, Close price, Previous close price, No. of trades, Volume, Value, Open Position, and Current Index).
Distribution channels to members.

Price Circuit Filter

Pre-defined in contract specifications.
Maximum variation range during trading.
Varies by commodity type.
Calculated from previous day's closing price.
Procedures for relaxation in significant fluctuations.

Price Circuit Filter (Parameters)

Spot and market trend of the commodity.
Latency / close price of different contracts.
Number of trades during the session.
Pending orders in the system.
Price movement in the contract and international market.

Price Circuit Filter Relaxation

SEBI-approved cooling period.
Circuit filter relaxation via automated message.
Special Margin levied when the filter is relaxed.
Further relaxation conditions for international commodities.

Why Margins?

Margin guarantee price performance and eliminate default risk.
Margin helps to ensure clearing member losses with trading positions.
All margins are collected upfront.

Margins (1/3)

Clients' money.
Exchanges' balance high security of contract.
Various scenarios of price changes.
Levy of additional margin, regulatory margin, long/short margin.

Margins (2/3)

Definition of Initial margin.
Procedures for Special margin and additional margin.
Delivery period margin specifications.
Margins at the client level.
Alert signals to members.

Margins (3/3)

Margin utilization alerts, Automatic 'Square-off' mode.
The member's behavior during Margin utilization (100%).

Marked-to-Market (MTM) Loss

Monitoring MTM loss, both notional and booked.
Real-time calculation.
Alert signals to members.
Automatic 'Square-off' mode.

Marked-to-Market (MTM) (2/2)

Margin deposit.
System alerts.
Member actions, “Square Off” mode, and depositing additional margins.

Open Position

Avoiding excessive open positions in any commodity.
Maximum allowable limit specified by SEBI.
Reduced limits for near-month contracts.
Monitoring through software utility.

Position Limits

General guidelines for position limits.
Numerical limits by each commodity.
Limits prescribed by SEBI.
Applicability of limits to trading members and proprietary positions.
Calculating open positions across all contracts.
Procedures for clubbing open positions.
Monitoring position limits.

Position Limits (Agri.) (1/3)

Numerical value of overall client-level open position limits.
Limits lower than SEBI limits to manage the market properly.
Norms applicable to client-level and proprietary positions

Position Limits (Agri.) (2/3)

Calculating client-level positions.
10 times the client-level limit and 15% of the market-wide open interest.
Determining near-month contract positions.

Position Limits(Agri) (3/3)

Defining categories of commodities.
Sensitive commodities (prone to frequent interventions).
Broad commodities (high average deliverable supply).
Narrow commodities (low average deliverable supply).

Position Limits (Non-Agri.)

Calculation of overall open positions by netting out long and short positions.
Client level limits 10* client level or 5% of market wide open interest.
Member level limits 10* client limit or 20% of market-wide open interest.

Position Limits (Hedgers)

Hedging limits (non-transferable).
Applicability to near-month contracts.
Case-by-case basis.
Disturbance avoidance in the derivatives market.
Exposure limits in relation to the commodities the entity owns.

Position Limit (Hedgers) - SE Disclosure Format

Formats for disclosure of hedge positions allocated to various hedgers.

Daily Price Limits (DPL)

General guidelines for DPL.
Base price determination for the first trading day.
Sufficient trade volume requirement.
Prescription of a narrower DPL than SEBI slabs, as per the exchange's discretion.

DPL for Agricultural Commodity Derivatives

Initial slab (4%, 4%, 3%).
Enhanced Slab (2%, 2%,1%).
Total DPL (6%, 6%, 4%).

DPL for Non-Agricultural Commodity Derivatives

Initial slab (6%, 6%, 6%, 3%, 3%).
Enhanced slab (3%, 3%, 3%, 3%).
Aggregate DPL (9%, 9%, 9%, 6%).
Trading beyond aggregate DPL and additional relaxations

Online Monitoring

Price volatility of Future Market relative to the Spot Market.
Margin utilization by members.
Marked-to-Market of members.
Sudden rise/fall in open interest.
Sudden increase in turnover of a commodity.
Abnormal trading patterns.

Exchange Surveillance Policy

Restricted entry through electronic access card.
Closed-circuit cameras in surveillance rooms.
Restricted access to confidential information.
No direct outgoing calls allowed.

Risks to/from Derivatives market

Price discovery.
Policy intervention/ market dynamics.
Divergence of spot and futures prices.
Systemic risks.
Financial default.
Physical delivery default and its systemic risks.
Risk management (various types).

Risk Management Framework

Comprises of liquid assets (Initial Margins, Extreme Loss Margins, Additional Margins, Pre-expiry Margins, Delivery Period margins, Concentration margins, Minimum Liquid Net-worth Requirement, MTM (Mark to Market) Settlement, Base Minimum Capital, Settlement Guarantee Fund (SGF).

Risk Management System (1/3)

Liquid assets' deposit by members.
Initial margin (IM) to cover potential future exposure.

Risk Management System (2/3)

Pre-expiry margin, delivery period margin.
Requirement for minimum liquid net-worth
MTM (Mark-to-Market) settlement.

Risk Management System (3/3)

Concentration margins.
Base minimum capital.
Settlement guarantee fund (SGF)

Liquid Assets

Cash equivalents, bank deposits, guarantees, government securities, liquid mutual funds, securities of central government.

Types of Margin

Initial margin, Additional/special margins, Extreme loss margins.
Tender period margins, Delivery Period margins.

Initial Margin (Futures)

Minimum initial margin for Non-Agri & Agri commodity under different volatility categories.
Excluding the mentioned additional margins.

Margin Imposition (IM, ELM & TPM)

IM, ELM, and TPM (Tender Period Margin) calculation example, using percentage of Contract Value.

Risk Controls

VaR-based margining.
Real-time alerts on margin utilization.
Risk reduction mode (RRM).
On-line monitoring of MTM loss.
Quantity/value limits.

Measures of Monitoring open position limits

Commodity level (client and member limits, Near month contract level, On-line alerts).
Self-match prevention tools.
Unique client codes, obtaining PAN details, and checks on UCCs.

Risk Controls (Mechanisms/Checks)

Algo permitted after approval.
IOC/Market orders not permitted.
Order-to-trade ratio controls.
Penalty for high order-per-second.
Entities debarred by SEBI.

Mark to Market (MTM) Settlement

Daily settlement of open positions.
Use of Daily Settlement Prices (DSP).
Cash settlement of gains/losses.

Options on Commodity Futures

Margining model.
Quantum of initial margins and time horizons to cover positions in stressed market.

Options on Commodity Futures (Additional points)

Initial margin adequacy, Margins at client level.
Real-time computation.
Mark-to-market provisions.

Risks pertaining to Options on Commodity Futures

Sensitizing option holders to increase in margins during futures contract expiry.

Other Margins

Calendar Spread Margin.
Inter-Spread Margin.
Concentration Margins.
Additional Ad-hoc Margins.

Minimum Liquid Net-worth

Initial margins, ELM, and other margins.
Deduction from liquid assets.
Clearing members and their 'Liquid Net-worth'.
Minimum requirements specified by SEBI (from time to time).

Base Minimum Capital (BMC)

Members without algo trading (INR 10 Lacs).
Members with algo trading (INR 50 Lacs).
Clearing members for non-algo trades (INR 25 Lacs), clearing member with algo trades (INR 50 Lacs).
25% of BMC in cash, 75% in Fixed Deposits/Bank Guarantee.

Risk Reduction Mode (RRM)

Mandating risk-reduction mode when 90% of liquid assets are used for margins.
Cancelling unexecuted orders.
Limiting allowed orders to IOC.
Monitoring margins and potential margin deficiencies.

Default Waterfall

Recovering defaulting member's monies.
Utilizing insurance, if applicable.
Accessing and utilizing Exchange funds.
Pro-rata haircut to pay-outs.

Settlement Guarantee Fund (SGF)

Core SGF for each stock exchange segment, backing trade settlements.
Adequate corpus to handle possible member failures.
Mandated contributions from clearing corporations and stock exchanges.
Clearing members' contributions, if applicable, are subject to conditions (e.g., no exposure beyond a percentage limit).

Penal Provisions for Non-delivery

Penalties for buyer/seller default in both contracts and options.
Calculations for penalties (e.g., percentage of Delivery Default Rate, or difference between spot and average of last 5 trade days).

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Description

This quiz explores key concepts related to risk management in commodity derivatives, including the Settlement Guarantee Fund, margin requirements, and asset liquidity. It delves into specific regulations like SEBI guidelines and the repercussions for trading members under various conditions. Test your understanding of these crucial financial frameworks.