This report is based on field visits to East India Cotton Association (EICA), Mumbai; the Domestic and the International Commodity Exchange Division of the India Pepper and Spice Trade Association (IPSTA), Kochi; Coffee Futures Exchange India Limited (COFEI), Bangalore; International Castor Oil Division of the Bombay Oilseeds and Oils Exchange Limited (BOOE), Mumbai; and the SOPA Board of Trade (SBOT), Indore. We are most grateful to the chief executives, officials and members of these commodity exchanges.

This report is also based on extensive discussions with policymakers and regulators, and potential users of commodity derivatives contracts. We gratefully acknowledge the co-operation of officials of the Forward Markets Commission (FMC), Ministry of Consumer Affairs and Public Distribution, Ministry of Agriculture and Co-operation, Department of Economic Affairs, the Reserve Bank of India (RBI), the Securities and Exchange Board of India (SEBI), the National Bank for Agriculture and Rural Development (NABARD), National Association of Warehousing Corporations and the National Association of Food and Civil Supplies Corporations. Their suggestions have been most valuable towards the formulation of the recommendations included in this report.

The assistance provided by the Indian Institute of Technology, Chennai, and Rinsy Ansalam in extensive modelling and stress testing is gratefully acknowledged. CommodityIndia.com and Foretell Capital Trust provided commodity price data for the modelling. Their assistance is gratefully acknowledged. We are grateful to the Office for Futures and Options Research at the University of Illinois, Urbana-Champaign for comments and feedback.

This consultancy report to the Forward Markets Commission, Government of India and the World Bank on the Guidelines for Clearing House Ownership, Operations and Bye-laws is aimed at strengthening the clearing and settlement process in the commodity exchanges in India. The consultancy assignment has six purposes.

Purpose 1: To upgrade and strengthen the clearing functions of the commodity exchanges so that the clearing functions are streamlined, trades are guaranteed and clearing functions help in improving the confidence of market participants and thereby improve the breadth and liquidity of markets.

Purpose 2: To work towards having one or a limited few clearing houses that clear and guarantee the contracts traded in several commodity exchanges.

Purpose 3: To evolve a system of margins and methods of its payment for the clearing operations.

Purpose 4: To have an action plan to move from the present system to a new system in a phased manner to be accomplished over next one or two years, including the phasing and steps to be taken in each phase.

Purpose 5: To strengthen the capacity of the FMC to assess the quality of clearing house operations and practices by the commodity exchanges.

Purpose 6: To hold a workshop where the necessity and importance of clearing is put across and the action plan can be explained along with the role of various functionaries and institutions in this process.

The report addresses five of the six purposes. The workshop conducted in New Delhi between February 7 and 9, 2000 discussed the action plan. The role of various functionaries and institutions in the clearing and settlement process was explained.

This report is aimed at commodity exchanges; members of commodity exchanges; prospective members of exchanges; prospective members of clearing houses, including banks and financial institutions; and the FMC. The specific objectives of the consultancy are listed in Annex 1.

This consultancy was carried out as part of the joint programme of the World Bank and the Government of India for improving the functions of commodity futures exchanges in India. The 1996 World Bank report, Managing Price Risks in India's Liberalised Agriculture: Can Futures Markets Help?, evaluated Indian agriculture futures markets. The World Bank report acknowledges India's long experience in operating and managing commodity futures markets. It notes that restrictive policies have not provided India's agriculture futures market a chance to contribute to price risk management and discouraged them from upgrading their institutional capabilities.

In our field visits and in our discussions, policymakers and decision-makers in the central and state governments reinforced such an evaluation. Their evaluation as well as that of potential users is that Indian agriculture futures markets lack the necessary capability to support large scale hedging.

The World Bank and policymakers in India have recognised that the inadequate capability to support large scale hedging stems from the vulnerability of futures open interest to systemic risks induced by contracting parties or participants of the commodity exchanges in India. Systemic risks, a combination of credit risk and liquidity risk, have an adverse effect on the capability of commodity exchanges to support large scale hedging. Such an effect is not confined to the Indian markets. However, when Indian agriculture markets become more open to the global supply and demand functions, the impact of systemic risk would be more pronounced. Therefore, to provide India's agriculture futures market a chance to contribute to price risk management it is necessary to equip them with the capability to manage systemic risk so as to support large scale hedging.

The institutional improvement of India's agriculture futures market has received focussed attention since 1993 from both policymakers and regulators in India. The Kabra Committee Report (1994) and the World Bank Report (1996) are widely regarded as the principal sources for policies aimed at the rapid modernisation of the agriculture futures markets.

The World Bank has played a vital role in enabling commodity-intensive developing economies to continually effect institutional improvements to manage volatile commodity prices. Commodity-intensive economies have used a variety of policies and instruments to manage volatile commodity prices. The use of policies aimed at production and buffer stocks has dominated the use of market-based instruments in developing economies. Such policies have usually required budgetary outlays by the governments of developing economies. In contrast, market-based instruments such as commodity futures, futures options and swaps have dominated the approach to price risk management in the developed economies. Empirical evidence gathered over the last three decades shows that market-based instruments are more flexible, effective and efficient compared with policies aimed at production and stocks in managing price risks.

The World Bank has initiated several programmes aimed at propagating information pertinent to the management of price risks using market-based instruments. The flexibility, effectiveness and efficiency of these instruments have motivated these efforts. The World Bank has continually evaluated the need for polices and programmes aimed at expanding the use of market-based instruments where such usage is expected to be more cost effective than other budget-based instruments.

Clearing and settlement operations constitute one of the many components identified by the World Bank and the Government of India as critical to the modernisation programme. The other components include commodity exchanges' rules and regulations, trading procedures, delivery system, trade supervision, regulation and monitoring, and promotional and development activities. The successful pursuit of these comprehensive components is expected to have a favourable impact on the confidence of users and potential users with a favourable impact on liquidity of futures contracts. The focus of this report is on clearing and settlement operations aimed at mitigating systemic risk. The action plan, principal recommendations pertaining to the establishment of a central clearing corporation and a brief discussion of the recommendations follow. The action plan is based on visits to some of the commodity exchanges and discussions with policymakers and regulators; it is aimed at the listed purposes.

The action plan comprises major policies, supporting policies and principal processes that should be addressed and enunciated by the Government of India and the FMC.

While the existing commodity exchanges and their affiliated clearing houses provide very valuable insights towards structuring institutional processes aimed at supporting large scale hedging, they are characterised by serious inadequacies pertinent to financial resources and human resources. Clearing institutions offer efficiencies of a large magnitude in the containment and mitigation of credit and liquidity risk. However, investments in financial and human capital are necessary to tap such efficiencies. Investments in these usually follow a step function and have to be in excess of a nontrivial minimum at each stage of evolution. Therefore, these investments offer considerable economies of scale and scope. The Indian economy is very large and needs significant capabilities in clearing and settlement. Fragmentation of such capabilities would not be optimal. Concentration of these capabilities would be optimal and the size of the Indian economy can support a large central commodities clearing corporation.

This report recommends the establishment of one central commodities clearing corporation. It is referred to as the National Commodities Clearing Corporation of India Limited (NCCC) in this report. The proposed NCCC has seven principal objectives.

Principal Objectives of the NCCC

The seven principal objectives that have influenced the structure of the proposed NCCC are listed below.

1. To have the necessary capabilities to clear and settle open interests of a very large magnitude, i.e., facilitate large scale hedging.
2. To enable existing commodity exchanges regardless of their technological sophistication to have access to reliable and cost effective clearing and settlement processes based on formal novation and complete clearing.
3. To have the necessary capabilities to provide clearing and settlement for contracts executed on the proposed national multi-commodity exchange (NMCE).
4. To enable commodity exchanges and clearing members to exercise control over the clearing institution's policies and processes.
5. To have a structure of netting and payments that is unambiguously immune to a payments contagion.
6. To enable vigorous capital efficiency.
7. To support risk-based provision of supplementary resources aimed at managing default.

Principal Features of the NCCC

Ten principal features are recommended for the NCCC. These are aimed at achieving the principal objectives. The recommended features are listed below.

1. The NCCC should be an independent clearing institution owned by commodity exchanges including the NMCE.
2. The NCCC should be a for-profit organisation. Its general structure and profit orientation should reflect the London Clearing House (LCH), the FCCCI and the PCCCI and the clearing house division of COFEI. The NCCC may be established by merging the interests of commodity exchanges and clearing members in the FCCCI, the PCCCI, the EICA, the SBOT and COFEI.
3. It should have a base capital of at least Rs.1.4 billion. The base capital would be adequate to support large scale hedging of almost all agriculture produce except food grains, pulses and dairy products.
4. Clearing members should contribute to more than 60 percent of the NCCC's equity and should provide risk-based resources aimed at managing default.
5. The NCCC should enable commercial banks, co-operative banks, co-operative societies and financial institutions to participate in the equity and clearing activities.
6. Warehousing companies should invest in the equity of the NCCC in order to bring about synergies and tight communication in respect of the market for physicals.
7. The netting system should be based on formal novation and complete clearing in order to conserve the capital of clearing members.
8. Contract and payment netting at the level of clearing members should enable clearing members to remain liquid and solvent to support the needs of commodity exchange participants. This would minimise the probability of a payments contagion.
9. Commodity exchanges should engage in decentralised credit and liquidity risk management in order to prevent overflow of any contract or payment crisis from spreading to another exchange through common clearing members.
10. The NCCC should position itself to take advantage of innovations in banking, money settlement and warehouse receipts systems.

The definition of futures contracts recognises contractual obligations as a combination of two distinct components. They are distinct but not independent. Futures contract is a contractual obligation for the long (the buyer) to buy at a future date at a price determined at the contract's inception. The seller is not specified. A futures contract is a contractual obligation for the short (the seller) to sell at a future date at a price determined at the contract's inception. The buyer is not specified.

A futures contract cannot be simplified into an obligation between counterparties to make a future-dated exchange at a price determined at the contract's inception. This is the most important reason why futures contracts are settled through novation where a clearing house is the common counterparty that emerges because of novation.

Futures contracts are standardised contracts. In a futures contracts the contracting parties negotiate only the price. Quantity, quality and the time of delivery are standardised by the exchange on which the futures are listed for trading. The components of standardisation are made known to the participants of an exchange by the exchange through contract specifications. Standardisation is not the sole or principal distinction between forward and futures contracts. Internationally, the definition of futures contracts assumes the elimination of counterparty risk. Elimination of counterparty risk is achieved through the process of novation and the interposition of the clearing house as the common counterparty.

For the buyer and the seller to perform independently and yet enable sellers and buyers to reap the benefit of contracting, the risk and the outcomes of their default need to be managed. Clearing houses are institutional arrangements aimed at the management of non-performance. Exchanges that adopt complete clearing lower the probability of non-performance of buyers and sellers and mitigate losses. The global record of successful management of non-performance is largely due to the internalisation of information and incentives obtained when a clearing house offers performance guarantees. Exchanges choose to have institutional arrangements such as clearing houses aimed at managing the outcomes of non-performance.

Clearing is the process of reconciling and resolving obligations between buyers and sellers. If clearing is reliable, buyers and sellers can buy from and sell to any seller and buyer most efficiently. Settlement follows clearing. It is the last step of the clearing process and extinguishes the obligations between buyers and sellers.

Direct clearing systems feature bilateral contracts with terms specified by the counterparties to the contract. Exchanges relying on direct clearing systems chiefly serve as mediators in trade disputes. Direct settlement involves the bilateral reconciliation of contractual commitments. Direct settlement is obtained through delivery or by offset between the original counterparties. Direct settlement has some disadvantages. It may lead to the accumulation of substantial losses as maturity of contracts increases. The failing counterparty has incentives to gamble in hopes of resurrecting net worth. This further increases credit risk.

Direct settlement limits settlement to the original counterparties. This is particularly important in the case of contract offset because the ability to obtain direct offset depends on the joint interests of both counterparties.

Ringing settlement involves netting of numerous claims and counterclaims. It applies the principles of multilateral netting and facilitates contract offset by increasing the number of potential counterparties. Ringing settlements reduce counterparty credit risk by reducing the accumulation of dependencies as contracts are offset. Ringing settlements also lower the cost of maintaining open contract positions, chiefly by lowering the amount of required margin deposits. Exchanges employing ringing methods generally adopt a clearing house to handle payments.

Ring settlements are arrangements between three or more counterparties having an interest in settling their contracts. Incentives to enter a ring stem from reduced exposure to counterparty risk and from reductions in the cost of maintaining open positions. To achieve these benefits, participants in a ring are required to accept substitutes for their original counterparties. The change in the identity of the original counterparties is referred to as novation. Some commodity exchanges in India have adopted rules and practices that facilitate ringing settlements thereby enabling access to those benefits.

Consider four parties having positions in a contract requiring delivery of five tons of sugar in a month's time. A sold to B at Rs.14/kg; B sold to A at Rs.13.30/kg; C sold to B at Rs.13.58/kg; and D sold to C at Rs.13.02/kg. Rules enabling settlement through rings must provide finality for all offsets arranged through rings. Referring to the above example, finality is obtained when neither B nor D can enforce a claim against C should their substituted counterparty fail to perform. Some commodity exchanges in India have not clearly intended finality.

To facilitate ring settlements, exchanges have adopted centralised mechanisms for payments and deliveries. These arrangements perform like bank clearing houses. Counterparties realising a loss following a ring settlement submit a record of their offset contracts along with a suitable payment (by cheque) to the clearing facility. These offset contracts are matched with the offset contracts submitted by counterparties realising gains. The clearing house credits a clearing account in the amount of payments received and debits this account when it disburses payments to counterparties realising gains. Deliveries are made by passing delivery orders to the clearing facility that then passes them to parties taking delivery. Clearing fees are usually included in the transaction fee.

Complete clearing interposes the clearing house as counterparty to every contract. This measure ensures that contracts are fungible with respect to both the underlying commodity and counterparty risk.

Novation is achieved through a third party mechanism that interposes itself between the seller and buyer of a futures contract leading to the elimination of counterparty risk. Such elimination is usually accomplished by the presence of a clearing house and processes employed by it to be the counterparty in all futures contracts traded on an exchange. The clearing house in such cases has an explicit role; the nomenclature alone is insufficient to determine whether the clearing house plays a role in novation and the resultant mitigation or elimination of counterparty risk. Several alternatives are available to accomplish novation.

Novation and the resultant reduction or total elimination of counterparty credit risk has a significant influence on the willingness of participants to trade futures contracts. The main component of the first purpose - improving the confidence of market participants and thereby improving the breadth and liquidity of markets - is related to both standardisation and the elimination of counterparty credit risk.

Complete clearing interposes the clearing house as the counterparty to each side of every exchange-traded contract. Contracts agreed to on the floor of the exchange and accepted for clearing require the clearing house to take the buy side of every contract to sell and the sell side of every contract to buy. This role substitutes the credit risk of the clearing house for the credit risk of individual counterparties. Thus, contracts exchanged in a complete clearing system are completely fungible: grade standards imply that commodities underlying contracts are the same and complete clearing implies that all contracts have equivalent credit risks. Futures contracts have all these intended properties.

Novation and the resultant reduction or elimination of counterparty credit risk are in the interests of commodity exchanges; such elimination of counterparty credit risk gives exchanges and participants an opportunity to trade without having to continually assess the risk that a counterparty would default on its obligations.

Novation and complete clearing enables all participants to pay attention only to the risk that the third party or common counterparty - the clearing house - would default on its obligations. The joint and simultaneous assessment of the risk that a clearing house would default on its obligations is of significance to participants, members and the commodity exchanges. Breadth and liquidity are always in the best interests of a commodity exchange.

While enlightened self-interest is more than sufficient to achieve standardisation, it may not be sufficient to influence a commodity exchange to adopt novation and complete clearing for the elimination of counterparty risk. In the absence of competition among commodity exchanges for listing and trading a commodity contract, all economic users of that commodity and the commodity contract would necessarily have to patronise the exchange that lists and trades that commodity and the commodity contract. Having accomplished the spatial and temporal concentration of all potential participants, the commodity exchange enables most participants to assess the bilateral risk that one or more participants may default on obligations.

The failure to adopt novation and complete clearing may not necessarily be a result of the exchange's failure to pursue its self-interest. The creation of an institutional process for complete clearing requires nontrivial financial and human resources. Small exchanges that earn small revenues through small trading volumes may find it more attractive to pass by or postpone any decision aimed at establishing a framework for novation and complete clearing. They and their members may find it more economical to restrict their attempts at containing default risk by collegial and informal processes. This low cost approach to the containment of default risk imposes no particular disadvantage on a commodity exchange that (1) enables all potential participants to assess one another and (2) faces no threat of competition from other exchanges whereby some or all existing members may migrate to the competing exchange(s).

Trading, clearing and settlement constitute the three important components of the commodity markets. Trading has typically occupied the prime spot in the regulatory environment in India. Such a focus has been reflected in the rules and regulations of commodity exchanges. However, the other two components - clearing and settlement - have a very significant role to play. Unreliable clearing and settlement militate against the success of trading systems and trading institutions. The streamlining of clearing and settlement system, as we see it a from a total system perspective, is necessary in order to increase the reliability and success of trading institutions. The reliability of global trading institutions or exchanges has over the last 25 years been increasingly predicated on the robustness of clearing and settlement institutions.

A systems view is essential to appreciate the importance of the three principal components and the sub-components. The principal functions classified under trading, clearing and settlement are given below (Table 1). It may be observed that a large number of critical functions are performed by the clearing and settlement system. A few functions are common to the systems. Given the common functions and the large number of critical functions that are performed by the clearing and settlement system, it may be seen why the specification, streamlining and regulation of clearing and settlement have come to the fore over the last 25 or more years.

The success of exchange-traded contracts results from the efficiency, transparency, speed and security of three components of the composite system - trading, clearing and settlement systems. Each component has its own role in determining the success of commodity contracts and in achieving the economic objectives of listing and trading commodity futures contracts and futures options contracts.

Netting is the principal step towards the creation of economies of scale in the context of contractual obligations among market participants. Netting may be applied to monetary obligations and asset obligations. Netting creates economies of scale in the case of single commodity exchanges. It creates economies of scale and economies of scope in the case of multi-commodity exchanges.

Registering futures transactions between counterparties is an important first step before any netting methodology is applied. The application of a netting methodology consolidates the obligations of registered transactions between counterparties. The manner in which obligations are consolidated determines how gross obligations existing between counterparties are simplified. Every gross obligation between counterparties is a source of risk and a component of cost. The lowering of risk and cost related to the management of outstanding futures obligations is a function of the process of consolidation.

Netting can be accomplished in one or more forms and the effect of netting is dependent on the chosen netting arrangement. In any case, netting is applicable only to like transactions and obligations. The objective of netting is to enable counterparties to meet obligations through one single payment and one single delivery of the like asset defined in the contract. The method of netting determines if there is a single payment and delivery between each pair of obligated counterparties or one single payment and delivery for each obligated counterparty and participant.

Distinctions between types of netting extend to the number of counterparties involved in the simplification process. In bilateral netting, the payment or contractual obligations is simplified between pairs of counterparties. The principal economies resulting from bilateral netting are reductions in the cost of making payments and reductions in the opportunity costs associated with maintaining margin or collateral deposits. Margin or collateral deposits are maintained by futures markets participants to proactively provide for the costs of default. Bilateral netting also results in the considerable reduction of risk.

The role of a clearing house is often illustrated in a three-party situation. We have presented most of the issues related to netting and the establishment of clearing houses through a two-party setting. However, a three-party setting is used to demonstrate multilateral netting. The two counterparties in the examples that follow, A and B, are not bound in the bilateral relationship by choice; they happen to be counterparties because of commercial compulsions.

Example 1: If A owes B Rs.15 and B owes A Rs.20, their obligations can be completed by making the respective payments. If payment transactions are cumbersome and costly, a cost reduction and an increase in convenience are obtained by netting the two due amounts. In this example, netting is possible since the two monetary obligations are in the same currency unit. In all other examples that follow, payment obligations are in Indian rupees and are, therefore, amenable to netting.

This payment netting allows A and B to complete their respective obligations on payment of Rs.5 from B to A. Results similar to this are common in futures markets where one counterparty receives and another pays without any corresponding exchange of an asset at the time of mark-to-market.

There is risk reduction in this netting arrangement. It avoids default by A after B pays Rs.20; it avoids default by B after A pays Rs.15. It reduces the risk to Rs.5 that is payable by B to A. A faces this risk; B faces no further risk. To eliminate the potential for default, A and B could make independent payments of Rs.15 and Rs.20 respectively to a third and common party that is creditworthy and then receive Rs.20 and Rs.15. The third and common counterparty may be regarded as the clearing institution. Such flows are common in payment-versus-payment (PVP) systems. Both A and B would have to accept the creditworthiness of the third party ex ante and perhaps endow upon it the necessary creditworthiness if other counterparties were evaluating the credit risk and liquidity risk of A and B.

However, it is not necessary for A and B to share the same intensity of purpose in the creation of the third and common counterparty. In fact, they would not share the same interest and intensity of purpose. Netting and the introduction of third and common counterparties introduce new asymmetries where none existed earlier. The financial collapse of the third and common counterparty after A made the payment but before B does would allow B to save Rs.20. The financial collapse of the third and common counterparty after B made the payment but before A does would allow A to save Rs.15. The financial collapse of the third and common counterparty before any payment is made would allow B to save Rs.5. The financial collapse of the third and common counterparty makes B better off than it does A.

The above asymmetry is the result of the relative magnitude of risk introduced by A and B. Since B introduces more risk than A into the system (with or without netting) that involves a constructive role for a third and common counterparty, B stands to gain from the financial or organisational collapse of the common counterparty. In contrast, A does not introduce any net risk and stands to lose. The gross risk introduced by A is less than the gross risk introduced by B.

If B had the alternative to not perform, a characteristic of all futures contracts, B derives an unambiguous advantage from the collapse of the common counterparty. In such circumstances, as in this bilateral obligation where B introduces more gross risk and can default, B would prefer to commence the commercial relationship with A and the common counterparty with a 50 percent or 50:50 ownership along with A of the common counterparty. The financial collapse of the common counterparty, even if it were merely a special purpose vehicle, would impose more costs on A than on B.

Therefore, A would be more interested than B in the structure of the third and common counterparty and its institutional continuity since A faces a payment risk while B faces no risk but can opportunistically choose to not perform. A's dependence on the third and common counterparty's expeditious treatment of dues would be significant if A owed C Rs.5 in some other bilateral transaction but depended on the receipt of Rs.5 to complete the payment. Any delay in the processing of payments by the third and common counterparty would force on A an involuntary default. As the net recipient, A would be quite interested in the expeditious processing of payment obligations and also interested in a payment system that enabled A to receive Rs.5 from the third and common counterparty and to pay C Rs.5.

There are many other possibilities in this example that requires two parties to make unequal payments to one another simultaneously. If temporal shifts in the redemption of obligations are introduced, the magnitude of risk to be borne by the counterparties changes adversely. However, with this simple bilateral obligation chain, we have introduced some useful constructs such as the third and common counterparty and alerted participants in and regulators of the Indian commodity markets to the asymmetric interest that counterparties would have in the structure of common counterparties.

We have also identified A as the counterparty that has more interest than B in the expeditious processing of obligations and effecting payments. The existence of such interest in payments is the basis for PVP systems and real time gross settlement (RTGS) systems. PVP could be used in single-currency obligations and multiple-currency obligations.

A introduces less risk than B does but has more at stake in the efficient, effective and risk-free functioning of the common counterparty. The asymmetry in the outcomes of credit risk introduced by A and B would be eliminated if B were required to invest in proportion to the risk that is introduced. This method of reducing asymmetry is not new. Margins are usually stipulated on the basis of risk introduced by counterparties. If the common counterparty were an institution independent of A and B and had its own financial resources, it would require B to deposit more margin than A to utilise the services of the common counterparty. If the common counterparty were to be established by A and B, even if for a temporary purpose, the financial stake could reflect the ratio of gross risk introduced by A and B, that is, in the ratio of 15:20. However, since A has a net inflow there may be a preference for a ratio based on net obligations and net risk. B may resist such a move. In this example, the ratio is lopsided (0:5) since it is bilateral. In a multiparty example, it would not be lopsided. The basis for capitalising clearing houses and the setting of clearing limits based on financial net worth are principal issues that need emphasis while establishing a framework for clearing in India.

These inferences are influenced by gross obligations and gross risk and the method of netting adopted to simplify obligations. The principal input to credit risk management protocols is the measurement of gross and net risk introduced by counterparties. Methods of netting play a nontrivial role in mitigating credit risk. More importantly, methods of netting have a nontrivial impact on liquidity risk.

Example 2: In contract netting between two bilateral counterparties, the asset side of the contract is considered along with the payment side. The asset side reckoning is applicable to like assets and permits no departure in any manner. Suppose A owes B Rs.15 for the purchase of 3kg of salt and B owes A Rs.20 for the purchase of 4kg of salt. If the payment side was handled in two gross parts, and the asset exchange side was handled in two gross parts, there would be four steps towards extinguishing the obligations. The risk would be considerable.

Bilateral netting can be effected on both the payment and asset side with the objective of reducing risk. The bilateral netting process would require A to deliver 1kg of salt to B and a payment of Rs.5 from B to A. This obligation requires simultaneous delivery of salt and payment of Rs.5. If the price of salt fell below Rs.5/kg, B would have an incentive to default. If price of salt rose above Rs.5/kg, A would have an incentive to default.

A and B could use a system of delivery-versus-payment (DVP) to exchange value and asset through a third and common counterparty. The role of the third and common counterparty would have to ensure that simultaneity is achieved where possible and default risk is discouraged where necessary. Ex ante, both A and B would have a significant interest in the expeditious processing of obligations since the price of salt could fluctuate up or down. This example emphasises the need for common counterparties to use high-speed equipment, say, computer, to process obligations. The example also points to the need for keeping salt in a state where it can be delivered to the common counterparty in a contemporaneous manner to match the payment. Commodity warehouses could operate along with common counterparties to effect DVP.

Example 3: If B owes A Rs.20 for the purchase of 3.8kg of salt, and A owes B Rs.15 for the purchase of 3kg of salt, A delivers 0.8kg of salt and B pays Rs.5 on the specified date after bilateral netting. This example reckons with two different prices of salt in the two contracts. Different prices are a feature of most futures marketplaces for the same underlying asset and for the same delivery date. The differences are driven by the time at which the contracts are entered into.

Example 4: If B owes A Rs.20 for the purchase of 3.8kg of salt, and A owes B Rs.15 for the purchase of 3.8kg of salt, A has no obligation to deliver any salt but B is obliged to pay Rs.5 on the specified date after bilateral netting. This example is similar to the preceding example but the bilateral netting produces results that are identical to the first example. This example reckons with intense volatility of price of salt, a feature that futures and options marketplaces and clearing houses are required to manage all the time.

The return to a state of netted obligation that is identical to that of the first example is intentional. Both hedgers and speculators achieve a significant part of their hedging and speculative objectives by closing out obligations at or before expiration of futures and options contracts. Such closing out is of course voluntary. Upon closing out or offsetting a long position with a short position in the same commodity and contract month, only the payment side remains. The management of credit risk and liquidity risk under the circumstances would then have to reckon with the hypothesised outcomes and suggestions included in the first example.

Example 5: If B owes A Rs.20 for the purchase of 4kg of salt and A owes B Rs.15 for the purchase of 2kg of silt, the payments side alone may be netted if A and B so desire. The asset side cannot be subjected to netting. This example captures a situation that is more likely to obtain if two or more single commodity exchanges choose to adopt common clearing. Common clearing indicates second order centralisation. Second order centralisation involves the establishment of a few clearing institutions that can clear and settle futures contracts traded on several commodity exchanges.

The obligations in this example may be met in one of several ways. The monetary side could be handled through PVP or through a net payment of Rs.5 by B to A. Salt and silt transfers could be effected through delivery-versus-delivery (DVD). A and B would agree to the PVP or the net payment only if the DVD could be supervised by and assured by a creditworthy third and common counterparty. Such an acceptance is more likely if the salt and silt were certified and stored by the same warehouse. If the PVP or the net payment is effected successfully and the DVD fails, B is exposed to risk. If the DVD is effected successfully and the PVP or the net payment fails, A is exposed to risk.

The obligations may also be met as two independent DVP tasks. The choice of PVP-cum-DVD or two DVPs would be determined by the creditworthiness of a common counterparty. It would also depend on the existence of warehouses that certify and store salt and silt. If one of the two commodities were not amenable to such treatment, it is likely that either A or B would not accept to PVP or net payment.

This example shows that netting efficiency in payment cannot be disassociated from processes aimed at effecting delivery of assets, especially commodities. Netting efficiencies are predicated on the reliability of physical transfers of commodities. Common clearing or the utilisation of one clearing house would enable netting of payments or PVP. However, for participants to have confidence in the netting of payments or in PVP, cost effective asset transfers that are contemporaneous with money settlement are a prerequisite. This example also shows why it is necessary for the FMC to focus on warehousing and warehouse receipts in order to take advantage of the dormant economies of scale and scope in clearing through netting.

If there are difficulties in achieving a system of cost effective asset transfers that are contemporaneous with money settlement, the FMC should encourage exchanges to pursue DVP in each commodity or DVD within an exchange or both such that at least some of the efficiencies associated with payment netting are realised. Payment netting contributes to more than 75 percent of the efficiencies that clearing houses generate in single-currency systems. In multiple-currency systems, payment netting contributes to more than 55 percent of the efficiencies generated by clearing houses.

A special case of the fifth example arises in the context of obligations pertaining to gur, potato and castor seed that are traded on two or more exchanges. An obligation to deliver gur in one exchange may not necessarily be amenable to offsetting against receipt of gur in another exchange. That makes the gur for delivery the equivalent of salt and the gur to be received the equivalent of silt.

The FMC should encourage exchanges to initiate and establish a programme for netting transfers of gur, castor seed and potato. This can be achieved through a common programme aimed at warehousing and the issuance of warehouse receipts. In our view, such a programme would also encourage the emergence of one or more exchanges for the trading of onion futures in India. The netting of commodities would support the netting of money settlements.

Multilateral netting is discussed next. Multilateral netting extends the economies and efficiencies by simplifying existing payment or contractual obligations across more than two counterparties.

Novation is the process and device that facilitates a higher order of netting. It involves the legal substitution of gross obligations by the net of these obligations, subject to a netting agreement. When obligations are simply netted, the obligations continue to exist. Even though the counterparties usually regard their obligations as being offset, a payment obligation may be restored on default of a counterparty to the net. Such restoration is indicative of the absence of legal provisions for netting.

On the other hand, when obligations are subjected to novation, the original obligations are extinguished by subsequent transactions that create new, consolidated obligations. Novation refers to the creation of new obligations. The benefit of consolidation through novation requires legal substitution of counterparties and a legally valid agreement among the original counterparties to accept and abide by the consolidation of obligations.

Since novation is based on the legal substitution of counterparties, it enables the substitution to have effect on all obligations included in the contract once novation is accomplished. Therefore, it is applicable to both monetary payments and the exchange of assets. Two examples follow. The immediately following example involves asset transfer. The succeeding example involves monetary payments that are amenable to netting.

Example 6: Consider two obligations in a multilateral netting scheme. The first obligation requires A to sell five tons of sugar to B, and the second requires A to buy five tons of sugar from C. By multilateral netting, the resulting obligation would require B to buy five tons of sugar from C, and A to do nothing. If there were no novation, if B does not perform on the settlement date, A is still obligated to buy five tons of sugar from C. This would be true even though A had no net obligation at the time of settling the two obligations.

If novation is valid, A's holding of a contract to sell five tons of sugar to B would be offset or cancelled by the purchase of a contract to buy five tons of sugar from C. This requires B to buy from C, and such a requirement should have legal validity at all times regardless of any default. A should have no need to perform any renewed obligations once the offset is effected and novation is legally valid.

The above example illustrates that the significance of novation increases when credit risk implications are considered. Novation creates a direct exposure for B from the new contract with C and a direct exposure for C from the new contract with B. B is now directly affected by C's failure to deliver sugar; C is affected by B's failure to take delivery of sugar or to pay. This exposure is involuntary since neither B nor C chose to trade with the other.

In this example of novation in a multiparty setting, B is directly affected by C's capability to perform the contract; C is directly affected by B's capability to perform the contract. This makes a material difference to the credit risk faced by B and C who had initially contracted with A but had no contracts with one another.

The resultant credit exposures arising from novation have important effects on the incentives to enter into a multilateral netting agreement. Creation of involuntary direct credit exposures reduces incentives to enter into a multilateral netting agreement. A direct credit exposure is the risk of loss owing to the operations of the counter party. The possibility that contract novation may assign an unsuitable counterparty will deter involvement with a clearing facility.

If the scope of novation is extended to create a common counterparty as in the first example given under bilateral netting, then neither B nor C is exposed to the credit risk of the other. The common counterparty is the clearing house in the context of futures and futures options contracts. Since B and C face the same counterparty, they both have an incentive, even if not equal, to accept the role of the common counterparty as an important risk intermediary and a facilitator. A too has an incentive to accept the role of the clearing house as a credit risk intermediary since it allows A to be free of all residual obligation upon the default of B or C. All residual obligation is that of the clearing house.

The introduction of the central and common counter party generally leads to the amelioration of problems associated with credit exposure and credit risk. If the common counterparty has a credit quality higher than that of A, B and C, all three counterparties derive significant benefit. None will object if all obligations among them are replaced by contracts with the central counterparty. If A, B and C can agree to create the common and central counterparty with higher credit quality, they all derive benefits.

Contracts requiring A to sell to B become contracts requiring A to sell to the central counterparty and B to buy from the central counterparty. Contracts requiring A to buy from C become contracts requiring C to sell to the central counterparty and A to buy from the central counterparty. There is no objection to this arrangement because each original counterparty buys or sells as originally intended, but does so with a common counterparty whose credit quality easily exceeds the participants credit quality. Thus A buys five tons of sugar and sells five tons of sugar, B buys five tons of sugar and C sells five tons of sugar. Their counterparty is the central counterparty or clearing house.

This explains why futures are contractual obligations for the long to buy. The selling counterparty is not specified. Similarly, futures are contractual obligations for the short to sell. The buying counterparty is not specified. This is the most important reason why futures markets settle buy and sell obligations through novation where the clearing house is the common counterparty that emerges because of novation.

Example 7: Consider a four-party setting in which six obligations remain to be settled. The six obligations have been determined after recording of transactions but before any netting (Table 2).

The number of payment flows (six at the beginning) and the value of funds to be paid and received drop consequent to bilateral netting from six and Rs.115 to five and Rs.85 respectively. Multilateral netting leads to a further decrease to one and Rs. 25. This example illustrates the efficiency gains that result from multilateral netting and novation. The cost of effecting payments falls. The inherent liquidity risk and credit risk decline significantly.

Novation causes a significant consolidation of obligations. However, it produces new counterparties who may have had no contractual obligations at the time of transacting. Novation produces very useful efficiency gains of a large magnitude but the gains come at a price. It requires counterparties to accept the credit risk of untested and unevaluated counterparties. In this example, C faces the risk of default by D. As in the example in which obligations to buy and sell sugar were novated, the introduction of novation and a common or central counterparty enables C to evaluate the common counterparty's credit quality. C does not have to be confounded or discouraged by the credit quality of D. In fact, the achievement of the efficiency gains in the effecting of payments and the mitigation of credit risk and liquidity risk are predicated not merely on the novation of obligations but on the interposition of the central counterparty.

Complete Clearing or Unconditional Guarantee?

In our meetings with policymakers in India, the importance of the interposition of the clearing house as the central and common counterparty was discussed. Such a discussion was based on the neutral position adopted by the L.C. Gupta Committee between (1) formal novation and the interposition of the central counterparty and (2) unconditional guarantee of performance by the clearing house. The L.C. Gupta Committee was constituted by SEBI. SEBI is the regulatory authority for the stock markets in India. Stock exchanges can choose either of the systems until the establishment of a central clearing corporation. The L.C. Gupta Committee has, however, mandated the implementation of full novation and the interposition of the clearing house upon the establishment of the central clearing corporation.

Full novation and the interposition of the clearing house produce efficiency gains and then formally eliminate all residual risk resulting from the default of counterparties who remain with consolidated obligations. The residual risk after formal novation is Rs.25. It is faced by C. The interposition of the clearing house imposes on the clearing house a residual risk of Rs.25. Though the value of the gross payments required to meet all the obligations is Rs.115 without any netting and Rs.85 after bilateral netting, the net residual risk declines to Rs.25. Such an efficiency gain is an important outcome of full novation and formal interposition of the clearing house. The common counterparty has at worst to deploy Rs.25 of own funds as collateral to guarantee performance to C. The cost of mitigating credit and liquidity risk is a function of Rs.25.

The system of unconditional guarantee by the clearing house permitted by the L.C. Gupta Committee and accepted by SEBI is not predicated on the legal acceptance of consolidation of obligations. The system of unconditional guarantee adopted by the BSE imposes an extraordinary cost on the clearing house. The clearing house faces a gross risk (since the guarantee is unconditional) of a maximum magnitude of Rs.115 without bilateral netting and Rs.85 with bilateral netting. Bilateral netting does not require any legal provision since it accomplishes netting without novation. We expect the legal system in India to assess the gross risk arising from the unconditional guarantee at Rs.85 or more. Multilateral netting would enable the gross risk to decline to Rs.25, which is the net residual risk, but it would not enable the clearing house to offer an unconditional guarantee. Multilateral netting is based on and gives rise to conditional circumstances. Hence, unconditional guarantee and netting beyond the level of bilateral netting are not compatible. A clearing house that chooses a system of unconditional guarantee has to deploy Rs.85 of own funds as collateral to guarantee performance to C or have an equivalent amount as margins from members though some members may have no net obligation. The cost of mitigating credit and liquidity risk is a function of Rs.85. A considerable amount of collateral efficiency is lost. This is avoidable.

A system of formal novation and the interposition of the clearing house as the common counterparty and a system of unconditional guarantee are both aimed at protecting counterparties from the credit risk of other counterparties. Full and formal novation backed by a clearing house of high credit quality improves the efficiency and acceptability of netting. The efficiency in managing residual risk and thereby the credit and liquidity risk is considerable. In contrast, the efficiency in managing systemic risk in a system of unconditional guarantee imposes a cost of large magnitude that is avoidable. Moreover, neither system can protect counterparties from credit risk and liquidity risk if the system has inadequate collateral. Providing collateral to a clearing institution that accomplishes full novation and legally valid interposition in order to manage residual risk rather than gross risk is easier and more efficient.

The adoption of complete clearing characterised by formal novation and the interposition of the clearing house as the common counterparty is recommended. The adoption is a prerequisite for sustaining open interests in a range of commodities. The adoption of complete clearing characterised by formal novation and the interposition of the clearing house as the common counterparty would require modifications to the Forward Contracts (Regulation) Act.

We draw attention to the fact that the Securities Contracts (Regulation) Act, an Act that is based on the Forward Contracts (Regulation) Act, has been amended to enable trading and clearing of derivatives. However, the Securities Contracts (Regulation) Act has not been amended to give effect to novation and the interposition of the clearing house. The amendment to the Securities Contracts (Regulation) Act stipulates the settlement of equity derivatives through a clearing house of the stock exchange in accordance with the rules and bye-laws of such stock exchange. The amendment does not specify novation and interposition. It also expects each stock exchange to have its own clearing house.

Since the Forward Contracts (Regulation) Act is the principal Act of the Government of India that deals with contracts for prospective performance, it would be most appropriate to amend the Act to cover novation and interposition by clearing houses, and the functioning and regulation of clearing houses. Futures, options and futures options are contracts for prospective performance. Regulations of the CFTC apply to both contract markets and clearing organisations. Similarly, the applicability of the Forward Contracts (Regulation) Act should be extended to commodity exchanges and clearing organisations. The amendment to the Act would lead to the sustenance of open positions and open interests.

Futures trading in gold is regulated under the Act. Banking institutions in India are expected to have a significant interest in trading gold and gold futures. Their participation in the gold futures marketplace is predicated on the availability of formal novation and the interposition of the clearing house as the common counterparty.

The costs imposed by settlement guarantee funds that skirt the issue of novation and interposition but offer unconditional guarantee are of a very large magnitude. Such a large magnitude of own funds of one or more sources may be inadequate to provide the necessary collateral for several single-commodity exchanges in India. It would also be unavailable in the case of a clearing house that is designed to clear and settle contracts traded on two or more exchanges. The temporary choice permitted by the SEBI-constituted L.C. Gupta Committee between complete novation and unconditional guarantee does not appear to be anything more than a Hobson's choice. There is no efficient alternative to full novation and interposition by the clearing house.

A system of settlement guarantee funds and unconditional guarantee may be appropriate though inefficient for an exchange that has assessed the direct costs and the dead-weight losses resulting from defaults. It would be quite inappropriate for a group of exchanges. Since each exchange has its own membership rules that are administered in a decentralised manner, each exchange and its members would be contributing to total systemic risk in different ways. This characteristic is common to all decentralised systems. In such a decentralised framework, it is unlikely that all exchanges that agree to second order centralisation, i.e., central clearing, would abide by any pecking order when there are two or more defaults.

Centralisation of guarantee against defaults ignores the decentralised action of exchanges, their members and customers of the members of the exchange. It also ignores their private interests and incentives of exchanges and their members. Efficient risk mitigation disallows any unwarranted mixing of centralisation of responsibilities and decentralisation of responsibilities. The presence of a centralised and unconditional guarantee, regardless of how unconditionally the guarantee is administered, takes away the incentive for individual commodity exchanges to undertake such of those actions aimed at controlling the introduction of risk into the central system. The FMC should discourage the emergence of situations characterised by moral hazard. The system of settlement guarantee fund aimed at providing unconditional guarantee to participants has been adopted by the BSE. Such a model is inappropriate in the context of second order centralisation. It is inappropriate even in the context of first order centralisation since it results in unwarranted inefficiencies.

Moreover, since there are only a few financially sound commodity brokerages in India, we expect the necessity of one or more commercial banks to supply own funds to act as collateral to support the mitigation of credit and liquidity risk. Banks are most unlikely to supply collateral to commodity exchanges and clearing houses that offer unconditional guarantees since their initial capital that acts as collateral is exposed unconditionally to complete liquidation. The method of netting and novation would determine the success of India's efforts aimed at the modernisation of its commodity exchanges and clearing houses. The determinants of choice of clearing facilities is discussed next.

Businesses, regulators and the general public determine the structure of clearing facilities and organisations. Preferences of businesses and market participants and regulatory policy have influenced the choice of clearing mechanisms. Public policy has seldom had a direct influence in the choice of clearing mechanisms.

Preferences of businesses and market participants are driven by the pursuit of cost effectiveness. It is rational for contracting counterparties to share incentives that are associated with the selection of clearing procedures that are cost effective. Costs considered by businesses and market participants usually include direct costs entailed in clearing their contracts plus any dead-weight losses incurred when contracting parties fail to perform. Dead-weight losses refer to costs imposed on one counterparty by another counterparty that has failed to perform.

Clearing involves the recording of obligations of each participant to other participants, netting of obligations by the adoption of one or more methods, and the settlement of obligations. Direct costs are related to the process of clearing. Costs related to margin and other collateral is one of the principal components of direct cost to participants. Dead-weight costs include the costs borne by a participant when a counterparty fails to perform or chooses not to perform.

Businesses and market participants would choose those clearing procedures that minimise the combined direct and dead-weight costs. Direct costs would be expended only if the pre-existing or potential dead-weight losses and the expected reduction of these losses justify the direct costs. Businesses and market participants would not incur direct costs if potential dead-weight losses or the expected reduction of dead-weight losses or both were trivial.

Clearing organisations permit centralised record keeping of obligations and the settlement of obligations; centralisation and concentration enable the emergence of scale economies. Clearing houses provide scale economies of a large magnitude in the management of risks associated with credit and liquidity. Since scale economies determine the raison d'être of a clearing house, the impact of scale economies on the components of total cost determine the structure and content of clearing processes. Direct costs respond to scale economies while dead-weight losses do not normally respond to scale economies. However, dead-weight losses are functions of the volatility of prices of assets that underlie trades among participants.

Dead-weight costs are also functions of the value of the alternative to not perform. If more participants valued the alternative not to perform, there would be more dead-weight losses and counterparties in general would be more willing to incur direct costs. Therefore, combined costs are direct functions of the number of market participants, and the number and complexity of traded contracts.

It is therefore reasonable to argue that as the number of contracts and participants increases, economies of scale and scope in clearing are likely to arise. Volatility of asset prices also drives the search for economies of scale and scope. The presence of and the need for these economies of scale and scope accelerate investment in the development of improved clearing facilities. Exchanges that face no competition from other exchanges may have little incentive to minimise combined costs if a significant part of the dead-weight losses can be opportunistically and asymmetrically imposed on some but not all participants. The opportunistic and asymmetric imposition of costs would deter many participants and lead to a loss of revenue to the exchange. If a commodity exchange were a monopoly, it would have no incentive to expand revenues through greater participation.

This characterisation leads to four propositions: (1) single commodity exchanges are unlikely to undertake investments in the development of improved clearing facilities, (2) commodity exchanges that attract only a small number of businesses and participants to trade are unlikely to undertake investments in the development of improved clearing facilities, (3) commodity exchanges that trade a single commodity whose price volatility is less than normal are unlikely to undertake investments in the development of improved clearing facilities, and (4) commodity exchanges that enjoy a statutory monopoly are unlikely to undertake investments in the development of improved clearing facilities. The four propositions are consistent with the proposition of Tsetsekos and Varangis (1997) and the empirical evidence presented by them.

However, there could be one or more exchanges that provide the exceptions to the set of four propositions. A single commodity exchange that trades a volatile commodity could benefit from investments in the development of improved clearing facilities, especially if it faces competition in the national market or global market or both.

The first futures clearing corporation that was incorporated in Chicago in 1925 had the objective of reducing credit risk and liquidity risk faced by participants in the commodity futures market. The period of incorporation of the Board of Trade Clearing Corporation (BOTCC) to undertake complete clearing of contracts traded on the Chicago Board of Trade (CBOT) coincided with the significant increase in the (1) number of participants, (2) number of commodities traded, (3) output of commodities and (4) volatility of prices. The date of incorporation also coincided with the initial years of regulatory oversight by the Grain Futures Administration (GFA) of the United States, a fact that is often misconstrued as the raison d'être for the BOTCC. Despite this synchronism, the innovation of the incorporation of the BOTCC and the guaranteeing of contract performance were the results of the efforts of businesses and market participants. The establishment of the BOTCC for performing complete clearing was not imposed on the CBOT by the exchange's regulators. Members of the CBOT had expressed interest in provisions to guarantee contract performance via an incorporated clearinghouse.

Regulatory policy was instrumental in the structuring of an institutional process aimed at complete clearing and the incorporation of a clearing house in 1972. However, the regulatory policy did not pertain to commodity futures. The CBOT had already incorporated BOTCC to provide complete clearing five decades before the pronouncement of any regulatory policy. The initiative for complete clearing and the incorporation of a clearing corporation came from the Securities and Exchange Commission (SEC) of the US in the context of equity options. At the time of the listing of equity options on the Chicago Board Options Exchange (CBOE) in 1973, only call options were approved by the SEC and listed by the CBOE. Put options were listed later. The CBOE was the first exchange in the world to list equity options.

The SEC quite correctly understood that call writers had an incentive to default on their obligations to in-the-money call holders, especially after receiving a premium from call holders at the time of selling calls. The value of the choice to not perform is not confined to futures. Such a value characterises options too but with an intensity that is considerably greater than in the case of futures.

First, prices of options are determined by several factors. The estimate of volatility of the underlying asset's price is one of the principal factors. Changes in the estimate of volatility magnify the volatility of the price of the option and thus enhance the value to call writers of the choice to not perform the option contract. The enhancement is greater in the case of American options than in the case of European options. Empirical evidence shows that volatility of options prices is of a very large magnitude compared with the volatility of futures prices. Therefore, option sellers are more likely to choose to default than futures sellers or buyers.

Second, call writers receive call premiums from call buyers at the time of selling calls to call buyers. If call writers choose not to perform after receiving the call premiums, the dead-weight losses borne by call buyers rise in magnitude. Futures sellers receive no premium from futures buyers; futures buyers pay no premium. The impact of dead-weight losses in the case of options is considerably more than in the case of futures. Expected dead-weight losses to option buyers and gains to option sellers are greater than the dead-weight losses to futures buyers and gains to futures sellers. The dead-weight losses include the premium and the opportunity loss resulting from the default by the counterparty.

The SEC, as the regulator of the equities and equity options markets, assessed the magnitude of dead-weight losses in the case of options to be high enough to warrant direct costs of a magnitude that was commensurate with the required and expected reduction of dead-weight losses. Recall that direct costs are amenable to economies of scale and scope. The SEC influenced the establishment of the Options Clearing Corporation (OCC). The OCC was organised as a corporation in 1972 under the laws of the state of Delaware. The OCC became the clearing house for clearing equity options traded on the CBOE.

Later when the American Stock Exchange (AMEX) sought the approval of the SEC to trade equity options, the SEC directed AMEX to avail the complete clearing services provided by the OCC. The SEC also directed AMEX to subscribe to the equity of the OCC. Other applicants were given similar instructions. However, the economic benefits of clearing through the OCC had become so clear and acceptable that the New York Stock Exchange (NYSE) chose to clear its equity options through the OCC without being directed by the SEC.

The OCC is the sole equity options clearing institution in the US. Its status as a monopoly is derived from the SEC's assessment of dead-weight losses, direct costs aimed at reducing dead-weight losses and the economies of scale and scope pertinent to direct costs and complete clearing. It is owned equally by the US exchanges that provide markets in options. Those exchanges are AMEX, the CBOE, the NYSE, the Pacific Stock Exchange and the Philadelphia Stock Exchange. The NYSE has agreed, subject to certain conditions, to transfer its options market to the CBOE. The OCC expects to repurchase the shares of its stock held by the NYSE after the transfer becomes effective.

The OCC's principal business consists of issuing equity options, providing facilities for the clearance and settlement of transactions in options, and providing incidental services to its clearing members and to the markets on which options are traded. When the OCC issues an option, it becomes obligated to purchase (in the case of a put) or sell (in the case of a call) the underlying equity for the stated exercise price if the option is exercised. In the case of a cash-settled option, the OCC is obligated to pay the exercise settlement amount when the option is exercised. Clearing members are generally securities firms that assume responsibility to the OCC for the settlement of transactions in options and the performance of the obligations undertaken by writers of options.

The establishment of the OCC was evaluated by the Commodity Futures Trading Commission (CFTC) of the US. In particular, the costs and benefits of complete clearing and the impact of economies of scale and scope were evaluated. In 1976 the CFTC stipulated that futures exchanges should clear futures contracts through multilateral facilities provided by clearing houses. This stipulation was made explicit in the context of financial futures. Commodity futures exchanges had by then adopted complete clearing through multilateral facilities for commodity futures. The CFTC specification enabled commodity futures clearing houses to add financial futures to their business. The CFTC's requirement specified in 1976 was based on the potential for exploiting the economies of scale and scope in the US market.

The SEC and the CFTC have both been driven by the potential for exploiting the economies of scale and scope in the US economy. The SEC was explicit in its policy aimed at influencing the (second order) centralisation and concentration of activities related to the clearing of equity options. The SEC policy was aimed at both first and second order centralisation and concentration. The CFTC has focussed on first order centralisation. However, most of the contract markets and clearing houses regulated by the CFTC are so large that any emphasis on second order centralisation would lead to the emergence of very unwieldy institutions. The CFTC would perhaps be an activist regulator if the BOTCC, the clearing house division of the CME, the clearing house associated with the New York Mercantile Exchange (NYMEX) and the New York Clearing Corporation (NYCC) were found inadequate in coping with global competition. The NYCC is the clearing house for the New York Board of Trade (NYBOT).

The CFTC's vision statement provides evidence of its orientation towards the premier position of the US economy in an era of untrammelled globalisation: Preserve and promote the vital role America's commodity markets play in establishing fair prices for goods and services and managing the risks of their production, marketing, and distribution in the world economy.

The CFTC is responsible for ensuring the economic utility of futures markets by encouraging their competitiveness and efficiency, ensuring their integrity, and protecting market participants against manipulation, abusive trade practices, and fraud. Through effective oversight regulation, the CFTC enables the commodity futures markets to better serve their important function in the nation's economy of providing a mechanism for price discovery and a means of offsetting price risk. The mission of the CFTC is to protect market users and the public from fraud, manipulation, and abusive practices related to the sale of commodity futures and options, and to foster open, competitive, and financially sound commodity futures and option markets.

The financial integrity of futures and options markets depends on the robustness of their arrangements for clearing and settling trades. The vigorous pursuit of economies of scale and scope pertinent to clearing institutions fosters financially sound commodity futures and option markets. The financial soundness of commodity futures and option markets is fundamental to any economy since financial soundness of exchanges fosters competition among brokerages and other service providers. Clearing institutions are critical to the fostering of financially sound, competitive exchanges and brokerages. The pursuit by regulatory agencies of economies of scale and scope in clearing institutions is consistent with policy objectives aimed at fostering open and competitive markets that are characterised by efficiency and integrity. The FMC can influence the pursuit of economies of scale and scope in India. The need for sustaining open interests of a large magnitude would enable and require the pursuit of economies of scale and scope in India.

Commodity exchanges in India have in general operated with the assumption that credit and liquidity risk and the resultant dead-weight losses are of a small magnitude. Therefore, direct costs aimed at mitigating dead-weight losses have also been of a small magnitude. Given the small assumed magnitude of dead-weight losses (default costs) and direct costs, economies of scale have not been of any importance. Moreover, as single commodity exchanges with statutory monopoly status, economies of scope have also not been of any importance.

Commodity exchanges in India have been structured in a manner that enables exchanges to proactively control dead-weight losses. Such control has been exercised through membership rules. In almost all exchanges, members are the principal users of the exchange. A separate class of users (customers) that accesses the exchanges through members is quite small, if such a class exists at all. The existence of a separate class of users would lead to higher dead-weight losses and higher direct costs. Exchanges and their members have avoided the higher costs by restricting the usage of commodity exchanges to a small class of member participants. The barriers to access are neither obtrusive nor obvious. The absence of promotional literature and campaigns related to (1) commodity exchanges, (2) the use of futures contracts and (3) the mechanism for accessing exchanges is not surprising.

The general view hitherto held by policymakers and regulators that futures trading was inimical to the broad economic interests of India required and enabled commodity exchanges to confine access to members. Therefore, the social benefits of commodity futures contracting have been available to a few participants in the economy. The inadvertent withholding of the benefits of futures contracting may be regarded as an invisible component of direct costs. There are other invisible components of direct costs.

Margins, price limits and position limits are the most dominant components of processes aimed at dealing with dead-weight losses. They are set in a manner that only a few trades would progress to the stage of default. The three components are set in compliance with the directions issued by the FMC. Trading volumes and liquidity in general and open interest in particular are small in the commodity exchanges and are in part a result of the three dominant components. The three components – margins, price limits and position limits – have in particular had the most adverse impact on open interest. Such an adverse impact imposes a cost that is an invisible component of direct costs.

High trading volume does little to soften the impact since high trading can coexist with small open interest. Trading volume is often incorrectly used as a barometer of activity of a commodity exchange. While high trading volume is certainly desirable, it does not automatically promote accretion of open interest. However, low trading volume is not desirable since it discourages potential hedgers and speculators who may fear poor liquidity. Low trading volume is also a drain on the resources of an exchange. High trading volumes bring more incomes to exchanges and signal potential liquidity to hedgers and speculators. Therefore, it is rational for commodity exchanges to pay attention to trading volume even if open interest is compromised. However, it would be appropriate if regulatory institutions such as FMC laid as much emphasis on open interest as on trading volume.

Open interest is of greater economic significance than trading volume in the context of futures and options contracts. An open interest comprises one open position by a long or buyer and one open position by one short or seller. An open position represents an investment by a long and a short, even if such an investment is leveraged. An open interest in a futures contract signals the confidence of the long and the short that their investments would remain viable until expiration or until the investments are liquidated voluntarily by them. Rational longs and shorts would signal their confidence in the viability of their investments only if they are certain about the financial soundness of the exchange and, in particular, its clearing and settlement processes.

Futures contracts are usually marked to market daily and the question pertaining to viability is dealt with each day. A futures position cannot be viable over the long term if it is not viable in the short term. However, the viability of a futures position in the short term does not guarantee its viability in the long term. Daily mark-to-market helps to ameliorate uncertainty but does not eliminate the chances of an involuntary liquidation over the intended term of a futures open position. Any involuntary liquidation as a result of default by another participant would not be in the interests of a hedger who has a pre-existing risk in the underlying asset and where the hedge has to remain in place until the pre-existing risk ceases to exist. Any involuntary liquidation would also not be in the interests of a speculator who has an estimate, even if stochastic or risky, of a particular price in the future and an expected profit commensurate with the risk. As a result of the nontrivial chances of involuntary liquidation of a futures open position before the completion of some intended term that is greater than a day, Indian commodity exchanges are characterised by small open interest even though they may have handsome trading volumes. The magnitude of open interest is measured relative to production of the commodity.

Low open interest is a result of inadequate clearing and settlement strengths but may be confounded by position limits imposed by the FMC and the exchanges. However, if the confounding impact of position limits is ignored, the very small open interest found in Indian commodity exchanges is a sign that both hedgers and speculators do not expect open positions to be viable. The lack of confidence has a direct and adverse impact on hedging as well as on price discovery.

The two principal benefits of futures contracts are hedging and price discovery. The benefits of hedging and price discovery occur over the long term. For example, it is customary for firms in the business of extracting vegetable oils from oilseeds to hedge against price risk. Firms hedge against total firm risk by selling edible oils futures over a certain horizon and, more important, by simultaneously buying oilseeds futures with expiration terms spread or stacked over the period of crushing between one harvest and the next. Any period between one harvest to the next is certainly long term in the commodity markets. In such circumstances, hedging by the extracting firm would need speculators or other natural counterparties such as edible oil traders, oilseeds farmers and co-operatives or all of them. More importantly, such counterparties should have an economic incentive to support their open positions through expiration and be confident that they would be able to unwind their positions in a liquid market when they reach the end of their horizon pertaining to speculation or hedging. In the absence of such incentives and confidence, oil extracting firms, oilseeds farmers, seeds co-operatives and oil traders would turn to over-the-counter (OTC) contracts, legal or otherwise, to hedge against price risk. Speculators would turn to short-term trades with a marked preference for day trades. They would also turn to being the intermediaries or counterparties or both in the OTC market for hedging against price risk.

The above example is descriptive of most of the commodity markets in India. There are a few significant exceptions. The example provides two useful pointers to potential outcomes. First, the process of price discovery is seriously impaired if commodity market participants turn en masse to OTC markets. Second, futures markets will not be comprehensive in serving the hedging needs of market participants if open positions cannot be carried from one day to the next with certainty after mark-to-market. Involuntary liquidation of long-term positions is a far more serious threat compared with the involuntary liquidation of short-term positions. Therefore, futures markets would be biased towards short-term hedging and speculation. Both outcomes are results of poor confidence of longs and shorts in the viability of their investments until expiration or until the investments are liquidated voluntarily by them. The poor confidence is a result of inappropriate management of costs of default through a financially sound clearing institution.

Impaired price discovery and a bias towards short-term hedging and speculation need not necessarily have an adverse impact on trading volume. The bias towards short-term positions generates a vigorous market, especially for day trading in near contracts. A near contract is one that has a short expiration period. In contrast, distant contracts have longer expiration periods. Distant contracts play a useful role in price discovery that enables price stabilisation as well as in hedging by producers, consumers and intermediaries. The likelihood of significant activity in distant contracts would be enhanced if open interest in distant contracts can be made viable unambiguously.

The sustenance of open interest in futures positions, especially in distant futures contracts, requires a very sound framework for clearing and settlement. The sustenance also requires a financially sound clearing institution that can support large open interests in a variety of commodities that play a vital role in India's real economy.

There is significant familiarity with clearing and settling stock market trades in India. There is a view that clearing and settling processes and clearing organisations that clear and settle cash transactions in the stock market could be replicated in part or full for clearing and settling commodity derivatives contracts. Such a view is perhaps driven by the very large market capitalisation of the Indian stock market relative to the size of the organised, private commodity market. The view is incorrect.

The framework required for clearing and settling cash transactions in an underlying asset is different from that used for clearing and settling transactions in futures and futures options in the same underlying asset. Clearing and settlement processes used for underlying assets are not as complex as those used for derivatives since the risk to be mitigated in the clearing and settlement of underlying assets is of a smaller magnitude. Clearing and settlement processes used for cash transactions in one underlying asset, say, equities, may be used for clearing and settling cash transactions in another underlying asset, say, government securities, but would be unsuitable to clear and settle equity derivatives.

The sources and impact of risk in the case of derivatives are often similar. Hence clearing and settlement processes used for futures and futures options transactions in one underlying asset may be used for clearing and settling futures and futures options transactions in another underlying asset. For example, clearing and settlement structures used for commodity derivatives contracts may well be used for clearing and settling financial derivatives including equity options, equity index futures and futures options, interest rate futures and futures options, and exchange rate futures and futures options. In fact, clearing and settlement systems based on commodity futures may be used with extraordinary effect to clear and settle cash market transactions in stocks. The reverse would produce less than satisfactory results.

In our meetings with policymakers and regulators in India, we discussed the principal differences between clearing and settling a stock market trade and clearing and settling a futures market trade. In the stock market, the risk borne by an exchange and its associated clearing house is solely related to the volume of trade transacted in the market and that are due for pay in and pay out after obligations are reckoned with. The risk related to clearing is not proportionate to the market capitalisation of stocks. Market capitalisation is a function of the number of stocks issued by companies and the market price of such stocks. Market capitalisation exists outside the stock exchange. Stock exchanges, their clearing institutions, and members and other intermediaries have no dynamic and decisive influence on the number of shares outstanding once such shares are issued. Their influence is confined to dynamic pricing through shares traded on the exchanges. Stock exchanges, their clearing institutions, and members and other intermediaries are exposed only to the price risk pertinent to the number of shares traded but awaiting settlement. They are not exposed to price risk of shares issued and outstanding.

Price risk changes affect stocks that constitute market capitalisation as well as those awaiting clearing and settlement. The exchange and its associated clearing house bear the risk of price changes pertinent to trades awaiting clearing and settlement. They do not bear the risk of price changes pertinent to stocks that belong to the portfolios of individual and institutional investors. A very large part of price risk in the stock market is borne by investors and not by stock exchanges and their affiliated clearing houses. The risk of viability of a portfolio is principally borne by investors and not by institutions related to the stock market.

Stock brokers merely effect transfers of stocks. The creation of new outstanding stock and the extinguishing of existing stock is not what is accomplished when members of a stock exchange execute stock transactions on behalf of investors. The viability of the number of shares outstanding is not determined by stock exchanges, their clearing institutions, trading members of stock exchanges and clearing members of clearing institutions. Therefore, stock exchanges can put to use simple structures such as settlement guarantee funds and trade guarantee funds to obtain adequate protection against credit risk and liquidity risk that arise from stock transfers effected by brokers. The simple structures are consistent with the economic fact that market capitalisation can exist and does exist outside the stock exchange.

In contrast, open interest in a commodity derivatives contract cannot exist outside of the commodity exchange that lists and trades the contract. Listing is the same as issuing a commodity derivatives contract. Recall that the OCC issues call and put options. Derivatives exchanges produce the instruments for investment and then extinguish them. The only investments in a futures marketplace by longs and shorts are in its open interest in near and distant futures contracts. There is no open interest if an open position and its corresponding opposite side were not carried in the books of customers of an exchange. There is no open interest without a commodity exchange. Moreover, open interest represents investments in a finite-life asset. All futures contracts and futures options contracts expire at specified maturity.

Commodity exchanges, their clearing institutions and the members of commodity exchanges and clearing institutions collaborate in the creation and extinguishing of open interest in futures investments on behalf of investors. Open interest is dynamically and decisively determined by commodity exchanges, their clearing institutions, members and customers. The responsibility for sustaining the viability is borne by them. This responsibility is a result of the principal-to-principal relationships between customer and trading member, between non-clearing member and clearing member and between clearing member and clearing house. Hence, risk mitigation is fundamental to the achievement of the economic objectives of hedging. It is also fundamental to the business of a commodity exchange. It is not a discretionary accessory.

All risk pertinent to price changes that affect open interest is borne by clearing institutions associated with a futures exchange. The open interest in its entirety is repriced every day consequent upon mark-to-market and is prone to risk. Unlike the stock market where a very large part of risk prone assets is carried in the books of investors and with no impact on stock brokers, stock exchanges and their clearing affiliates, every part of risk prone open interest of a futures market is carried by its customers, trading and clearing intermediaries, and the exchange and its clearing organisation. There is more. Changes in open interest between two settlements are also a source of risk and this risk is borne by trading and clearing intermediaries, and the exchange and its clearing organisation.

Open interest of a futures market has more economic significance than market capitalisation of a stock market. The sustenance of each open position until expiry or voluntary liquidation is the task of a futures and options clearing organisation regardless of whether the clearing organisation clears commodity, equity, interest rate or exchange rate derivatives. If the viability of open positions in near and distant contracts is not sustained, hedgers and speculators would have no interest in a futures regardless of the merits of the contract design and contract specification, and the convenience and sophistication of the trading system and trade capture system. In the absence of a credible framework and an institutional process for supporting viable open positions, constructive efforts aimed at contract design, contract specification, trading system and trade capture would not automatically lead to the improvement of the commodity markets. Inappropriate clearing institutions have an adverse impact on the ability of exchanges to list finite-life assets. Once an exchange's capability in this regard is eroded, the exchange's future business in the creation and extinguishing of open interest in futures contracts is undermined.

Futures and options clearing organisations such as the BOTCC, the clearing division of the CME, Eurex Clearing AG, the LCH, the OCC and the SFECH have successfully sustained the viability of open interests of very large magnitudes. These magnitudes exceed the risk-prone transactions in the underlying commodity, debt, equity and foreign exchange markets by a large factor. Each of these institutions possesses features that are unique to the institution's history, economic environment and principal purpose. Several significant features are the outcomes of regulatory stipulations and influence. All institutions have a record of successful mitigation of credit risk and liquidity risk in the long term. This explains why experts in systemic risk management hold the view that standards more complete than those laid down in the Lamfalussy Report can be obtained from the close examination of futures and options clearing houses.

The successful modernisation of India's commodity futures markets rests on the establishment of clearing institutions and processes that are appropriately structured to support price discovery and hedging. India's stake in the effective management of price risk germane to agriculture commodities is very high. The magnitude of India's agriculture commodity economy requires policies that support large-scale risk management initiatives. India is a large production and consumption economy in the context of agriculture commodities. Such an economy would require more intense and widespread management of price risk as the process of liberalisation creates new economic opportunities and new challenges. The capacity to cope with price volatility would be determined by the cost effectiveness and efficiency in managing risk pertinent to open interests of a large magnitude. The FMC and the commodity exchanges should pursue risk mitigation, innovation and centralisation simultaneously.

Futures and options clearing houses have been in existence in the developed economies for more than seven decades. When the first futures clearing corporation was incorporated in Chicago in 1925, it had the objective of reducing credit risk and liquidity risk faced by participants in the commodity futures market. The economic role and the importance of clearing organisations associated with exchanges that trade derivatives contracts have since then grown exponentially because of the significant economic benefits they offer to users of the futures and options contracts and exchanges. Futures and options clearing houses have emerged as important risk mitigating institutions over the last three decades around the world.

Clearing organisations have propagated rapidly because of these benefits; they now serve the economic needs of the financial and commodity futures industry in a very significant manner. The emergence of financial futures has had an important impact on the clearing processes associated with commodity contracts. Clearing houses have been subjected to continuous innovation during the period of propagation and there is little difference now between the approach to risk mitigation pertinent to commodity derivatives contracts and the approach to risk mitigation pertinent to financial derivatives contracts. Therefore, the development and strengthening of clearing organisations associated with the Indian commodity futures markets would also be of interest and relevance to the banking and financial sector.

The economic reasons for the unceasing innovation and propagation of clearing houses are not complicated. Clearing houses are, by their economic character and structure, institutions that concentrate and centralise activities related to (1) the registering of obligations that result from transactions and (2) the settlement of obligations. The registration of obligations and the settlement of obligations are amenable to initiatives that exploit economies of scale and scope. Economies of scope and scale drive the business of clearing houses.

The concentration and centralisation of registration and settlement of obligations can be achieved in a number of ways. However, some processes of concentration and centralisation are more efficient than other processes. For example, netting of obligations is one of the principal steps towards the achievement of economic efficiency. However, there are several methods for netting. The processes and the objectives of netting have an unambiguous impact on the efficiency. Moreover, benchmarks for economic, commercial and technological efficiency have been dynamic. The dynamic pursuit of efficiency has required clearing organisations to subject themselves to continuous innovation. Clearing organisations of today offer selections from a service menu that includes trade acknowledgement, third-party contract valuations, third-party collateral management, netting arrangements, guarantees of contractual performance and surveillance of counterparties.

The centralisation of activities related to the registering and settlement of obligations enables market participants to seek and avail a common forum for entering into contracts. A commodity exchange is an example of a common forum for entering into standardised commodity contracts. The common forum enables buyers and sellers to pursue price efficiency. Since each buy-sell transaction requires registering and record keeping, each buyer and seller is better off if that service were provided by the commodity exchange. Every recorded obligation requires to be settled. If the commodity exchange enabled contracting parties to know who owes whom how much and when, they would be better placed to meet the obligations and to expend more time on the pursuit of price efficiency in their transactions. If the commodity exchange also enabled the contracting parties to receive dues in time, recipients would face little credit and liquidity risk. The mitigation of credit and liquidity risk requires all the other services or components of services typically rendered by a clearing organisation. For example, clearing organisations permit centralised record keeping of obligations and the settlement of obligations. Centralisation and concentration enable the emergence of scale economies.

Clearing houses provide scale economies of a large magnitude in the management of risks associated with credit and liquidity. Clearing houses also promote the centralisation of vital economic and transactional information; they improve the flow of information. They permit financial audits including those pertinent to taxation. Clearing houses and clearing organisations rely on reliable financial payment and settlement systems. They have promoted as well as taken advantage of the emergence of reliable financial payment and settlement systems to support transactions in commodity and financial futures. Clearing organisations have propagated rapidly because of these benefits. They have also been subjected to continuous innovation during the period of propagation.

Three factors have been critical to the initiatives of clearing houses aimed at innovation. First, clearing arrangements and activities associated with the banking sector and payment and settlement systems have undergone changes aimed at the considerable reduction of risk and improvement of reliability. The decline in risk pertinent to PVP and the increase in reliability pertinent to DVP have enabled as well as forced clearing organisations associated with futures and options exchanges to restructure their internal organisation and work flow. Second, commodity and financial markets continue to regroup themselves with the objective of competing where necessary and collaborating and co-operating where possible. With an almost exponential growth in the last decade and 2.2 billion futures and options contracts traded throughout the world in 1998, competition is stiff in the derivatives industry. The derivatives industry is composed of competing firms: exchanges, banks and brokerage houses offering and facilitating exchange trading and over-the-counter trading. In the reckoning of the Futures Industry Association (FIA), clearing houses are not in competition with other clearing houses. The regrouping of exchanges has in turn had an impact on the structure, governance, risk management protocols and affiliations of clearing houses. Clearing houses have had to ally with or merge with other clearing houses. Alliances outnumber mergers. Third, commodity and financial brokerages have laid significant emphasis on the reduction of costs borne by them and an increase in the utilisation of their capital. These business goals have had an impact on clearing member firms and clearing houses. All three factors have had a combined impact on the scale economies of clearing organisations and clearing members in the futures and options markets.

Futures and options clearing houses concentrate activities that would otherwise be performed by many participants in the marketplace. In the absence of clearing houses, participants would necessarily have to reckon with and manage risks associated with credit and liquidity on their own and, more importantly, through numerous bilateral relationships. In fact, contracting parties would have to record and then monitor all their bilateral receivables and payables by expending their own effort. If clearing houses did not exist, a broad and important range of activities currently performed by them futures and options clearing houses would be performed ineffectively and inefficiently, with a concomitant adverse impact on supply management and settlement of obligations.

Each clearing organisation, whether a division or department of an exchange or an independent corporation, accomplishes the critical steps towards first order centralisation and concentration of several functions related to registering, netting, assigning and settling obligations. First order centralisation refers to the process wherein participants in a single marketplace and often in a single commodity choose to effect all settlements through multilateral netting and depend on the credit risk of one single clearing institution. Market participants have come to depend on these services provided by clearing houses and clearing corporations associated with the exchanges. Moreover, market participants expect these institutions to be both responsive and cost-effective.

Towards providing the desired levels of responsiveness and cost effectiveness to clearing members and their customers, many global clearing organisations have shifted their focus to second order concentration and centralisation. Second order concentration and centralisation refer to the process wherein participants in multiple marketplaces and often in multiple commodities and contracts choose to effect all settlements through multilateral netting and depend on the combined credit risk of one or more clearing institutions. The combination may be in the form of an alliance, a joint venture, a merged entity or a working arrangement that allows mutual offsets.

Increased concentration of activities related to clearing and settlement and the pursuit of scale economies by clearing houses have been the principal results of the thrust on reliability, responsiveness and cost effectiveness. The emphasis on cost effectiveness and responsiveness has led to the increased reliance on the performance of a few clearing corporations and clearing houses. Where the clearing institutions are robust, the payoffs have been significant. The pursuit of robustness and cost effectiveness by clearing houses has promoted mergers and alliances among two or more clearing institutions in the world. Some of the mergers and alliances are also the results of mergers and alliances among the commodity and financial derivatives exchanges.

Regulators of derivatives marketplaces and banking systems have addressed the results of the increased reliance on a few clearing institutions. Regulators continue to address the potential results of the concentration of clearing and settlement activities and the increased reliance on a few clearing institutions. The apprehension of regulators is that the increased concentration and reliance may lead to the fragility of the financial system in general and the derivatives marketplaces in particular. This fragility, referred to as systemic risk, is usually viewed as the potential result of liquidity risk and credit risk of a magnitude sufficient to have an extreme and adverse impact on most participants and institutions.

Futures and options exchanges and their associated clearing houses have responded to these concerns with unqualified enthusiasm since exchanges and clearing houses have an economic incentive to mitigate systemic risk. Exchanges and clearing houses have collaborated with regulators of futures marketplaces, bank supervisory institutions, and central banks and monetary authorities to evolve programmes and institutional protocols aimed at mitigating systemic risk. Such collaboration has been pronounced since the late 1980s, in particular from 1987. The efforts at collaboration were redoubled after 1997. The interest and the involvement of central banks and bank supervisory institutions in the evaluation, even if not always formal, of clearing house processes stems from the large magnitude of financial derivatives contracts cleared by clearing houses relative to commodity derivatives contracts. For example, the BOTCC cleared a little over 700 million futures and options on futures contracts in 1999, of which over 550 million were financial contracts. BOTCC is an independent clearing institution that clears futures and options contracts traded on the CBOT and the MidAmerica Commodity Exchange. BOTCC is owned and capitalised by clearing members.

Other clearing houses such as the Sydney Futures Exchange Clearing House (SFECH), the LCH and Eurex Clearing AG are primarily in the business of clearing financial futures and options on futures. Options on futures are commonly referred to as futures options. The SFECH and the LCH clear commodity derivatives and financial derivatives. However, financial derivatives constitute the majority. Eurex Clearing AG clears financial derivatives alone. The experience of BOTCC, SFECH, LCH, Eurex Clearing AG and other clearing houses such as the clearing house division of the Chicago Mercantile Exchange (CME) has enabled a better understanding of factors that determine the reliability of clearing institutions. Their experience has also enabled monetary authorities and bank supervisory institutions to obtain guidance in forming regulatory standards for clearing houses pertinent to banking, payment and settlement.

Monetary authorities and bank supervisory institutions have benefited from the clearing houses' experience while implementing the standards laid down in the Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries for the Bank for International Settlements. This report published in 1990 is more popularly known as the Lamfalussy Report. The Lamfalussy Report established minimum operating standards for facilities clearing foreign exchange contracts and includes six standards.

Experts in systemic risk management hold the view that standards more complete than those laid down in the Lamfalussy Report can be obtained from close examination of futures and options clearing houses where credit risk is managed jointly with liquidity risk. Some experts assert that futures and options clearing houses address credit risk more completely than the standards laid in the Lamfalussy Report. Futures and options clearing houses have a long and successful history in managing these risks and therefore have provided an excellent guide for developing standards appropriate to other clearing systems posing similar risk concerns. The extension of exchange-style clearing systems to banking and the OTC markets is based on such standards. The standards and the extensions are aimed at making significant scale economies available to market participants without any adverse impact on the containment of credit and liquidity risk. Any failure in India to exploit the latent economies of scale and scope may be regarded as regulatory failure.

The fundamental nature of risk mitigation through clearing institutions and the sustenance of open interest imposes a responsibility on the FMC to catalyse the emergence of an appropriate framework. Both China and the US offer valuable clues to the FMC towards bearing this responsibility. China's success with the establishment and management of commodity futures marketplaces has been less than satisfactory. China's regulatory authorities have paid more attention to the establishment of commodity exchanges and the trading of contracts than to the establishment of clearing and settlement processes aimed at supporting open interest. The regulatory attention paid in China has not been commensurate with the size of its economy. In contrast, regulators in Australia, Germany, the UK and in the US have had a holistic approach to trading, clearing and settlement.

Germany's derivatives exchange, Eurex, does not trade commodity contracts. The magnitude of the commodity futures and futures options marketplace in the US exceeds those in Australia and the UK significantly. Australian and UK markets trade both commodity and financial contracts but the ratio of financial contracts to commodity contracts traded in Australia and the UK is very high. Therefore, the FMC may examine the holistic approach adopted by the two US regulators, the SEC and the CFTC. The policies of the SEC and CFTC pertinent to clearing institutions should not be viewed by the FMC as mutually exclusive policies.

The SEC is not associated with the commodity markets. It is usual to regard the CFTC as the most relevant regulator in the context of commodities. However, in the context of clearing institutions, the SEC has played a vital role in the establishment of the OCC. The structure and the organisational characteristics of the OCC should not be overlooked by the FMC. The SEC model requires equity options marketplaces to have their trades cleared and settled by the OCC. The OCC is the sole issuer of equity options contracts. The SEC's approach gives no freedom to exchanges to make their own arrangements for clearing. The OCC is the central clearing institution for equity options in the US. It is owned by the exchanges that trade equity options.

This model has been recommended by the L.C. Gupta Committee for the Indian equity derivatives markets. The L.C. Gupta Committee was constituted by SEBI. SEBI is the regulatory authority for the stock markets in India. In its 1997 report, the committee has made it mandatory for stock exchanges to agree to clear through a central clearing corporation upon the establishment of such a corporation. At the time of commencement of trading in equity index futures in June 2000 by two stock exchanges, there was no central clearing corporation. The Stock Exchange, Mumbai (BSE) and the National Stock Exchange of India (NSE) have chosen heterogeneous models for clearing. The former has adopted a system of unconditional guarantees in lieu of a formal complete clearing process. The latter has adopted a system of complete clearing.

The CFTC is associated with the commodity markets. The CFTC model allows commodity exchanges the freedom to structure their clearing institutions and arrangements. However, the CFTC has its regulation structured in a manner that they apply to contract markets and clearing organisations. Commodity markets in the US have exercised their freedom and structured their clearing institutions. They have not at any time examined seriously the economic merits and demerits of a central clearing corporation for commodities. Commodity and financial analysts and derivatives economists have often recommended the merger of the clearing processes of the CBOT and the CME. The CFTC has not made any such recommendation. The CFTC is the regulator for financial derivatives too. The CFTC's global prestige is determined by the prestige of the financial markets in the US. It is likely that the CFTC has thought that the long-term prestige of the US financial markets was best enhanced by allowing the CBOT and the CME to make their own clearing arrangements and not be constrained in their domestic and global competition. It is interesting to note that the CBOT has an alliance with Eurex and the CME has an alliance with the London International Financial Futures and Options Exchange (LIFFE). LIFFE and Eurex, the two principal European derivatives exchanges, compete for prestige and trading volumes in the global marketplace.

A common feature of all clearing houses is that they are under the supervision of regulatory authorities. This is in contrast to the Indian marketplace where there is no stipulation that traded contracts should be settled through one or more specified clearing processes. In the absence of a regulatory stipulation, the need for supervision of clearing houses does not arise.

Eurex, the only derivatives marketplace in Germany, predominantly trades financial contracts. Eurex does not trade commodity contracts. Eurex Clearing AG clears Eurex's contracts. Eurex and its clearing institution are supervised by the Stock Exchange Supervisory Division (Börsenaufsichtsbehörde) of the Ministry of Economics of the State of Hesse.

The LCH clears contracts traded on LIFFE, the International Petroleum Exchange (IPE), the London Metal Exchange (LME) and Tradepoint. The four exchanges own 25 percent of the equity of the LCH. Clearing members own the remaining equity. The LCH clears almost all derivatives transactions in the UK but does not enjoy the status of a statutory monopoly. Its status as a clearing house is recognised by the Financial Services Authority (FSA) of the UK.

The FSA's regulatory influence over the LCH and the LCH's global reputation for providing common clearing to three large global exchanges are of relevance to the FMC. An examination of the factors determining the choice of the LCH by the exchanges shows that exchanges that pursue efficiency in clearing choose to avail the services of an external clearing house that have achieved economies of scale and scope. The IPE and the LME are in direct competition with NYMEX. LIFFE competes with several exchanges for a share of the business in commodity and financial derivatives. The competition includes Eurex and NYBOT. The provision of clearing and settlement services by an independent and competitive clearing house such as the LCH boosts the competitive strength of LIFFE, the LME and the IPE.

Like Eurex, the Sydney Futures Exchange (SFE) is the only operating futures exchange in Australia. It provides facilities for trading in futures and options contracts to its members. Contracts are cleared by its wholly-owned subsidiary, SFECH. The SFE and SFECH are empowered by the Australian Securities Commission and are specifically charged with a duty, under Chapter 8 of the Corporations Law.

Unlike many developing economies, India has a long experience in operating and managing commodity futures exchanges. It also has a long, well-established tradition of regulating commodity futures exchanges. It now requires suitable infrastructure for managing credit and liquidity risk. The centralisation of the principal functions, the provision of responsive and cost-effective services and the mitigation of credit and liquidity risk are of importance to the Indian economy and the commodity exchanges. Indian commodity exchanges in general have yet to achieve the desired levels of centralisation and concentration of the critical functions related to registration, netting, assignment and settlement of obligations. Most single commodity exchanges have yet to achieve first order centralisation and mitigation of credit risk and liquidity risk.

The emphasis of the FMC should be on the achievement of first order centralisation and mitigation of credit and liquidity risk in single commodity exchanges. The establishment of clearing processes aimed at the mitigation of credit and liquidity risk in all commodity exchanges should be made mandatory. Sustaining the viability of open interest justifies this stipulation.

There are important exceptions to our observation that most single commodity exchanges have yet to achieve first order centralisation and mitigation of credit and liquidity risk. However, all the exceptions are results of the FMC's role as a catalyst in the recent past. Also, the exceptions do not possess the appropriate magnitude to have a favourable impact on those exchanges that have yet to achieve first order centralisation and mitigation of credit risk and liquidity risk. Those exchanges that have achieved first order centralisation and mitigation of credit risk and liquidity risk have yet to achieve cost effectiveness. Therefore, policies aimed at the modernisation of the Indian commodity markets should include first order centralisation and mitigation of credit risk and liquidity risk through cost effective means. The emphasis of the FMC should be on encouraging exchanges that have achieved first order centralisation and mitigation of credit risk and liquidity risk to pursue further economies of scale and scope and cost effectiveness. The pursuit of economies of scale and scope could be through the provision of clearing and settlement services to exchanges that require such services but do see significant economies in the production of these services.

Since Indian commodity exchanges and clearing organisations have yet to exploit the benefits of first order centralisation, they have an opportunity to combine the first stage of the evolution of clearing houses with the principal components of second order centralisation. Second order centralisation involves the establishment of a few clearing institutions that can clear and settle futures contracts traded on several commodity exchanges. Such centralisation is possible in the case of commodities in which futures trading has yet to commence.

Exchanges and their associated clearing houses that have achieved first order centralisation trade relatively fewer contracts and in lower volumes compared with similar exchanges in other parts of the world. Moreover, existing clearing houses are associated with exchanges that trade agriculture commodities with a low combined weight in India's total output of agriculture commodities. Many commodities including sugar, a range of edible oils and grains have yet to be traded on futures exchanges. The listing of more commodities with higher weights in production or consumption or both would require second order centralisation. The expansion of the customer base in India would also require second order centralisation. The emphasis of the FMC should be on using its regulatory objectives and insights to cause the establishment of a central clearing institution that is equipped and capitalised to provide the necessary clearing and settlement services for a range of commodities that are traded across the nation.

The creation and acceptance of the clearing house as the common counterparty is not predicated on the commodity contract that is traded. It is a function of the netting methodology and the efficiency that emerges from netting. The clearing house's role as a credit risk intermediary does not require any particular relationship with any commodity. A credit risk intermediary is similar to a banking intermediary since banks perform the role of a common counterparty to savers and borrowers, and banks do not normally benefit from narrow specialisation. Diversification of borrowers is a source of strength.

Since the functions of a clearing house and the particular characteristics of commodity contracts that the clearing house clears and settles do not have a tight linkage, the structuring of clearing institutions and clearing processes is not dependent on the commodities and the contracts. This explains why clearing institutions pursue economies of scale and scope. The homogeneity or heterogeneity of contracts cleared does not determine the core competence of a clearing institution. Efficiencies may be derived from clearing a range of contracts.

This explains why clearing houses such as the BOTCC, the LCH and the SFECH have developed clearing processes that may be broadly used for clearing and settling any commodity or financial contract. If they could apply their core competence on even one contract to derive the necessary and possible economies and efficiencies, they would. However, the magnitude of open interest and trading volume in any one contract is a function of several factors related to the contract and may not exceed a bound that results from the factors. The addition of new contracts for clearing and settling enables a clearing institution to achieve increased economies of scale and scope. This is the fundamental reason for clearing institutions to remain efficient and to pursue efficiency.

An exchange that operates its own clearing house has the same incentives to achieve increased economies of scale and scope. The achievement of such economies has a favourable impact on the net income of the exchange. However, to exploit the latent economies, exchanges would have to trade new contracts.

New contracts may be launched for trading with the same underlying commodity or financial assets as are currently traded but with new contract specifications and expiration months. An exchange that trades contracts with four expiration months – March, June, September and December – could change over to six expiration months: February, April, June, August, October and December. The launching of futures options is an example too.

New contracts may be launched for trading with new underlying commodity or financial assets that are different from those that are traded currently. The addition of one more commodity, say, a metal, by an exchange that trades another metal is an example. The listing of financial contracts by the CME when it was a commodity exchange is another example.

There are barriers to the successful listing of new contracts. While one or more exchanges have successfully launched new contracts, there have been many that have failed to expand their businesses through the launching of new contracts. The barriers to the launching of contracts with new specifications and expiration cycles in the same commodity arise from factors related to the economic interest in the new specifications and cycles. Futures contracts are standardised contracts. The addition to existing standardised contracts is often an attempt to meet specific or bespoke needs that lead to unsustainable customisation in the long run. The move from four contract months to six contract months, for example, spreads out interest and has the potential to make the introduction appear superfluous to the market as a whole though one or more users may benefit from the introduction.

The barriers to the introduction of contracts in new underlying assets are more pronounced in the case of single-commodity exchanges. The long experience in one commodity and the mutual form of ownership and management that reflect the specific commercial needs of participants in the market for that commodity are barriers to the exploration and evaluation of the addition of new underlying assets. The addition can be easy if exchanges are owned and managed by a general mercantile group with interests in many commodities or by professional investors. However, such ownership characteristics are precluded if the licence to operate an exchange is based on the mercantile group's specific interest and competence in a commodity. Almost all commodity exchanges in India are single-commodity exchanges and have been established through the efforts of mercantile groups with specific interests and competence in those commodities.

The prospects for the addition of new contracts with the same underlying asset in the single-commodity exchanges are not bright. The achievement of meaningful economies of scale and scope pertinent to their in-house clearing processes is difficult. Hence, the FMC should encourage commodity exchanges that have yet to adopt complete clearing (first order centralisation) through novation and interposition to ally themselves with other exchanges that have yet to adopt complete clearing to establish a framework for clearing.

Such a framework that involves centralisation would improve the transparency of the exchanges by routing all transactions through the central counterparty. Centralising the credit decision-making process can potentially mitigate the threat of systemic risk. Systemic risk arises from the possibility that failures may cascade owing to an implicit mutual reliance on the credit decisions of others. This is true of the commodity markets in India. The risk-reducing benefits offered by the presence of a central counterparty are contingent upon the credit quality of the central counterparty being at least equal to that of the most creditworthy participant.

The FMC may have other economic and regulatory objectives pertinent to commodity markets that may be pursued effectively by catalysing the emergence of a sound clearing institution. A clearing house is an important information node that can provide useful inputs for the management of the commodity economy and supply management. The clearing institution is a repository of contractual and credit information regarding commodities. It achieves significant economies by centralising the collection and storage of these data. These economies stem from the elimination of redundant collection facilities operated by counterparties in a bilateral system. In the absence of a central clearing facility, this information is spread across counterparties.

Centralisation enables better credit risk assessment. Better credit risk assessment of commodity market intermediaries and customers would enable other intermediaries such as commodity brokerages and co-operative and commercial banks to raise the efficiency of their businesses. The fact that the FMC has access to similar information and may wield its regulatory influence and power to cause the exclusion of one or more counterparties that pose a threat to other counterparties reduces the ex ante vulnerability of the marketplace. This enhances the vitality of the marketplace and its participants.

The creation of a central counterparty with the desired credit quality is of importance to the FMC and market participants. The financial strength of the clearing facility must be consistent with its financial duties. An important duty of a clearing house is to perform regardless of default by any of the counterparties that agree to novation. This duty is usually described as the clearing house's performance guarantee. The performance guarantee is associated with credit quality.

Therefore, the discussion of the creation of a central counterparty has to be necessarily preceded by (1) a comprehensive understanding of international best practices, (2) an analysis of clearing practices in India and (3) an unambiguous understanding of what is centralised, what systemic risk is mitigated, what performance risk is borne or guaranteed by a clearing house, and who the direct and indirect counterparties and beneficiaries are.

The global futures industry is confronting unprecedented challenges. Futures broking commission levels have fallen sharply in many markets, technology is creating new opportunities, but also significant threats. Alliances and links are being developed. The Globex alliance (CME, MATIF, Singapore, Montreal and Brazilian exchanges), the Eurex alliance (CBOT and Eurex) and the Nordic alliance (Sweden, Norway and Finland) are three examples. These alliances involve financial and/or commodity derivatives. Stock exchanges are merging with derivatives exchanges in Asia and Europe. In Singapore and in Hong Kong, the respective stock exchanges have merged with the futures exchanges. The LCH is integrating the exchange-traded market and the OTC markets through its clearing and settlement services.

Triggered by poor performance of many floor members of the futures markets, the direction of futures exchanges and clearing houses is in turmoil and no longer straight forward or guaranteed. Futures contracts over a period of time have become commoditised or standardised. Once this is achieved, technology steps in. This evolution has seen electronic communication networks (ECNs) transform futures markets. Brokers have found a way to execute their trades for a cost that is less than what exchange can provide by attaching their business to an ECN. ECNs are now contributing to the turmoil of the direction of the exchange.

While the future direction of international futures exchanges and clearing houses remains uncertain, two things are certain. First, change is a global phenomenon and India cannot exclude itself from the impact. Second, the progression in international clearing is not a result of design and prescience wherein each step was taken with full knowledge of the purpose and content of the remaining steps. No clearing house knew what the remaining steps were. At each stage of the progression, the transformation was complete. If all requirements had been known in one complete capsule, international clearing houses would have responded to them in one single step.

The most important advantage India has over the rest of the world is that its futures industry is in its infancy and the futures industry is well placed to learn from the international experience without having to replicate the progression and steps taken by international clearing houses. Our recommendations in this report are based on such an advantage.

When we study the international experience we can see a common thread of progression within each exchange and/or clearing house. Although there is much happening in the international futures markets, if we analyse the progression of each of the major international exchanges/clearing houses, we can identify common milestones that each of them have reached although this has been clouded by the timing and method of approach.

The progression that has characterised international experience need not be replicated by Indian futures exchanges and their clearing houses. Since the components of the progression have been tried and tested, a quick bypass is possible. A quick bypass is necessary if large scale hedging has to be made available to India's agriculture produce sector.

All international clearing houses started their clearing business by offering clearing services to support the local market. For example, the Sydney Futures Exchange commenced operating as an exchange for the local wool industry. The growth in financial futures saw new players enter the market. Financial markets became internationalised as markets were deregulated. Internationalisation brought increased volumes to most clearing houses. Clearing houses had to cope with increased volume as well as a wider product base. This put clearing houses in the public spotlight, which put increased pressure on their image. To maintain business and to pacify the market, clearing houses had to be seen as offering services of integrity with prudent risk management practices to gain market confidence. Such efforts characterised almost all clearing houses.

The first milestone towards upgrading and strengthening clearing functions was to adopt international best practice. What were the areas the international clearing houses set out to achieve international best practice? An understanding of the components of international best practice would be necessary for the FMC to assess the requirements and the recommendations pertinent to the NCCC.

The clearing houses' primary objective is to manage risk and therefore it was in the area of risk management that international best practices were first established. They then focussed on their weaknesses. When the international clearing houses upgraded both these areas to meet international best practice, it strengthened their clearing functions and improved the confidence of market participants. Clearing houses focussed their attention on five areas of risk: clearing member default, settlement bank failure, financial resources, operational risk and legal risk. International best practices pertinent to each of these are discussed first. The approach towards eliminating weaknesses is discussed thereafter.

There are two components of risk that are germane: credit risk and liquidity risk.

The clearing house has an obligation to clearing members on either side of the contract. Therefore if the clearing member were to default, the clearing house would replace the contracts by going into the market and purchasing or selling contracts identical to those on which the clearing member defaulted. The size of the replacement cost would vary from product to product and whether it is a futures or options contract and if an option, whether the premium is paid up front and passed on to the seller or whether the premium is paid in arrears.

A clearing house must fulfil its obligations to non-defaulting clearing members without delay so that questions about solvency do not arise.

In the event of default, the clearing house would look to the assets of the defaulting clearing member to meet any obligations however these assets may not all be cash. The investment of funds belonging to clearing members is the responsibility of the clearing house if clearing members capitalise the clearing house. (The FCCCI is an example.) Non-cash assets must be liquidated or pledged before the clearing house can meet its obligations and this may be time consuming and costly. Where assets are in foreign currencies, conversion of proceeds into the required currency may be necessary.

During market volatility, exchange-traded derivatives can have important implications for the management of liquidity risk. Daily average money settlements associated with exchange-traded derivatives are quite modest in absolute terms and, certainly, very small relative to money settlement in the money markets. However, peak settlement amounts are typically a multiple of the daily averages. Moreover, historical peaks have reached levels an order of magnitude larger than the daily averages. Most important, they have occurred during periods when financial markets undergo significant stress. The October 1987 stock market break is an example. During such periods, market participants tend to experience significant liquidity demands in the cash markets as well as derivative markets. Therefore the timely receipt of funds and securities between clearing houses and its members is critical. During such periods of market stress, the loss of an exchange's market liquidity or a delay in the completion of settlements could lead to systemic disturbances.

In addition, principal risks may exist if contracts provide for delivery rather than cash settlement and if a DVP mechanism is not utilised to effect deliveries. This is because clearing houses can incur large credit exposures on settlement and delivery days when the full principal value of transactions is required. The clearing house's role is to manage in advance the sequence of deliveries and payments and limit the risk by introducing asymmetry: the transfer of the asset from seller to the clearing house and the payment from the buyer to the clearing house. This requires providing clearing members with real time information on their deliveries.

The approach for managing counterparty credit and liquidity risks is for the clearing house to deal with only creditworthy counterparties. To do this, each clearing house has established a set of requirements for membership. Clearing houses impose financial and operational requirements for membership in the clearing house to manage the risk of clearing member default. Principal requirements are discussed.

Minimum capital requirements – often stated as the larger of a fixed amount and a variable amount that depends on some measure of the scale and risk of the firm's positions with the clearing house and in other financial markets - are imposed. In most cases, membership is restricted to regulated entities that meet regulatory minimum capital requirements. Clearing firms that carry client accounts are often required to meet capital standards that are more stringent than regulatory minimum requirements.

Compliance with capital requirements is often available only at monthly or quarterly intervals. It should be noted that the entire financial position of the clearing member cannot really be assessed without information on activities in other markets. Some clearing houses periodically review their members' access to funding, especially their bank credit lines, and members must be prepared to and be in a position to provide this information. Surveillance of members' positions on an ongoing basis augments monitoring during the reporting periods.

Clearing members must establish standards of operational reliability including the timely allocation of trades to accounts and ability to meet settlement obligations. Currently, there is much focus on a clearing member's disaster recovery procedures and back-up systems should their primary operating systems fail.

Care should be exercised; recommending stringent membership requirements could be counterproductive. It may increase clearing house risk due to the membership being limited to a small number of members that are able to meet the membership requirements.

Membership requirements in India: The efforts undertaken in India since 1996 to establish the FCCCI and the PCCCI (two independent clearing houses) and COFEI's clearing house division have overcome the principal flaws associated with many of the international models of membership and rules aimed at containing the risk of clearing member default. Indian clearing houses enable clearing members to invest equity in varying magnitudes. Clearing limits are set as a function of the magnitude of the direct investment in the clearing house. The efforts since 1996 support our view that India can bypass the various stages of evolution that international clearing houses have been through. Since the direct investment model does not impose any one homogeneous set of membership requirements, a paucity of high quality clearing members is most unlikely to afflict Indian clearing houses. The NCCC should reflect the model adopted by the FCCCI, the PCCCI and COFEI. The FMC and the NCCC may then focus on clearing members' disaster recovery procedures and back-up systems should their primary operating systems fail.

Two major independent clearing houses, the BOTCC and the LCH, are owned predominantly by clearing members. The most significant advantage of independent clearing houses is that they can provide clearing and settlement services to a number of exchanges. This reduces the operating costs of clearing houses and their clearing members significantly. Clearing members can through their membership in one clearing house provide clearing and settlement services in more than one exchange. The total outlay for the clearing members in terms of equity as well as margins would be much lower. In particular, a clearing house can apply cross margins across exchanges and contracts. Therefore, financial capital gets utilised more efficiently.

When clearing is through an independent clearing house, the capital of an exchange is not at risk. The funds of the clearing house are at risk. The funds of an exchange remain unexposed to the adverse effects of default risk. By combining trading and clearing operations, an exchange places its total capital at risk. COFEI is an example of an exchange that has exposed its total capital to default risk.

Margin Requirements

Margins collateralise current and potential future credit exposures and limit the build-up of such exposures by periodically settling gains and losses. The speed with which clearing houses can match trades and compute open positions enhances their capacity to monitor intraday exposures. Most clearing houses now have the authority to conduct intraday margin calls to manage intraday risk rather than relying on an end of day batch process.

All clearing houses impose initial margin requirements to provide collateral to the clearing house to cover potential future losses on open positions in both futures and options. Clearing houses require their members to separate their own account positions from their client positions and compute margin requirements separately. Margin requirements for own account and client accounts often differ in terms of the amounts required and the types of collateral accepted.

In addition, in the case of futures contracts, clearing houses nearly always impose variation margin requirements, that is, requirements that clearing members make periodic payments to the clearing house (and that the clearing house make periodic payments to clearing members) to settle any losses (gains) that have accrued on the clearing member's contracts since the previous variation settlement.

Clearing houses and exchanges in India have a system of initial margins and variation margins. The bye-laws of exchanges require clearing members to separate own account and client account positions.

In the case of option contracts, while few clearing houses impose variation margin requirements, most do not. In the most common approach which is termed as "options-style" or "premium up front" margining system, the buyer of an option contract is required to pay the option premium at the inception of the contract and is not required to post initial margin. The seller of the option receives the premium at inception and is required to maintain initial margin to cover the sum of the current market value of the option (initially equal to the premium) plus a cushion for potential

future increases in the option's market value.

By contrast, in a "futures-style" margining system, the buyer does not pay and the seller does not receive the premium up front. Instead, as in the typical case for futures contract, both the buyer and seller are required to post initial margin and are required to make daily variation settlements.

Futures-style margining periodically eliminates current credit exposures to clearing members through money settlements of any losses or gains arising from changes in market values of positions, while options-style margining collateralises current credit exposures to clearing members (the current market value of their positions).

The use of options-style margining tends to reduce the vulnerability of a clearing house to liquidity pressures. In a futures-style margining system, at each settlement the clearing house must pay out to its member's gains on outstanding open positions, while in an options-style margining system it pays out premiums collected as a result of new options sold. If a clearing member were to default, the clearing house would be faced with a shortfall and this shortfall tends to be larger under futures-style margining than under options-style margining. In addition the clearing house would liquidate margin collateral of the defaulting clearing member and the amount of initial margin tends to be larger under options-style margining because initial margin must cover current exposures (current market values) as well as potential future exposures.

Apart from the above, the issues would be similar under either style in the event of default.

The main protection against credit losses under either style of margining is determined by four factors.

1. The procedure used to determine the level of margin required, including the percentage of potential losses that the clearing house intends to cover and the reliability of the methodology it uses to estimate potential losses (Annex 2 contains details pertinent to margin methodologies.)
2. The price stability and liquidity of the assets accepted as margin collateral by the clearing house also determines the quality of the protection
3. The frequency and finality of settlements of initial margin deficits (surpluses) and variation losses (gains)
4. Real time position accounting – particularly being able to account for positions that have been executed and matched since the last settlement

Determination of open positions can be more difficult in gross margining systems because of the need to capture information on the effects of trades on gross open positions within the client account.

There is a balance between the risk reduction benefits of greater collateralisation and the opportunity costs that greater collateralisation imposes on members. Faced with this trade-off, most clearing houses have tended to set margins at levels intended to cover 95 to 99 percent of potential losses from movements in market prices over a one-day time horizon.

Because counterparty credit exposures on exchange-traded derivatives are determined by changes in market prices between settlements, the measurement of counterparty credit risks shares many common elements with the measurement of market price risk. Margin requirements are similar to the "value-at-risk" (VaR) estimates employed in market risk measurement in that the confidence limit, often 95 to 99 percent, and time horizon, often one day are critical parameters. The methodology used by the clearing house to measure potential losses is important as a weak methodology could produce coverage that is significantly less than intended.

The types of assets accepted as margin collateral by a clearing house affect the degree of protection against credit losses. The assets accepted typically include cash, short-term domestic government securities and, in many cases, some form of bank guarantees (for example, standby letters of credit) because they are liquid and can be sold quite promptly. The liquidity of bank guarantees is dependent on how quickly the contract enforces the bank to provide the clearing house with funds in the event of a default.

If the clearing house invests cash margins, it may take time to receive the funds depending on the term of the investment and the time the interbank transfer system can achieve finality. Longer-term government securities, other debt instruments and equities also are accepted fairly frequently, but the collateral value assigned to such securities is typically less than the market value by a percentage "haircut" that reflects the potential for the value of the security to decline. Such haircuts may need to be quite large if the value of the collateral is related to the value of the positions that it is supporting. The collateral's value would tend to decline at the same time that the value of the positions decreases. For example, if a short position in a futures contract or a put option were supported by collateral in the form of the underlying asset, a very substantial haircut would need to be applied.

Currently, many clearing houses accept collateral denominated in currencies other than the currencies in which the exchange's contracts (and therefore the resulting payment obligations) are denominated. In such circumstances, additional haircuts may be applied to the asset values to reflect the potential for exchange rate changes to diminish the value of the collateral.

Collateral in India: Clearing houses in India are very conservative. Most margins are in cash; all cash margins are invested in bank deposits that are very liquid. Since all margin deposits are in Indian rupees, many of the problems given above have no relevance.

The frequency of settlements is also a determinant against credit losses. Most clearing houses currently conduct one settlement each day. After the close of each trading day, the clearing house calculates initial margin deficits and surpluses, based on open positions as of the end of the day, and variation losses and gains, based on closing prices. Settlement of these obligations typically occurs early on the following business day, if possible before the opening of trading (depending if evening or overnight trading has been introduced).

Several clearing houses have introduced a second routine intraday margin call during the afternoon. Most other clearing houses have the authority to make intraday margin calls. In some cases, a margin call occurs automatically if market prices change sufficiently, for example, if a price limit has been reached. Some clearing houses have the authority to make selective margin calls to require settlement by some clearing members whose variation losses or initial margin deficits exceed some predetermined threshold.

Procedures that authorise prompt resolution of a clearing member's default through close-out of its proprietary positions and transfer (to a non-defaulting clearing member) or close-out of its clients' positions play a vital role in shoring the confidence of customers.

Clearing houses calculate margins based on a one day time horizon, i.e., one trading day. This assumes that a clearing house is able to take action to eliminate its credit exposure to a clearing member within one day from the last settlement.

In fact, most clearing houses have one routine margin settlement per day based on the positions and market prices at the end of the previous trading day. Therefore settlement losses and margin deficits due to change in open positions and market prices can arise from the period between the end of day T-1 through to the time of settlement on T+1. To reduce this period of risk, some clearing houses routinely conduct an additional intraday settlement on the afternoon of day T, while most other clearing houses have the authority to do so.

In the event of default, the clearing house would either close out their own account positions by offsetting trades on the exchange or assigning the contracts to non-defaulting clearing members at off-market prices determined by the clearing house. The margin collateral supporting those positions would be liquidated as soon as possible. If the last margin settlement was based on positions as of the end of T-1, margin may not have been collected on new positions created since that point in time, which could lead to losses that would exceed the value of collateral. Alternatively, if the exchange was perceived as being temporarily illiquid, the clearing house would have the discretion to delay liquidation of positions to avoid further disruptions to the market. Own account positions could then be hedged in other markets however, in this case, the basis risk would need to be assessed and managed.

Most clearing houses would seek to transfer a defaulting clearing member's clients' positions and margin collateral to other non-defaulting clearing members. Where the clearing member's default is caused by one or more clients, client positions and margins may also be liquidated. There are a few clearing houses that would close out clients' positions and liquidate margins even if none of the clients had defaulted on their obligations to the defaulting clearing member.

A summary of the above follows. Margin requirements are not intended to cover losses from all possible price movements and there may be a shortfall of cover. Although margin estimates are based on a one day time horizon, the clearing house may in fact require more time to close out a position in default. The defaulting member may have increased the size of its open positions since the last margin settlement. Online margining, as practised in India, prevents such an occurrence.

In any event, it is advisable for any clearing house to be part of and promote information sharing agreements where information on clearing member's large open positions is available to authorities and clearing houses. The establishment of the NCCC would enable the FMC to have all information pertinent to a clearing member's open positions in the exchange-traded markets.

A discussion of the maintenance of supplemental clearing house resources follows. Supplemental resources are capital, asset pools, credit lines, guarantees, or the authority to make assessments on non-defaulting members to cover losses that may exceed the value of the defaulting member's margin collateral and to provide liquidity during the time it takes to realise the value of that margin collateral. An assessment is a call for fresh funds by a clearing house from its clearing members who are not in default. Some clearing houses such as the SFECH have the authority to make assessments on non-defaulting clearing members. Failure by a non-defaulting clearing member to meet the assessment would push it into default. The LCH does not have the authority to make assessments on its clearing members.

There is always the potential that the defaulting member's collateral may not be sufficient to meet its losses. Therefore the clearing house has to rely on additional financial resources to cover the shortage and to provide liquidity during the time it takes to liquidate the defaulting member's assets.

These additional financial resources are usually provided by the clearing house directly or via a contingent claim on the clearing members by sharing the losses equally. This seems to have the effect of clearing members ensuring that the clearing house imposes stringent membership requirements and margin requirements.

The supplemental clearing house resources may be in the form of capital and reserves, clearing guarantee fund (collateral provided by members but controlled by the clearing house and managed separately to margin amounts), lines of credit arranged by the clearing house, member assessments and insurance policies. In most cases these financial resources may not be available to the clearing house immediately or within the timeframe required to settle payments.

Most clearing houses have adopted several self-insurance devices against losses that could exceed margin deposits. These protective devices vary in form and substance. Some clearing houses have more aggregate financial resources to withstand members' defaults than others. Major forms of self-insurance, in addition to clearing houses' own resources include clearing funds, parent-exchange guarantee funds and surety bonds for individual clearing members. Some clearing houses may rely on the financial backing and liquidity facilities provided by their shareholders, others rely on reserves, share capital and banking funds. Most US clearing houses have guarantee funds that are funded by contributions from clearing members. These contributions are related to the size of a member's positions, average margin requirements over a certain period of time or the member's level of capital.

Risk-based position limits refer to the maximum size of positions held by any one clearing member in relation to its capital. It is an important risk management tool in some clearing houses. (The FCCCI and COFEI impose position limits based on clearing member's capital invested in the clearing house.)

Almost all clearing houses impose some form of position limits on the number of contracts or the percentage of total open interest in a contract that a single client (or single clearing firm) can hold. In some cases, position limits are imposed by exchanges for the purpose to inhibit the ability of market participants to manipulate prices, particularly for those contracts with limited open positions or are non-speculative.

Clearing houses monitor clearing members' positions and have the authority to request clearing members to reduce any positions. The monitoring is part of a clearing house's risk management procedure and may apply position limits for individual contracts per clearing member and/or the aggregate of positions across all contracts per member, with the limit being proportional to the capital or net tangible assets of a clearing member. They are often referred to as risk-based position limits.

To limit the risk of private settlement bank failure, only the most creditworthy commercial banks are selected. In addition, some clearing houses have structured their settlement agreements with the banks to minimise the clearing house's potential losses and liquidity pressures in the event that a failure should occur. Specifically, the agreements provide that transfers between clearing members and the clearing house on the books of each settlement bank are effected simultaneously and are final, and that final transfers of funds between settlement banks are effected as soon as possible. Together, these steps can reduce substantially the amount and duration of a clearing house's exposures to any one settlement bank.

In some countries in which central banks are used, the clearing house could receive a provisional payment from a clearing member early in the day but have the payment unwound late in the day because the clearing member could not cover a net debit balance at the central bank. In the interim, the clearing house's credit exposure to the defaulting clearing member could increase substantially as a result of price changes or new trades that increase the defaulting member's open positions. Moreover, if the payment system does not settle until late in the day (when money markets tend to be illiquid) and the defaulting member owed a substantial amount, the clearing house could have considerable difficulty meeting the resulting liquidity pressures. The risk of liquidity problems could be quite significant if the clearing house does not clearly recognise the provisional nature of transfers in the payment system.

When private settlement banks are used as settlement banks, transfers on their books from clearing members to the clearing house may be final prior to transfers in the interbank payment system. However, transfers between settlement banks usually are not final until the central bank payment system achieves finality. Therefore, the clearing house is exposed to settlement bank failure from the time its account at a settlement bank is credited until the time the payment system achieves finality. In addition, if a clearing house's legal agreements with its settlement banks and clearing members are not drafted clearly, there is a potential for disputes to arise in the event of a default of a clearing member or of a settlement bank. It must be made clear when and under what conditions the settlement banks will make (or irrevocably commit to make) final transfers from clearing members to the clearing house. It also requires a clear understanding of when and under what conditions interbank funds transfers are considered final.

If a clearing house uses the central bank as the settlement bank and by using RTGS system, it will be able to reduce the duration of its credit exposures to clearing members and eliminate the spectre of unmanageable liquidity pressures from an unwind of a large payment late in the business day.

When margin exposures are collateralised by securities, consideration of risk has to be given to the time it takes securities settlement systems to permit final transfers of securities.

As noted previously, the use of the central bank as the settlement bank reduces or eliminates the risk of settlement bank failure. When utilising private settlement banks, legal agreements may shift the risks of failure to other settlement banks or to the clearing members.

The approach to managing private settlement bank failure consists of four components.

1. Establish strict criteria for the choice of highly creditworthy settlement banks
2. Use multiple settlement banks to diversify risk and supported by settlement agreements so as to shift the risk to settlement banks and/or clearing members
3. Use procedures that minimise the amounts and the duration of exposures to settlement banks and between settlement banks
4. Maintain supplemental financial resources to cover any losses or liquidity pressures from a settlement bank failure, as no margin collateral is available to offset losses

Clearing houses usually invest in highly liquid short term markets. Investments in such markets assist in risk minimisation. However, the clearing house does have exposure to the investment counterparties.

Clearing houses face credit, liquidity and custody risks through investing their financial resources and margin assets. To limit credit and liquidity risks, clearing houses establish standards for the creditworthiness of investment counterparties and limit investments to liquid or short-term instruments. Custodians should be selected carefully and their performance monitored closely. Deposits should be spread among multiple banks and securities spread among multiple custodians.

Operational risk is the risk of credit losses or liquidity pressures as a result of inadequate systems and controls, human error or management failure. The result would be that the clearing house is unable to monitor and control its market exposures or in the case of human error or management failure, the efficacy of its risk management approaches can be compromised.

The most fundamental safeguard to minimise operational risk is to establish backup facilities for processing, communication and power supply. Clearing houses generally have business recovery sites away from their main operations where processing can be transferred within a very short period of time and data stored. Data security to prevent fraud and unauthorised use of information should also be implemented to reduce operational risk.

Clearing members should also maintain similar standards to the ones outlined above. Some clearing houses consider operational capabilities in their membership requirements.

Once the backup infrastructure is in place, 'dry run' of business recovery procedures and systems should be tested regularly.

Appropriately trained staff and effective supervision will also minimise operational risk. The establishment of an internal audit group to review procedures and advise on segregation of duties is recommended.

In the event of a clearing member's bankruptcy, the most significant is the legal risk that the multilateral netting arrangement between clearing members and the clearing house would not be upheld under the national law. Clearing houses in many jurisdictions have been afforded special legislative protection to ensure that their netting is valid. Another significant potential source of risk is that bankruptcy administrators might challenge a clearing house's right to close out (or transfer) positions and liquidate (or transfer) a defaulting member's assets. Again, national legislation should seek to protect clearing houses from such challenges.

When the defaulting member has the bulk of its assets in a foreign jurisdiction, conflicts of law may arise that could cause difficulty for a clearing house.

Legal risks in India can be very significant and quite embarrassing. There is no national law that may be used to uphold multilateral netting. There is no national law to uphold a clearing house's right to close out a contract.

The financial integrity of futures and options markets depends on the robustness of their arrangements for clearing and settling trades. The Ad Hoc Study Group on Exchange-Traded Derivatives analysed clearing arrangements for exchange-traded derivatives in the G-10 countries and put forward a number of recommendations to strengthen clearing arrangements. They concluded that the integrity of exchanges was dependent on the robustness of their clearing houses.

The Ad Hoc Study Group identified three areas of weakness for international clearing houses to address:

1. Inadequate financial resources to meet losses and liquidity pressures from member defaults induced by extreme price movements
2. Lack of mechanisms to monitor and control intraday risks
3. Weaknesses in money settlement arrangements, including reliance on payment systems that entail the risk of unwinds of provisional funds transfers late in the day

The above three areas are very relevant to the Indian market.

For each area of weakness identified, the international clearing houses adopted policies to strengthen clearing arrangements.

"Stress testing" is aimed at identifying and limiting potential exposures to clearing members from extreme price movements and ensuring that the clearing house's financial resources are adequate in such circumstances. "Stress testing" is the selection of extreme price scenarios, that is, price movements not covered by margin requirements, and the simulation of potential losses and liquidity pressures that could result if such price movements led to a clearing member's default. Such tests can be used both to identify and to limit exposures to individual clearing members and to gauge the adequacy of the clearing house's financial resources. If the simulated credit exposures to one or more members approached or exceeded the amount of a clearing house's resources, it could either reduce the exposures (by requiring the individual members to reduce their open positions or increase their margin assets) or increase the size of its own resources. If the simulated liquidity needs exceeded available liquidity, the clearing house could require the members in question to post margin assets of greater liquidity or it could alter the composition or size of its own resources to provide greater liquidity. "Stress tests" also reveal weaknesses in options modelling techniques.

Enhanced intraday risk management through more timely trade matching, access to real time prices and clearing members' own account and client positions enables more frequent calculation of exposures. This develops the capacity to reduce intraday exposures through more frequent settlements and margin calls.

Position monitoring and large loss analysis of underlying client positions involves noting any delta equivalent positions in a particular contract as a percentage of net total open positions. If the position exceeds a trigger level or there has been a position movement greater than a trigger level, the underlying client or accounts are noted. To compliment this "delta equivalent" analysis and in order to consider the effect of large price movements similar to stress testing, large loss estimates for major clients of clearing members should be produced daily. Price movements equivalent to the full initial margin should be routinely used to generate the loss estimates with any potential losses greater than a trigger level noted.

Trend losses are settlements as a percentage of initial margins. Trigger levels are accumulated losses of clearing members. These should be monitored for the current month and the previous two months. Where accumulated losses for the current month and previous two months exceed a trigger, say, 50 and 80 percent of a clearing member's net tangible assets, then further investigation should be undertaken.

Settlements as a percentage of initial margins should be analysed for both the house and client accounts. Any percentage greater than the trigger level should be investigated. Such investigation would include detailed analysis of positions held with large potential losses assessed due to option positions.

The ability to undertake pre-trade risk analysis at a client or member account level is quite important. Potential losses should be compared to collateral held.

Pre-trade risk analysis is even more important in a screen dealing market. One of the problems facing a clearing house in a screen dealing market is setting and controlling limits. In an open outcry market, limit monitoring is far more manageable as the trade is not novated until it is confirmed. This could be some minutes after the trade is executed on the trading floor and the chit written out and the chit details entered into the allocation and confirmation system. Limit monitoring is also supported by trading pit managers who can watch traders on the floor. Trading pit managers can see which traders may be overextending their resources.

In a screen dealing market, the traders are 'faceless' and cannot be watched by pit managers. Also, the time of novation is when the trade is matched in the trading system. In most cases, the trading system is not owned by the clearing house and therefore the clearing house has very little control over implementing system limit caps. (The ownership of the trading system is an important issue that cannot be ignored by the NCCC. The recent efforts of the FMC to discuss screen-based dealing and the ownership of the dealing system are most appropriate.)

There is added complexity if the exchange trading system has the capacity to attach order routing systems. These systems allow clients to enter an order which can be routed to their broker and automatically sent on to the exchange trading system if it passes the criteria set by the broker. This straight through processing (STP) capability enables many orders to be transmitted and executed per second.

From the clearing house's limit monitoring point of view the above is very difficult to manage. The clearing house can impose clearing members to set limits for their clients. However, the clearing house has no real way of auditing the limits as these limits are set within the clearing members' proprietary order management systems. The clearing house can perform audits on the clearing member but this is well after the fact.

Therefore, limit monitoring may have their origins at the exchange or at the regulatory institution, but are related to the purpose and objective of clearing and settlement.

The strengthening of money settlement arrangements through the use of RTGS systems for payments and securities transfers and by clarifying settlement agreements with clearing members and settlement banks are important prerequisites for safety.

The ability to debit clearing member accounts on a real time basis intraday is very critical especially if there is insufficient collateral adequacy due to a change in price or open positions. If there were insufficient funds in the clearing member's account, then the trade would not be registered or novated.

Even after novation, a clearing system should continually perform revaluations on the portfolio to ensure that existing collateral held by the clearing house is sufficient and in the event of any large margin erosion, the clearing system would provide a warning mechanism and/or debit the appropriate clearing account.

The expeditious and composite adoption of international best practice standards by Indian commodity exchanges and their clearing houses, in particular by the clearing houses, is recommended. The FMC should benchmark, monitor and assess clearing operations and the structural capabilities of clearing houses by using the best practices followed by international clearing houses. This will serve the fifth purpose of the consultancy: to strengthen the capacity of FMC to assess the quality of clearing house operations and practices by the commodity exchanges. The standards set by international clearing houses, which are more or less operating monopolies in their respective economies, would enable the FMC to establish standards for the central clearing institution in India.

The principal characteristics of the functions related to the clearing and settlement of contracts in five commodity exchanges in India are discussed in this section.

The commodity exchanges:

• EICA, Mumbai

• Domestic and the International Commodity Exchange Division of IPSTA, Kochi

• COFEI, Bangalore

• International Castor Oil Division of the BOOE, Mumbai

• SBOT, Indore.

The EICA lists and trades cotton futures. The International Castor Oil Division of the BOOE lists and trades castor oil futures. The domestic and the international divisions of IPSTA trade black pepper. Hence both divisions are single-commodity divisions. The exchange is also a single- commodity exchange. However, the rules relating to membership, trading, clearing and settlement are different for each division. COFEI trades one grade each of Arabica coffee and Robusta coffee. Since the time we visited the coffee exchange, it has listed raw coffee contracts in both Arabica coffee and Robusta coffee. The SBOT lists and trades soybean and its derivatives, soy meal and soy oil. We visited SBOT when the exchange had not commenced trading. Trading commenced in February 2000. The SBOT's principal contract at present is the soy oil contract.

All five exchanges are oriented towards a commodity of their choice (known as single-commodity exchanges in India) and are in business with the economic purpose of facilitating trading and hedging in the chosen commodity. All exchanges enjoy a tight economic relationship with the commodity of their choice and the market participants of that commodity market.

With the exception of the domestic division of IPSTA, the commodity exchanges or their divisions have been in business for around two years. The BOOE and the EICA are old institutions. However, the International Castor Oil Division of the BOOE began operations in 1999. The EICA resumed futures trading after decades of inactivity.

The domestic division of IPSTA has been in business for more than 40 years. It has adopted a system of novation since the end of 1999; the system uses a settlement guarantee fund that has been approved by the FMC. The other commodity exchanges or their divisions, including the International Commodity Division of IPSTA, have had their rules pertinent to membership, trading, clearing and settlement approved by the FMC at the time of their inception.

Despite the near contemporaneous approval of the rules pertinent to membership, trading, clearing and settlement, the exchanges and the divisions are characterised by significant heterogeneity. Two examples underscore the heterogeneity.

The EICA has chosen not to effect formal novation in its contracting environment. The EICA uses ringing settlement but requires original counterparties to remain obligated if ringing fails. Cotton is a very important commodity in India. It is grown and processed in a dozen states; the physical market is spread across as many states. The decision to continue with ringing settlement when futures trading was resumed in 1998 supports our view that Indian exchanges work with very small estimates of dead-weight losses.

IPSTA chose to establish a clearing house based on the principles of demutualisation in 1997 when demutualisation had not become a dominant international theme for the structuring of exchanges and clearing houses.

The principal characteristics of the five exchanges and their clearing systems reflect significantly the clearing and settlement systems followed by most commodity exchanges in India. The other exchanges such as the jute, gur and potato exchanges have systems or such components that are quite similar to those that are in operation in the five exchanges.

The principal characteristics of the five exchanges are listed in Table 3 through 7. The comments and discussion pertinent to the characteristics and the significant international experience related to the structure, membership and management of clearing houses are the basis for the action plan. The action plan may be used to strengthen the present practices and to establish a single clearing house that may provide services to the commodity exchanges.

The clearing systems and the practices are analysed. The analysis is on 16 dimensions pertinent to the exchanges and one dimension pertinent to the FMC.

2. Novation

With the exception of the EICA, all the exchanges have novation as the cornerstone of their clearing systems. Novation became necessary when IPSTA was given the mandate to list and trade pepper futures contracts that could be accessed by participants in the international pepper market.

3. Online clearing

Where novation has been adopted, it becomes effective as soon as trades are matched after pre-trade processing. No commodity exchange in India has adopted screen dealing or electronic trading. Yet, online clearing of floor trades has enabled novation to become effective without the particular problems of unmatched trades.

4. Counterparty and commodity orientation

The FCCCI and the PCCCI are the counterparties to trades executed and cleared in the context of black pepper and castor oil. In the other exchanges, the exchange is the counterparty, though they have clearing houses that are structured and operated as divisions of the exchange. However, the bye-laws of IPSTA and COFEI require original counterparties to assume residual risk despite the existence of the clearing house as the common counterparty.

Each of the exchanges that has adopted novation accesses the services of a clearing house (either as a division or as a separately incorporated company) in a manner that renders the clearing houses specialised institutions oriented to a commodity rather than to clearing and settling trades of any exchange. This can be explained by the efforts of each of the exchanges to establish systems for clearing and settlement, even if some of the efforts are likely to be replaced by clearing houses that may clear contracts in more than one commodity.

However, the particular efforts of exchanges provide a useful input for the action plan. Commodity exchanges are unlikely to switch to clearing houses that may clear contracts in more than one commodity if such a clearing house is seen to be unresponsive to the particular needs of market participants related to that commodity in which the exchange specialises. The decision of the domestic division of IPSTA to establish a settlement guarantee fund instead of accessing the services of the FCCCI does not, however, fit such a view.

5. Extent of guarantee

Novation was regarded as a necessary feature of a futures exchange (futures contracts in commodities have yet to be described legally in India) when IPSTA was in the process of establishing a system of clearing house guarantee that could be accepted by global participants. In order to improve such acceptance, the FCCCI and IPSTA have implemented a system that obligates the clearing house to fulfil the obligations of a clearing member to a trading member or member without clearing rights. The protection of a trading member against the adverse impact of default by a clearing member was seen to be prerequisite for the integrity of the market, especially in the assessment of international customers.

The practice of the FCCCI, since then replicated by other exchanges and clearing houses in India, is significantly different from international practices. International clearing houses limit their obligations to clearing members who are not in default. The task of protecting customers of exchanges is the responsibility of the exchanges and is governed by the mission statements and oversight of the regulatory institution. However, the general perception in the Indian marketplace is that a clearing house is a guarantor to customers. This perception ignores the difference between risk that emerges in transactions involving counterparties and the bilateral risk that involves exchange members and their customers. The perception also ignores the difference between principal-to-principal relationships and principal-to-agent relationships. The former characterisation is more desirable than the latter.

6. Margin as collateral

All exchanges have a system of margins aimed at providing collateral that can be accessed in the event of default. All margining systems are quite rigorous. Margins as the first line of defence have total acceptance. There are exceptions.

The EICA and the SBOT use a system of free limits that do not require margin requirements to be met if positions do not exceed quantitative ceilings that are usually measured in physical terms rather than in monetary terms. Free limits based on financial deposits are inconsistent with the practice of providing good faith performance bonds that rise in proportion to open positions that induce risk into clearing and settlement systems. Moreover, when financial deposits that determine free limits are also used to act as supplemental resources or as determinants of the magnitude of risk-based positions that can be sustained on behalf of a clearing member by the clearing house, free limits lead to a weakening of the first line of defence as well as their utility as supplemental resources.

The reliance of cash margin is nearly universal in India. Warehouse receipts, bank guarantees and fixed income securities are rarely used in practice. While this is unambiguously biased towards continued liquidity of collateral funds, it may place nontrivial constraints on the total cash margin that clearing and other members can post. The reliance on cash margins is of advantage to commodity exchanges since interest earnings on margins accrue to the exchanges.

7. Online margining

All exchanges require members to fulfil margin requirements before trades can be accepted by the clearing house. Even in the case of exchanges that use free limits, online margining is adopted for positions that exceed the free limit.

8. Relevant position for margining

All exchanges, even those where free limits are in vogue, determine the magnitude of positions that need to be margined most conservatively. The magnitude of positions that need to be margined and the amount of margin that needs to be posted are higher than those determined using portfolio methodologies. The conservative approach to margining reflects the perceived utility of margins as not merely the first line of defence but also as the sole line of defence. The dependence on supplemental resources is a new phenomenon in India. The coffee exchange is in particular conservative despite the availability of supplemental resources.

9. Segregation of accounts and position limits

With the exception of the domestic division of IPSTA and the EICA, all exchanges require segregation of customer accounts and customer funds from that of members. The EICA provides no guarantee to any member and such segregation may have no significance since all risk is bilateral. In the case of the domestic division of IPSTA, the adoption of the settlement guarantee fund makes each member a clearing member. Under such circumstances, the aggregation of clearing member's own or proprietary trades along with customer trades into an omnibus account induces asymmetric risk and a situation characterised by moral hazard. A member can capture profits from favourable positions while losses from a loss-making position, if in excess of the member's settlement fund contribution, can be spread across other members. Moreover, IPSTA has a system of position limits that can be exceeded by posting incremental margins without having to provide supplemental resources.

10. Mark to market

All exchanges have a system of daily mark to market.

11. Settlement bank

All exchanges and their affiliated clearing houses use the services of one or more settlement banks. Settlement risks have been assumed away in the Indian economy. Such an assumption may be inappropriate in the future.

12. Demutualisation and supplemental resources

The FCCCI, the PCCCI and COFEI have been established on the principles of demutualisation that have enabled them to create a second line of defence against default. The value of the first line of defence is based on positions that can be margined and emerges from dynamic collateral. The value of the second line emerges from the equity invested by clearing members in the clearing house or, as in the case of COFEI, in the exchange. Contributing to the guarantee fund can enhance the value of the second line of defence. Some contribution to the guarantee fund is mandatory, as in the case of COFEI, and appropriations from clearing fees are added to the guarantee fund.

Demutualisation and unambiguous investments in funds aimed at supporting the clearing functions have been attempted boldly by these exchanges and this has obviated the need to depend on the measurement and audit of balance sheet variables. Such measurement and audit are part of contemporary international practice and are a must since clearing members do not commit equity funds aimed at ownership. The LCH is one of the principal exceptions. Clearing members commit equity to the LCH. The BOTCC is another example.

The thrust towards demutualisation, equity investments and clearing rights based on the value of supplemental resources is a desirable characteristic. The determination of the value of positions that can be cleared by a clearing member on the basis of (1) such investments and (2) the value of supplemental resources is also a desirable characteristic. However, there are significant and dangerous flaws in the models followed by the FCCCI and COFEI. The flaws are discussed after discussing the avenues created for banks and financial institutions to provide services as clearing members.

13. Banks and financial institutions as clearing members

The general disposition towards banks and financial institutions as clearing members is favourable. All exchanges have bye-laws that enable them to admit banks and financial institutions. The FCCCI has succeeded in admitting three banks. The advantages of well-capitalised clearing members with capital committed to supporting clearing is recognised by market participants. In our action plan, we have recommended the inclusion of co-operative banks as institutional clearing members.

The applicability of Sections 6 and 8 of the Banking Regulation Act, 1949 with regard to banks becoming institutional clearing members of a commodity clearing house for the purpose of novation and multilateral performance guarantee has been reviewed by the Department of Banking Operations and Development (DBOD) of the RBI. Banks may become institutional clearing members subject to the following conditions:

• Banks' role should be only to provide services of clearing of trades - that is, maintenance of records of trades executed by members, arriving at their net trading position at the end of the day, reporting these transactions to the commodity exchange or clearing house or both. Banks should not take up any exposure to a commodity on behalf of any member of an exchange.

• Banks should not undertake any trading activity directly or indirectly.

• Banks should ensure that their activities do not violate the provisions of Section 8 of the Banking Regulation Act, 1949.

• As regards equity participation of banks in clearing corporations, the proposals received from them would be considered on merits by DBOD, RBI.

Section 6 of the Banking Regulation Act, 1949, deals with the forms of business in which banking companies may engage. Section 6 has two sub-sections, I and II.

Sub-section I: In addition to the business of banking, a banking company may engage in any one or more of the following forms of business, namely... as in 15 sub-clauses (a) to (o). Sub-section II prohibits a banking company from engaging in form of business other than those referred to in sub-section I.

Sub-clause (e) of sub-section (I) of Section 6: Carrying on and transacting every kind of guarantee and indemnity business. Sub-clause (e) of sub-section (I) is of relevance to banks becoming institutional clearing members.

1. Clearing limits and liability of clearing house

The determination of clearing limits at the FCCCI and COFEI with reference to the value of supplemental resources and open positions is apt. Since the equity is invested in the clearing house, there is no ambiguity regarding claims in the event of a default. Moreover, direct capital invested in an onshore clearing house obviates the necessity to scrutinise cross-border legal arrangements regarding access to funds belonging to a clearing member in default.

Clearing limits may be set using net values of positions cleared by clearing members or by using gross values. Gross values would induce less risk than net risk. However, the risk to a clearing house is always from the net positions of each clearing member. This explains why clearing houses restrict the performance guarantee to clearing members.

The FCCCI and COFEI use net open positions. This is inappropriate and dangerous since the performance guarantee is extended beyond the level of the clearing members. Where the clearing limit of a clearing member is determined on the basis of the value of the net open positions cleared by that clearing member, as in the FCCCI, the danger that a clearing member would induce risks of a very large magnitude into the clearing system is very significant. Since net open positions may have a small value while either the long or the short positions can be considerable, the gross principal risk could be of a very large magnitude. However, in the case of the FCCCI and COFEI, the use of gross margining systems may mitigate such a risk.

The bye-laws of the FCCCI and COFEI provide for the usage of the funds of the clearing house to meet defaults. Such bye-laws may jeopardise the integrity of the clearing institution. Such bye-laws require instantaneous amendment.

(1) The extension of guarantee to trading members who are not clearing members, (2) the determination of clearing limits linked to the monetary value of net open positions, and (3) the authorised utilisation of funds from the clearing house in excess of the contribution by a clearing member are inconsistent with the objectives of a clearing house. The apprehension of the RBI in the context of the vulnerability of banks to risks of a large magnitude is justifiable.

2. Delivery and full value of contract at risk

Clearing houses and exchanges have been careful in accepting responsibility after a default by a clearing member. All responsibility is financial. The specification of financial responsibility is usually associated with the residual risk of price change, especially after a short has defaulted. Replacement risk, even when merely financial, under such circumstances can be considerable and may bankrupt a clearing member. With the exception of COFEI and SBOT, commodity exchanges have no processes aimed at eliminating such risk. The former uses certified warehouse receipts and a period of tendering when tenders by shorts may be made only through warehouse receipts.

3. Closing out and transfer of positions

Though all exchanges have bye-laws aimed at closing out positions of clearing members by the clearing house as well as positions of trading members and customers affiliated to clearing members, the bye-laws are not unambiguous. Similarly, the transfer of positions of trading members and customers affiliated to a clearing member in default to another who is not in default is also ambiguous. Such ambiguity militates against the continuity of hedges.

4. Risk containment and human resources

While margins and supplemental resources play a role in managing the adverse outcomes of meeting the obligations of a clearing house, no exchange or clearing house has a proactive programme that includes assessment of the likely risk and the potential changes in the liquidity and solvency of (1) clearing members and (2) the clearing house. COFEI is an exception.

5. FMC and bye-laws related to clearing and settlement

The FMC grants approval to commodity exchanges by a registration or a recognition that is determined on the basis of membership structure, and factors related to supply management. Novation, clearing and settlement, and the systemic risks thereof are not reckoned with while registration or recognition.

Section 11 (2) of the Forward Contracts (Regulation) Act, 1952 empowers recognised commodity associations, the official nomenclature for commodity exchanges, to make bye-laws pertinent to a clearing house. Exchanges may provide for the following:

• A clearing house for the periodical settlement of contracts and differences thereunder, the delivery of, and payment for, goods, the passing on of delivery orders and for the regulation and maintenance of such clearing house
• The number and classes of contracts in respect of which settlements shall be made or differences paid through the clearing house
• Fixing, altering or postponing days for settlement
• The terms, conditions and incidents of contracts including the prescription of margin requirements
• The making, comparing, settling and closing of bargains
• The regulation of fluctuations in rates and prices
• The limitations on the volumes of trade done by any individual member

The Forward Contracts (Regulation) Act, 1952 comprehensively covers and allows for all the functions included in the system view of the marketplace. Margins, settlement, price limits and position limits are covered comprehensively. However, novation is not spelt out, but it is certainly not disallowed. Similarly, novation has not been made mandatory. The Forward Contracts (Regulation) Act, 1952 empowers a commodity exchange to choose its method, subject to the previous approval of the Government of India, for making, comparing, settling and closing of bargains. Bargains here refer to transactions in commodity contracts. All forms of multilateral netting and novation are possible. Futures contracts require novation and commodity exchanges require clearing institutions.

In our evaluation, India is equipped well to establish a central clearing corporation. We have argued that India should opt for formal novation and complete clearing. The central clearing corporation should be the central counterparty to all trades on the Indian commodity exchanges. If the clearing house is the common counterparty, who are its counterparties? Are they the hedgers and speculators who buy and sell futures and options? Or, are they clearing members who are members of the central clearing corporation? These questions require answers since there is an assumption that clearing houses are counterparties to the final buyers and sellers of futures and options.

A clearing house's counterparties are its clearing members and clearing members are in general a subset of the exchange's members. Other trade counterparties, both non-clearing exchange members and customers of the exchange, must become clients of one of the clearing members, either directly or through another intermediary.

Clearing houses centralise risk borne by it as a common counterparty and then require clearing members to choose and serve the business needs of non-clearing exchange members and customers of the exchange. Since clearing houses centralise risk and then bear such risk, they play a role in selecting and admitting clearing members to the clearing house so that they become eligible for the multilateral netting processes and the performance guarantee offered by the clearing house. A principal-to-principal relationship best describes the relationship between the clearing house and its clearing member.

Clearing houses do not play any role in the identification and selection of these non-clearing exchange members and customers of the exchange. The responsibility of screening non-clearing exchange members is thrust on clearing members. The responsibility of screening customers of the exchange falls on clearing members and non-clearing exchange members. The shifting of responsibility to clearing members is consistent with the principles of decentralisation. It is also consistent with the principle of principal-to-principal relationship between clearing members and non-clearing members.

The clearing house and its clearing members typically have a principal-to-principal relationship. Thus, it looks to the clearing members for performance on trades for their own account and on trades for the account of their clients. Similarly, clearing members have a principal-to-principal relationship with their non-clearing member clients and other customers. Customers have the freedom to choose the non-clearing exchange members for executing transactions. Non-clearing exchange members have the freedom to choose the clearing members for clearing transactions. Thereafter, the responsibility of being the common counterparty is that of the clearing house but it is a common counterparty only to its clearing members.

The legal environment governing contracts and the role of the common counterparty affects the structure and performance of the clearing house. If a clearing house has to be a common counterparty to final buyers and customers, it would negate the principal purpose of enabling easy access to the futures markets by hedgers and speculators and the generation of unprecedented efficiencies in credit risk and liquidity risk management through multilateral netting.

Since the clearing house has to assess the credit risk of numerous customers, it would either have to invest in a very complicated and centralised infrastructure for assessing prospective buyers and sellers of futures. All prospective buyers and sellers of futures would have to subject themselves to a credit scrutiny by the clearing house even though their prospective investment in futures may not be known. Under such circumstances, the clearing house is unlikely to have an interest in more than a few customers. Even if it did, it would have to involve itself in managing payments and fund flows of a very large magnitude. This would impose on the clearing house an enormous amount of gross risk that would require a very large amount of collateral. The centralisation of risks pertinent to users of exchanges militates against efficiency in risk management.

There would be significant incentives to attenuate systemic risks if clearing houses are exposed to the credit and liquidity risks induced by clearing members, clearing members are exposed to the credit risk of non-clearing members and customers of clearing members, and non-clearing members are exposed to the credit risk of customers.

Clearing houses are in an advantageous position to internalise the risk imposed by clearing members, and by design clearing houses can control the risk induced by clearing members. The design of such a clearing house is discussed. Clearing members, more than the clearing house, are in an advantageous position to internalise the risk imposed by non-clearing members, and can control the risk induced by non-clearing members by the dynamic choice of non-clearing members and their operating practices. Clearing members and non-clearing members are in effect business partners; they are not counterparties.

Similarly, non-clearing members, more than the clearing members, are in an advantageous position to internalise the risk imposed by customers, and can control the risk induced by customers by the dynamic choice of customers and their operating practices. Customers and non-clearing members are in effect business partners; they are not counterparties.

Exchanges play a very effective role in admitting reliable members and this important feature is the bedrock on which clearing members and non-clearing members jointly provide access to customers of the exchange. Customers, say, A and B are the counterparties; the clearing house enables A's open position to remain viable despite B's default and B's open position to remain viable despite A's default. The clearing house enables the clearing member that carries A's open position to be protected from the credit and liquidity risk of the clearing member that carries B's open position. It does the same to B's clearing member. This is the essence of clearing.

We recommend the adoption of a sturdy and sustainable chain of responsibilities wherein the chain commences with the clearing house and ends with the clearing members. Our arguments above are aimed at emphasising the importance of pursuing simple and efficient structures that enable clearing houses to stand by their performance guarantee to clearing members in a centralised manner and then enable clearing members to choose, control and manage the risk introduced by non-clearing members and their customers. The latter component is based on the principles of responsible internalisation of the outcomes of decisions that are taken in a decentralised manner.

The centralisation at the top tier and the progressive decentralisation enable the unambiguous legal treatment of open interest and the termination of open interest. Legal requirements for terminating contracts are important. In a default situation, legal recognition of closeout netting greatly facilitates the termination procedure. It is usual for clearing houses to have the right to close out the positions of a defaulting clearing member. Clearing members have similar rights vis-à-vis non-clearing members. Non-clearing members have similar rights vis-à-vis customers.

The centralisation at the top tier juxtaposes all clearing members in a single risk mitigation vehicle. The ability of clearing members to cope with and control the risk introduced by non-clearing members determines the risk transferred by clearing members to the clearing house. Residual risk transferred by clearing members to the clearing house has to be borne somehow. These residuals are usually reckoned with after all other collateral such as margin is applied.

If the clearing member who has to receive a payment bears the loss, then the clearing house has no further economic role as a common counterparty. Clearing members would need unlimited resources to be in the business of clearing but other clearing members would take undue advantage of the resources.

If the clearing house bears the loss without imposing any penalties on clearing members, all clearing members would have an incentive to transfer residual risk. Clearing houses would then need unlimited resources to be in the business of clearing. All clearing members would take undue advantage of these resources. Moreover, it is unlikely that a clearing house can access unlimited resources.

The choice of the loss-bearing process lies somewhere between the two untenable alternatives. However, it is important to recognise that clearing members are the principal sources of risk to a clearing house. Their failure to manage credit and liquidity risks that characterise their partnership with non-clearing members is the sole cause of the transfer of residual risk to the clearing house.

Clearing facilities, therefore, define loss-sharing arrangements in order to allocate losses to clearing members. Loss-sharing arrangements alter the incentives of participants. Centralised loss sharing mutualises risk. There is an effective alternative with centralisation that demutualises risk. Thus, all participants of the clearing house have incentives to restrict the risk-increasing activities of other participants. Decentralised loss sharing diffuses exposure. Loss exposures are limited to those realised between immediate counterparties.

There is little ambiguity in the approach to loss sharing in the context of clearing members and non-clearing members, and non-clearing members and customers. Decentralised loss sharing is most appropriate.

There is no alternative to centralised loss sharing in the context of clearing members and the clearing house. Centralised loss sharing is a prerequisite for suppressing the propagation of liquidity and credit risk, the two components of systemic risk. Without centralisation, the efficiency gains of netting, novation and interposition would be lost. Centralised loss-sharing that mutualises risk usually results in the uniform allocation among clearing members of the right to introduce risk. However, not all clearing members, especially in the context of a common clearing house for two or more commodity exchanges, would need rights of equal magnitude to introduce risk.

Some clearing members may have to introduce more risk than others may because of the size of their clientele. Ex post, if they introduce more risk that results in losses, they face the same penalty as other clearing members who have introduced no risk. In order to obviate the asymmetry, limits may be placed on such clearing members. Limits may impose constraints on their businesses. Those whose businesses are small may not find the loss-sharing process fair since it imposes a penalty on them. The asymmetry of potential gains and losses in a mutualised loss-sharing system that allocates rights of equal magnitude to introduce risk is a deterrent to the participation of small farmer co-operatives, co-operative banks, and brokerages operated by farmers as well as large farmer co-operatives, large commercial banks and food processing companies as clearing members.

We recommend the adoption of a loss-sharing system that simultaneously achieves centralisation and demutualisation. Centralisation is inevitable. It also engenders a system that discourages the admission of financially weak clearing members. Weak clearing members are threats to a clearing house as well as to financially strong clearing members. However, financial strength is relative; so is financial weakness. Hence, an equity investment in the clearing house by clearing members achieves centralisation without any ambiguity regarding the financial strength of clearing members.

All clearing members are required to commit equity to the clearing house but the commitments need not be of equal magnitude. This enables clearing members to choose the level of commitment in a manner that enables them to signal their ability to manage residual risk. If the clearing house allocates the right of clearing members to introduce risk on the basis of their equity commitments, demutualisation is accomplished. Moreover, clearing members get the right to vote on all issues related to the management of the clearing house. Such a right is an imperative if the clearing house has the right to demand contributions from surviving clearing members in the event of unsustainable losses resulting from the default of another clearing member.

For example, the SFECH and the National Securities Clearing Corporation Limited (NSCCL) have the right to demand contributions from surviving clearing members in the event of unsustainable losses resulting from the default of another clearing member. Failure to contribute to the clearing house is treated as a default. In both the SFECH and the NSCCL, clearing members have no voting rights since the two clearing houses are wholly-owned subsidiaries of exchanges. The OCC is owned by equity and equity options exchanges. Clearing members of the OCC do not own stock in the OCC. Eurex Clearing AG, the NSCCL, the OCC and the SFECH do not enable clearing members to vote in the affairs of the clearing house. The OCC may be an exception but enough of an exception to be considered in the context of structuring a clearing house. Since the OCC is owned by exchanges that are owned by their members, it may be claimed that members of exchanges exercise control over the OCC. Since not all members of the exchanges are clearing members, our view is that clearing members share corporate influence along with others who are not clearing members.

We recommend a clearing house structure that enables clearing members to own equity and vote on that basis. Our recommendation that clearing members should possess voting rights in proportion to their equity investment in the clearing house is aimed at enabling small and large farms, firms and institutions in the commodity and financial sector to vote in managers who have an unambiguous incentive to protect the interests of diverse clearing members. The sustenance of open interest in commodity derivatives of a large magnitude requires a structure in which the principal risk intermediaries – clearing members - have the right to vote in proportion to the magnitude of intermediated risk.

The sustenance of open interest in commodity derivatives of a large magnitude requires a structure in which the principal risk transference institutions – the commodity exchanges – have the right to vote on issues related to the centralisation of risk mitigation. Since commodity exchanges and their customers are the principal beneficiaries of efficiencies in netting and systemic risk mitigation, they have a stake in the accomplishment of these. They can signal their stake in these by investing in the equity of the clearing house. The need to include commodity exchanges in the equity structure of the clearing house leads to the rejection of the BOTCC model.

We recommend the adoption of the LCH model in which the equity of the clearing institution is owned by derivatives exchanges and clearing members.

We have one more recommendation. In our examples relating to asset transfers, we have alluded to the role of warehouses and warehouse receipts. In our view, gained from numerous meetings with participants in the Indian commodity markets, there is a genuine expectation of transfer of underlying commodities consequent upon futures and futures options transactions. Most participants are of the view that warehouses and warehouse receipts enable (1) the combination of cash market positions with derivatives transactions and (2) the fulfilment of margin requirements. There are important synergies that customers, non-clearing members, clearing members and exchanges can achieve if warehousing corporations invest in the NCCC.

The establishment of an independent commodities clearing corporation - the NCCC - for clearing and settling commodity futures and futures options contracts is recommended. The NCCC should be a for-profit organisation owned by existing commodity exchanges, the proposed NMCE, warehousing corporations, the National Bank for Agriculture and Rural Development (NABARD), and institutional clearing members and trading-cum-clearing members. A board constituted by the equity holders should govern the affairs of the NCCC. The principal contents of the memorandum of association and the articles of association are given in Annex 3.

The NCCC should adopt formal and full novation and interpose itself as the counterparty to buyers and sellers of commodity futures contracts and futures options contracts. The NCCC's services and business capabilities should be made available to all commodity exchanges in India that seek the services of the NCCC. When found appropriate, the NCCC may assume a dominant role in clearing commodity and other contracts traded in the global markets.

There is considerable interest in the establishment of the NMCE for the trading of a range of commodity futures contracts. The establishment of such an exchange is most likely to create the necessary positive externalities that are in favour of hedging and price discovery on a very large scale. A very large magnitude of open interest is most likely upon further liberalisation of India's agriculture and agriculture produce economy. The expected magnitude of open interest drives the need for a very reliable clearing institution. Moreover, the establishment of the NMCE would catalyse the Indian economy's move towards hedging through exchange-traded contracts. The single-commodity exchanges would necessarily have to keep pace with these changes that are likely to be spawned by the NMCE.

Most commodity exchanges are characterised by inadequate capability to support the creation and maintenance of open interests of a large magnitude. The inadequate capability is a result of the overemphasis on margins on open positions by the FMC, and price and position limits. Commodity exchanges have accepted the margin regime because of its contribution to cash inflows. Margins from members are deposited by commodity exchanges in banks. These deposits earn interest in favour of commodity exchanges and interest is the most important component of operating cash inflows. The overemphasis on margins by the FMC and the acceptance by exchanges have obviated the need for the exchanges to develop skills related to credit and liquidity risk mitigation. Credit risk and liquidity risk are the two components of systemic risk. Most commodity exchanges lack the human resources and infrastructure to manage systemic risk. Open interest in these exchanges is of a very small magnitude.

The few exchanges that have developed adequate human resources and infrastructure to manage systemic risk face poor economies of scale. The open interest in these exchanges that have adequate skills has yet to become large enough to produce economies of scale. Their skills and resources may be combined and then augmented with external skills and resources to constitute the NCCC. The inadequate capabilities of some commodity exchanges and the under-utilised capabilities of a few exchanges point to the opportunity to establish a very reliable clearing institution.

Users of commodity exchanges with open positions in commodity exchanges are the principal users and beneficiaries of reliable clearing and settlement functions. Therefore, several models of clearing house architecture were evaluated with the objective of supporting their open positions in the existing exchanges and the prospective open positions in the proposed NMCE. These models have been tested for their ability to support the present and future clearing needs of the Indian economy.

Technology pertinent to the trading of cash and derivatives contracts has changed dramatically and is expected to do so once every two years or more frequently. These changes make irrelevant the investment of scarce resources in large exchanges with complicated infrastructure. Internet technologies have produced and will continue to produce new scale economies even among small user groups who collaborate to set up small exchanges using electronic networks. Internet technologies will also produce unprecedented economies of scope across clusters of small user groups and commodities. However, the need for efficiencies in payment netting and settlement of contracts will not become irrelevant among any of the user groups.

Among the international and domestic models of clearing house architecture, the model of ownership and capitalisation of the LCH is most suitable for the NCCC and for meeting the hedging needs of a large economy such as the Indian economy in which commodity exchanges are unlikely to merge their businesses. Technological changes and the emergence of new commodity exchanges would not adversely affect the suitability of the LCH model. The NCCC, modelled along the lines of the LCH, would be able to meet the clearing and settlement needs of a large number of exchanges.

Clearing houses are the specialist providers of payment netting and contract netting. They do so by first registering obligations and then settling them through very efficient processes that include novation and interposition. The LCH model with suitable changes qualifies as the most apt model. The proposed NCCC, if based on the LCH model, would serve the interests of exchanges, new and old. It would also enable clearing members to emerge as the principal components of the commodity futures marketplace that is forever in pursuit of efficiencies. Clearing members would include commodity brokerages.

The LCH model enables commodity exchanges and clearing members of commodity exchanges to own and control the process of clearing. Indian commodity exchanges' resistance to formal novation and the formal interposition of an independent clearing house as the common counterparty to buyers and sellers stems from the fear of loss of control and loss of income. Loss of control and loss of income are addressed.

Our model places control of the clearing institution unambiguously in the hands of exchanges and clearing members. It enables clearing members to reap the significant economic advantages of efficiencies generated by multilateral netting, novation and the mitigation of credit and liquidity risks. Commodity exchanges bundle the efforts related to membership administration, contract design, trading, clearing, settlement, and elimination of credit and liquidity into one composite fee-earning activity. Each component responds to scale and cost economies in different ways.

The unbundling activities related to clearing, settlement, and elimination of credit and liquidity followed by the repackaging of these activities into a vastly more efficient NCCC, would release economic surplus for meeting the costs of activities related to membership administration, contract design and trading. This would enable members of exchanges to pay exchanges such transaction fees that meet operating costs and the costs of their innovations aimed at staying in business. The NCCC is modelled in a manner that makes it an institutional ally of the commodity exchanges and clearing members, and a reliable business ally of market participants.

Several views were expressed during our field work that the clearing process established by the BSE and the clearing institution established by the NSE may be appropriate for the purpose of clearing commodity contracts. The National Securities Clearing Corporation Limited (NSCCL) is a wholly owned subsidiary of the NSE. A direct use of the BSE's process and the NSCCL is ruled out by the differences in the regulatory domain. Stock markets and commodity markets have different regulatory institutions in India. A replication of the two models is also not apt. The BSE model, which involves an unconditional guarantee of transactions, would induce inefficiencies and uncertainties of a large magnitude into the commodity exchanges and their clearing processes. The NSCCL model enables one exchange to own the clearing house and disallows ownership of equity and voting by clearing members. Both alternatives have been rejected in favour of the LCH model. The NCCC would be superior to any unconditional guarantee protocols and would enable risk-bearing clearing members to have control over the governance of the clearing process and institution.

Business relationships and technology have jointly determined the structure and scope of service providers in the financial and commodity markets. While numerous changes have made a significant impact on financial market transactions, many changes have not had any significant influence on commodity market transactions. It is true that the trading of cash and derivatives contracts in commodities has changed dramatically but the other activities such as clearing and settlement, and warehousing have not been impacted in a similar manner. They are least likely to be impacted in the future. There are two reasons. First, clearing and settlement involve numerous banks and a large amount of multilateral contract and payment netting across numerous market participants even if the participants use many public and private marketplaces. Clearing institutions continue to provide new efficiencies and there is no substitute for centralised institutional processes that clearing institutions apply to achieve multilateral netting. The technology applied towards multilateral netting would undergo change but multilateral netting would remain unaltered. Second, commodity markets essentially deal in physical assets though a large number of derivative instruments including warehouse receipts are traded in the intermediate markets. The physical nature of commodities requires physical storage and the final markets involve physical exchange of commodities. Multilateral contract netting through clearing houses, perhaps on a global scale, and final markets that involve physical exchange of commodities are immune to changes in technology, especially technology pertinent to trading.

Upon an examination of 16 possible linkages that bind commodity exchanges, clearing houses, banks, warehousing companies, commodity market regulators, and customers, trading members and clearing members of commodity markets, we observe that six linkages are determined by commodity exchanges. Four are determined by clearing houses and six by warehousing companies. Therefore, there are 10 linkages that are immune to the technology used for trading commodity contracts. These 10 linkages are related to warehousing, and clearing and settlement. Therefore, decision-makers who focus on investments in commodity market infrastructure and technology should give priority to clearing and settlement, and warehousing. This would enable commodity exchanges to take advantages of investments in clearing and settlement, and warehousing. They would then be able to invest in new trading technologies.

The 16 possible linkages may be viewed in another manner. Only four linkages are driven by clearing houses. Twelve are driven by commodity exchanges and warehousing companies. Therefore, we have quite intentionally not added our detailed recommendations pertinent to the technology that may be used to link the NCCC to the commodity exchanges and the sites of warehousing companies. However, since the NCCC would be more effective if it cleared matched trades, we recommend the adoption of real time matching of trades at the exchanges so that clearing members and then the NCCC can register the trades. A bird's eye view of the technology is given at the end of this section in order to dispel any apprehensions commodity exchanges may have regarding their preparedness to use the NCCC's clearing and settlement services.

There are several benefits that would accrue to the Indian economy if the NCCC were established to provide centralised clearing and settlement services to users of commodity exchanges across the country. The four principal benefits: (1) cost

savings through standardisation and the elimination of duplication, (2) reliable and improved management

of systemic risk, (3) centralisation of information flows for better monitoring by the FMC and better supply management at the national level, and (4) increased confidence and a better perception of market

integrity by avoiding customer confusion over the different

safeguards at the commodity exchanges.

The majority of the commodity exchanges would not lose control over novation and interposition since these exchanges practice settlement by ringing and do not use formal novation and interposition. In fact, they would gain control over novation and interposition of the clearing house as the common counterparty since they would be shareholders. Moreover, members of the exchanges would also be shareholders of the NCCC. Representatives elected by clearing members will make the necessary decisions in the

interest of those whose capital is at risk. Our model envisages a majority of the equity capital to be invested by clearing members.

There would not be any adverse impact on the ability of commodity exchanges to compete with one another. Commodity exchanges in India, with a few exceptions, are monopolies that do not compete with one another. Therefore, exchanges that have invested in modern clearing infrastructure would lose little if they provide clearing and settlement services to other commodity exchanges. The other commodity exchanges would lose little by receiving services from those that have invested in modern clearing infrastructure. One reason clearing organisations are not a source of competitive

advantage is that financial integrity in the commodity markets is a step

function. A marketplace and its clearing organisation either have

integrity or do not have integrity. In any case, a clearing organisation derives its business from clearing and settling contracts in general and not from any particular contract. From such a perspective, the viability of most single-commodity exchanges would be enhanced if the exchanges choose to clear and settle their trades through the NCCC.

Clearing organisations are natural monopolies. Their principal purpose is to provide services related to payment and contract netting, and to interpose themselves as the common counterparty in transactions. Payment netting and contract netting are related and are amenable to economies of scale and scope. Once clearing houses achieve economies of scale they cannot

meaningfully distinguish themselves from one another. The NCCC can fill a vital need by

developing a structure that maximises the benefits of

financial integrity, minimises the cost of transacting business through standardisation and allows a true partnership with commodity exchanges and clearing

members.

Given such a purpose, the establishment of the NCCC would have no adverse impact on the ability of commodity contracts to introduce new contracts. Commodity exchanges compete on the innovations in contract design. Contract design has no meaningful impact on payment and contract netting. All payment netting is in the currency in which the contract is denominated. All contract netting is in the asset that underlies the contract.

Therefore, the FMC may bestow upon the NCCC monopoly status in a manner that reflects the FMC's commitment to the sustenance of futures open interest of a large magnitude. The OCC of the US has such a status and clears all equity options contracts that come under the regulatory purview of the SEC of the US.

The NCCC's status as a monopoly is, however, not a prerequisite for the strengthening of the clearing and settlement process but it is most desirable. Even if the NCCC is not granted the status of a monopoly, it is likely that clearing members who become members of the NCCC would refrain from becoming clearing members of another clearing corporation. Clearing members are the principal drivers of competition in the business of clearing and to be in competition they require financial and human resources.

A single central clearing corporation such as the NCCC would enable clearing members to avoid duplication of deployment of financial and human resources and to meet the composite needs of customers most effectively and efficiently. The sustenance of open positions is a capital-intensive operation. Clearing and settling open interests created on several exchanges through one clearing corporation conserves capital resources, operational resources, managerial resources aimed at risk mitigation and, above all, regulatory resources. Our motivation for recommending a monopoly in an era of vigorous competition should therefore not be viewed with suspicion.

At the operating level, all clearing houses in the global marketplace are monopolies or near monopolies. Clearing members compete at the structural and operating levels. A for-profit clearing corporation such as the proposed NCCC would inspire heightened competition among profit-oriented clearing members and make available efficient and cost-effective clearing and settlement services to the commodity exchanges, and their members and customers. Such profit orientation aligns the interest of exchanges too and enables the appropriate centralisation of performance guarantee at the level of the clearing house and the appropriate decentralisation of performance assurance at the level of the exchanges, clearing members, non-clearing members and customers.

The institutional framework adopted by global clearing houses enables them to guarantee performance to clearing members because clearing members are part of the clearing institution. Clearing houses are not equipped to provide guarantees to those outside of the institution. In our model, the NCCC's counterparties are its clearing members. The NCCC's performance guarantee applies to NCCC's clearing members since the NCCC would not play any role in the selection of non-clearing exchange members and customers of the exchange. Clearing members screen potential non-clearing exchange members and then accept them as constituent members whose trades they then agree to clear. Clearing of the trades of constituent member follows such an agreement. The shifting of responsibility to clearing members is consistent with the principles of decentralisation.

Since the responsibility is shifted to the level of clearing members, only the obligations between the clearing house and its clearing members remain. Each set of obligations between one clearing member and the clearing house can be represented as the net of the open positions cleared by the clearing member. Therefore, we recommend the restriction of the NCCC's performance guarantee to the net and not the gross open positions cleared by each clearing member. Estimated requirements of capital and the sources of capital to support the performance guarantee are included in Annex 4.

Indian commodity exchanges and the FMC have purposefully embarked on the internalisation of governance and risk within commodity exchanges, and clearing members of commodity exchanges and clearing houses. The focus of the FMC on such internalisation is of considerable importance to the NCCC's governance and mitigation of risk. In our evaluation, the initiatives that characterise the new exchanges and clearing houses are extraordinarily contemporary in nature and can be extended in scale and scope. For example, the FCCCI assigns clearing limits that are based on the magnitude of equity invested in the FCCCI. Clearing members of the FCCCI take part in its governance since they are its equity holders. A commodity exchange, IPSTA, is an equity holder of the FCCCI. The FCCCI was incorporated in 1996.

The model of governance proposed for the NCCC reckons with the magnitude of equity invested in the NCCC by the commodity exchanges, the clearing members and other equity holders. Clearing members alone would be eligible to clear contracts. Commercial banks, co-operative banks, financial institutions, commodity brokerages and members of commodity exchanges would be eligible to seek clearing membership. The magnitude of equity invested in the NCCC and other funds would determine the open interest that may be cleared by a clearing member.

In order to encourage the emergence of clearing members with a national reach to customers of commodity exchanges, our model does not bind clearing members to particular commodity exchanges. In particular, we recommend that commercial and co-operative banks, financial institutions and commodity brokerages accredited by and registered with the FMC should be allowed to clear the contracts of any commodity exchange. However, they would have to be members of those exchanges. Exchange membership would make available the appropriate machinery for arbitration pertinent to trading members (non-clearing members) and clearing members.

The NCCC may also be established by merging the interests of commodity exchanges and clearing members in FCCCI, the PCCCI, the EICA, the SBOT and COFEI. This would enable clearing members to possess national reach to customers of commodity exchanges and to maximise the utility of their equity and guarantee fund investments aimed at possessing clearing rights.

Clearing members would have to nominally assign invested capital and other funds to the exchanges whose contracts they clear. The nominal assignment is not permanent and may be reviewed and reallocated periodically. Such aggregate allocation by clearing members to an exchange would determine the aggregate open positions of that exchange that can be cleared. The equity investment by a commodity exchange would not automatically provide it access to nominal capital for clearing open positions and supporting open interests.

Trading volumes and open positions of commodity exchanges and their trading members would be determined by their institutional clearing members and trading-cum-clearing members. Therefore, we expect commodity exchanges in India and their trading members to adopt such policies that continually enhance the economic attractiveness of the exchanges to clearing members. These policies may include a switch to screen-based or electronic trading. The NCCC would be designed to accept matched trades for clearing. Electronic trading makes possible the easy, instantaneous and reliable clearing of trades.

In the section on multilateral netting we have argued that the institution of a settlement guarantee fund with an unconditional guarantee as a substitute for formal novation and the interposition of the clearing house is an avoidable excess. However, we do not expect all commodity exchanges to shift to formal novation through the NCCC. One or more commodity exchanges are likely to practice ring netting with novation but without interposing a clearing house as the common counterparty. They would overcome residual and resultant risks with an unconditional guarantee of contractual performance by the exchange. The competitive dynamics rather than the merits of novation and interposition by a clearing house may drive such decisions.

However, the FMC can use its regulatory influence to provide the right economic incentives to commodity exchanges to choose novation and interposition. In order to provide the right incentives to commodity exchanges, which are monopolies in the commodities that they trade, to shift to clearing through the NCCC, we recommend the preservation of their monopoly status only if such exchanges choose to adopt novation and interposition through the NCCC.

Margins have played a dual role in the Indian commodity exchanges. They have provided the necessary base for incomes to the exchanges. They have also acted as the first and sole line of defence against default. There is a great likelihood that the incomes of commodity exchanges of exchanges that choose to clear through the NCCC would decline when members' margin deposits begin to earn interest income in favour of the NCCC.

We expect the most resistance to the NCCC and central clearing on account of the expected decline in incomes. To provide a level field, our model advocates deposit of margin rather than payment of margin. Any cash margin deposited by a customer, trading member or clearing member would earn interest in favour of the owner of the deposited margin. We believe we have avoided a transfer of wealth from exchanges to the NCCC. Moreover, the interest earnings would enable users of exchanges to pay appropriate transaction fees to maintain the exchanges' operations and capability to innovate. It is pertinent to recall that we have avoided a collective transfer of control over clearing operations from the exchanges to the NCCC.

Margin may be posted in cash, warehouse receipts, bank guarantees and approved securities by customers, trading members (non-clearing members) and clearing members. The posting rather than the payment of margin obviates the need to formally impose the separation of funds belonging to customers, trading members (non-clearing members) and clearing members.

Margin funds including liquid and easily accessible collateral should remain in the individual accounts of customers, trading members (non-clearing members) and clearing members. These accounts would be held in clearing and settling banks. The accounts would facilitate holding cash, warehouse receipts and approved securities by customers, trading members (non-clearing members) and clearing members. The same principle of segregated accounts should be used for managing accruals and obligations resulting from marking to market.

Contractual agreements would enable trading members to have a lien on customer funds and liquid collateral. Similarly, clearing members would have a lien over trading members' funds and other collateral in the event of default. The clearing house would have a lien on clearing member funds, liquid collateral and equity shares in order to meet the obligations of a defaulting clearing member. The lien over liquid collateral is of considerable importance and creditors should be able to recover dues without any delay, trivial or otherwise. We recommend that at least a fourth or more of applicable margin be deposited in the form of cash that can be accessed by creditors instantaneously.

Simple linear margins based on long positions and short positions in futures are most suitable for managing risks induced by clearing members into the NCCC. Margin methods that are based on portfolio methodologies of risk assessment have yet to gain ground among most market participants. Moreover, these methods are aimed at taking advantage of any negative covariance in commodity prices. Our empirical analysis points to significant positive covariance; there is little advantage to be derived from portfolio methodologies. The NCCC may use VaR and other proprietary portfolio methodologies such as SPAN and TIMS after at least two years of operations though it should prepare itself and its clearing members for these methods. In particular, the empirical infirmities of VaR disqualify it for application by the NCCC during the initial years. Futures-style margins are recommended even after futures options become legal.

The application of simple non-portfolio margining methods for collateralising risk of non-performance for each commodity across contract months requires and allows no further netting across commodities. It also offers a significant risk measurement and risk management opportunity to commodity exchanges to take advantage of the efficiencies of a central clearing corporation without losing control over the magnitude of credit risk and liquidity introduced by other exchanges and their trading members (non-clearing members) and customers.

We emphasise that the model that we have recommended for defining the scope of performance guarantee centralises systemic risk management at the level of clearing house and its members. It simultaneously enables and requires exchanges and their clearing members, non-clearing members and customers to adopt decentralised risk management.

Such a facility and requirement is consistent with the basic logic of settlement of obligations at the level of an exchange. The sum of mark-to-market gains (losses) of all long open positions in an exchange should necessarily equal the sum of mark-to-market losses (gains) of the short open positions in that commodity and contract month. In the context of both mark-to-market gains and losses and gains and losses consequent upon final settlement, a buyer in an exchange, say, a hypothetical tamarind exchange, would pay to or receive from a seller in the same contract month in the tamarind exchange. The bought and sold positions should be for tamarind. This applies then to other contract months, all commodities traded on the exchange and to the exchange. Hence, there is no net outflow from one exchange to another nor is there any inflow. The only linkages relate to clearing members. Each commodity exchange is an island.

The performance guarantee of the NCCC enables each clearing member to overcome the credit risk and liquidity risk pertinent to other clearing members regardless of which contracts they clear and the exchange on which the contracts are traded. This insures that no clearing member would face credit and liquidity risk because of default by another clearing member. Therefore, a clearing member may default only because of the member's own-account activity and that of non-clearing members and customers of one or more commodity exchanges to which the clearing member has nominally assigned capital. A clearing member would not default because of the member's affiliation to the NCCC. A clearing member has complete control over its own activity and that of its constituent non-clearing members and their customers. Yet, if a clearing member were to default despite such control, its default would not spread to other clearing members of the NCCC. The NCCC and its resources act as the firewall. The firewall avoids the spread of a payments contagion from one clearing member to another.

Each exchange is an island in the context of systemic risk. The potential for payments contagion is eliminated by the guarantee provided by a solvent and liquid clearing house. Therefore, each exchange is enabled and required to manage the credit risk and liquidity risk of its non-clearing members and customers. The emergence of the NCCC does not make redundant the commodity exchange in performing its most vital function.

Basic numerical illustrations followed by algebraic modelling and formal stress tests show that a settlement guarantee fund with an unconditional guarantee to counterparties offers no protection against contagion. A settlement guarantee fund with an unconditional guarantee amplifies liquidity risk in the event of even a small disturbance in money settlement and payment. The amplification of liquidity risk in turn has the potential to trigger high levels of credit risk across exchanges. A settlement guarantee fund with an unconditional guarantee has all the necessary ingredients to promote a payments contagion or cause a gridlock in payments if the settlement guarantee fund, regardless of its magnitude, is used to guarantee the performance of contracts traded on more than one exchange. In the case of one exchange, the size of the fund required to offer the guarantee is extraordinarily large.

A solvent and liquid clearing member of the NCCC poses no credit risk and liquidity risk to non-clearing members of an exchange. To reinforce the gains from eliminating the possibility of a contagion, we recommend the netting of contracts so that an obligation in one exchange may be cancelled against another obligation in the same exchange but not with another obligation in another exchange. Such netting would apply to payments and asset transfers.

Money settlement and payments constitute a very important component of futures marketplaces. Money settlement and payment bring futures marketplaces and their participants close to the banking system and perhaps make many of the internal operations of the clearing house dependent on the banking and payments system. Such dependence is not an outcome of the role played by banks as clearing members. It is the fundamental nature of marking to market of futures contracts to produce cash flows aimed at securing performance.

We recommend that all clearing or settlement banks, whose role is well entrenched and understood in the Indian commodity futures markets, be part of the RTGS system to be established by the RBI. The presence of one or more institutional clearing members with the additional responsibility of playing the role of a settlement bank would enable individual commodity exchanges to avert contagion.

The RBI is aware of the need to organise an efficient funds transfer mechanism to cover a large branch network spread over a vast geographical area. Its technological and organisational focus is on providing payment services to the Government and the financial markets. It is also aware of the need to build a safe and technologically efficient payment and settlement system to cater to the needs of the major financial centres. We recommend the inclusion of commodity market centres in the plans of the RBI.

The RBI and the banking sector in India have jointly set up a satellite-based network using VSAT technology, named the Indian Financial Network or INFINET. INFINET, supported by terrestrial lines, will provide the basis for integrating the banking system and enable the delivery of electronic services to a number of financial centres. INFINET has been commissioned in part and should enable the commodity futures markets to take advantage of its safety and efficiency.

The RBI's approach towards payment system reform has shifted from a purely technology oriented perspective to a more holistic approach. The RBI has initiated a great deal of adjustment by the banking and financial sector, including upgrading of the payment and settlement systems. Changes in the legal and regulatory infrastructure, and structural reforms in the telecommunications policy have been effected to meet the requirements of the financial sector. The development of electronic RTGS and integration of all the major financial centres in a single national network are the goals of reform. Some of the reforms may have to reckon with the needs of the commodity sector.

The development of RTGS systems is a response to the need for sound risk management in large-value funds transfer systems. Since the NCCC would be the central clearing institution for commodities, we expect clearing members to be paying out and receiving funds of a large magnitude. The RTGS systems can offer a powerful mechanism for limiting settlement and systemic risks in the interbank settlement process, because they can effect final settlement of individual funds transfers on a continuous basis during the processing day. In addition, RTGS can contribute to the reduction of settlement risk in securities that are used as collateral and when the lien over such collateral is exercised.

The introduction of RTGS is an important objective of policy in India. This would provide a high degree of certainty to important inter-bank payments and would, from the perspective of the RBI, provide the necessary safeguards by lifting the duration of inter-bank credit exposure. This would also enable more efficient linkages with government securities settlement and provide concavity between major financial centres. In our recommendations pertaining to collateral, we have included Treasury securities. The settlement of claims when these securities are used as collateral would be made certain and instantaneous. The implementation of RTGS in India can have a major impact on the commodity futures market and the NCCC.

Banks maintain current accounts with the RBI at 15 of its offices spread over the country. At these centres, the banking clearing house is managed by the RBI. Major commercial banks serve as agents of the RBI in other parts of the country where the RBI does not have an office. The RBI's 15 offices and those of other major commercial banks serve the settlement needs of over 300 commercial banks with about 64,000 branches and 2,300 co-operative banks throughout the country. That is a major source of strength to the NCCC. The RBI will settle RTGS transactions through the current account of the banks. It would be appropriate for the NCCC to effect the fulfilment of mark-to-market obligations among its clearing members through the current accounts of these banks.

The principal components of the above guidelines on ownership, operations and bye-laws are necessarily a part of the regulatory approach to the management of clearing institutions. Annex 5 permits a comparison of the above with the regulatory requirements in some major economies of the world.

Clearing institutions are principally aimed at the management of systemic risk. Regardless of whether they clear financial derivatives or commodity derivatives, their principal role and purpose is to provide devices and processes aimed at averting the adverse outcomes of credit and liquidity risks. Credit and liquidity risks are common to financial and commodity markets and this explains why derivatives clearing houses such as the LCH have significant expertise to clear financial derivatives or commodity derivatives. The characteristics of the contracts have little impact on the clearing institutions and the technology used by them.

We have argued that intra-exchange payments have no impact on the NCCC and that all such intra-exchange payments have a material impact only on clearing members. We have also argued that inter-exchange payments are driven solely by clearing members of the NCCC and not by the NCCC. However, the NCCC's integrity is predicated on the liquidity and solvency of its clearing members and the integrity of the clearing members vis-à-vis other clearing members is predicated on the NCCC's liquidity and solvency. The implementation of RTGS in India would have a major impact on the liquidity of the NCCC. Hence, the technology to be used by the NCCC should focus on its clearing members, their payments to the NCCC, their receipts from the NCCC and the measurement of their solvency and liquidity. All other components are subordinate to this principal requirement.

We recommend a system wherein clearing members effect clearing on behalf of the NCCC, a typical example of a principal-to-principal relationship, at the exchanges. Clearing should be effected in a distributed manner; it should not be centralised at the NCCC. That is, clearing members should effect onsite clearing. We expect them to clear matched contracts as is done at COFEI and IPSTA.

Each constituent commodity exchange may choose what is apt for its members and customers. Exchanges could continue to trade on the floor or migrate to electronic trading. Clearing members who effect onsite clearing need to integrate their operations with that of their non-clearing members in such a manner that they jointly act with the objective of providing timely collateral and fulfilling mark-to-market obligations.

A centralised technology solution is required to enable clearing members to nominally assign capital to commodity exchanges, to provide timely collateral to the NCCC and to fulfil mark-to-market obligations. These three objectives require data processing, information transfer, measurement and financial flows. Issues related to financial flows have been addressed. The remaining may be effectively met through the application of Internet technologies so that any clearing member in any part of the country can be linked to the NCCC's processors. A typical trading and matching engine needs speeds and bandwidths of a very high order. The NCCC does not enable trading and matching. It merely registers matched obligations. Therefore, the existing bandwidth resources are adequate to support data processing, information transfer and measurement. We emphasise that technology is needed to link clearing members to the NCCC. The success of the centralisation of commodity clearing in India is not a function of the technology applied by the commodity exchanges towards the trading of futures contracts.

Clearing houses use different systems to calculate margin requirements. These systems can be divided into two categories: risk-based systems and systems based on a fixed percentage of the contracts' values. Standard Portfolio Analysis of Risk (SPAN) and Theoretical Intermarket Margin System (TIMS) are the most common risk-based systems while many European clearing houses have developed their own proprietary risk-based margin systems. The Japanese and many of the clearing houses in the Asia-Pacific region use margin systems based on a percentage of the contract's value.

SPAN or Standard Portfolio Analysis of Risk is a margining system developed by the Chicago Mercantile Exchange (CME) in 1988. Since its introduction, SPAN has become the most widely adopted margining system in the international futures industry. It has the benefits of being able to calculate the initial margin pertaining to an entire portfolio, which may include positions on more than one exchange. In calculating these risk performance bonds, SPAN performs inter-commodity spreading as specified by the clearing house. Since inter-commodity spreading may be both intra- and inter-exchange, a concept called an 'exchange complex' is a feature of SPAN e.g. the CME is an 'exchange complex' by itself. The Chicago Board of Trade and the Mid-America Commodity Exchange are two exchanges, which are part of the same 'exchange complex'.

The success of SPAN stems from its effectiveness in matching initial margin requirements to risk. By using a set of pre-determined parameters set by the Clearing House, SPAN assess what the maximum potential loss will be for a given portfolio over a one-day period, and matches the level of initial margin to cover this risk. In calculating the amount of margin required, SPAN recognises the unique characteristics of options while also taking into account other factors such as inter-month and inter-commodity spread relationships.

Another benefit is a feature of combined commodities. Sometimes clearing houses define two or more commodities, which are treated as one for initial margin calculations. To deal with this situation, SPAN applies the combined commodity feature where every regular commodity can be part of one and only one combined commodity.

SPAN is not tied to any particular currency. A portfolio to be assessed using SPAN may contain combined commodities in which requirements are in a variety of different initial margin currencies. In a single-currency mode, all combined commodities for that clearing house meet initial margin obligations in the native currency (parameter driven) and share the same ratios of initial to maintenance margin requirements. In multi-currency mode, all combined commodities for that clearing house meet initial margin obligations in various currencies and different ratios of initial to maintenance margin. Of the two modes, multi-currency is more flexible because it allows different ratios of initial to maintenance margin within commodity groups. Single-currency mode is being phased out by the CME as the multi-currency mode adequately covers it.

The use of SPAN is considerable benefits to the futures and options market as it provides results which more accurately reflect the true risk of positions held. SPAN is a flexible calculation tool in that it allows the clearing house to establish and review the parameters that determine the risk coverage in each market. The use of SPAN also allows a clearing house to be standardised with internationally accepted portfolio based margining methodology whilst increasing the attractiveness of a market to international investors who are already familiar with SPAN.

Unlike other margining systems which make risk assessments based on individual positions within a portfolio, SPAN considers how the value of an entire portfolio of options and futures will respond to changes in futures (or underlying) prices and volatilities. The SPAN algorithm calculates worst case loss scenarios on a contract portfolio adjusting this loss for the net premium cost or benefit from liquidating any option positions and then adjusting for any offsetting profits generated by closely correlated portfolios in other contracts.

In calculating the profit or loss a portfolio will make, SPAN uses 16 'what if' scenarios where futures prices and volatilities are altered to varying degrees.

The 16 scenarios form a 'risk array' which is calculated by the clearing house at the close of trading on each business day. The clearing house produces a file called the SPAN risk parameter file, which contains a risk array for each future and option contract. It is important to note that the risk array is calculated from the perspective of a long position, i.e., being long the instrument rather than being long the market. When calculating the margin of a short position, this array will be multiplied by the appropriate negative number of contracts. The risk arrays summarise how each future and option reacts to the scenarios. These arrays contain simple gains and losses, denominated in dollars or other currencies. The risk arrays are then applied to the selected portfolio of transactions, with the individual risk arrays being aggregated by scenarios. The largest loss (represented by a positive value) across the 16 scenarios becomes the SPAN margin for that portfolio. This figure is known as a Scanning Risk and forms the first and key element in the initial margin calculation. This figure is then adjusted for inter-month margins, inter-commodity concessions and spot month isolations. That is:

Total Initial Margin = Scanning Risk + inter-Month Risk - Inter-Commodity Spread

The above is suitable where the option premium is payable in arrears. In the case of the option premium is payable up front, the following applies:

Total Initial margin = Net Option Value (premium) = Scanning Risk + Inter-Month Risk - Inter-Commodity Spread

To assist members and clients with information on SPAN, a PC-based SPAN calculator developed by the CME known as PC-SPAN can be used. SPAN risk parameters files for many clearing houses can be obtained electronically from the CME Information Service on CompuServe.

In summary, comparing SPAN to other systems:

• SPAN handles a wide range of products in markets around the world
• SPAN's open and modular design gives each organisation control over its system
• SPAN simulations recognise complex profiles for options and other derivatives
• SPAN recognises key risk factors that other systems may miss
• SPAN allows flexibility in setting coverage levels and recognising risk offsets – other systems that recognise offsets only through scanning loses flexibility and recognise offsets only through correlations loses accuracy with options
• No other exchange margining system handles such a wide range of products and no other exchange system is so widely used in production for both clearing and customer requirements
• SPAN recognises non-linear risk profiles and it routinely considers the impact of changing implied volatilities
• Real-world systems must generally handle large positions in a number of complex products under severe processing time constraints. As a result, all systems make trade-offs between theoretical perfection and operational necessity. SPAN starts by handling each commodity separately. It then forms allowable inter-commodity spreads, and calculates a credit for each inter-commodity spread. This allows a great deal of flexibility in setting coverage rates for each inter-commodity spread.

TIMS examines the total positions held for each clearing member's account including own account, market-maker's account and clients' accounts and measures the 'cost' of liquidating that total position given assumed changes in the price of the underlying securities. A dollar risk figure is calculated and this becomes the risk margin requirement for that account or portfolio. TIMS calculates margin requirements for portfolios containing equity, index, and currency options as well as futures and options on futures for ICC, and the cross margined products included in the various cross margin programs. It supports 'European', 'Capped', 'American' and customised style options. TIMS uses the Cox-Ross-Rubenstein pricing model for all options and futures products cleared at OCC and ICC. Features of TIMS include:

(i) Class Groups/Product Groups

All options and futures for the same underlying security are placed in into the same class group and all class groups where the underlying security shows a close price correlation are placed into the same product groups.

This enables a margin requirement to be established for the whole position in these class and product groups.

Note: The lack of perfect correlation between class groups means that only a specified amount of the margin credit of one class is available to reduce the potential margin requirement in another class group.

(ii) Margin Interval

OCC and ICC set the maximum one-day movement – up or down – which can reasonably be expected based on ongoing statistical analysis. The statistical analysis takes into account the daily price changes over the last one to ten years. The margin interval provides two end points between which TIMS will calculate the greatest potential loss (at 20 price points up and 10 points down).

(iii) Asset Valuation

Securities held as general collateral against margin requirement (See below) are valued on a daily basis with reference to the market price.

(iv) Minimum Portfolio Margin

This is an optional feature within TIMS whereby TIMS will assess an absolute minimum additional margin requirement at the product group level for series net/contract month net long and short options and futures held within a product group. This is not an additional add-on margin as ordinarily calculated but solely an absolute minimum additional margin requirement. In the case of long options with a value of less than 1/8th of a point per contract (OCC's policy parameter), the minimum will be the long option value.

(v) Short Option Adjustment

This is an optional feature within TIMS which accounts for the potential risk of deep out-of-the-money option positions. Should the market conditions change, the deep out-of-the-money options could quickly be in-the-money and pose a risk. This is more probable close to expiration.

(vi) Spread

TIMS spread logic uses direct dollar for dollar spread offset for credits which can be used to offset debits within a class group because of 100 percent correlation. This spreading or netting can also be applied between product groups. The amount of offset between product groups depends on the degree of correlation.

(vii) Inter-month Spread Charges for Futures

TIMS allows spreading of futures contracts. TIMS will spread net long futures in a contract month against the net short futures in another contract month. Spreading is accomplished before additional or risk margin is calculated. Spread rates are assessed to the spread futures and the remaining long or short futures only are considered when calculating risk margin.

(viii) Spot Month

Applicable for certain ICC cleared futures time spreads.

OCC's calculation of the margin requirement through TIMS is supplemented by the ConMon system, which quantifies market risk for each member's position in various scenarios and measures risk in relation to capital adequacy. Risk limits are established and a member's exposure analysed by quantifying risk on a wide range of potential volatility and price assumptions. Staff of the OCC analyse members' positions using real time data pertinent to positions and prices. A clearing member close to its own specific risk limits must post higher margins, increase capital or reduce position size.

The OCC has made available the RMS system that is similar to ConMon to assist members to manage the risks of their clients and to evaluate their positions in securities, options and futures.

Most clearing houses have begun to assess potential changes in option values through the use of option pricing models which take account of non-linearities and also account for other sources of changes in option values, notably changes in the expected volatility of the price of the underlying asset, by performing full revaluations of option values at different values of the underlying asset and the underlying's volatility. Many clearing houses use SPAN developed by the CME or TIMS developed by the OCC or variants of one of these methodologies.

Cross margining refers to the process where two or more clearing houses agree to allow positions on another exchange to be used as collateral to meet the margin requirements of common clearing members. While it is primarily discussed in relation to equity contracts it can equally apply to interest rate or commodity contracts (or even between exchange traded and OTC products).

Currently the cross margining between the clearing house division of the CME and OCC represents the global benchmark for cross margining arrangement. Under this arrangement proprietary, non-customer and market maker accounts are eligible for cross margining. Cross margining is applied to those products, which have the same underlying asset or where the underlying assets show significant price correlation. Further, as similar risk based margining methods are used by the CME and OCC (SPAN and TIMS respectively) the technical complexities of combining both methods are significantly reduced.

A participant must be a clearing member of both clearing houses and is required to establish cross margining accounts at both the CME & OCC. The member appoints either the OCC or CME as the 'designated clearing organisation' that then becomes responsible for margin calls on cross margining accounts. Positions eligible for cross margining are allocated to the cross margining account and the positions are passed daily between the two clearing houses so they can calculate the initial margin on the combined position. In the original cross margining arrangements, the initial margin was the average of the two clearing houses initial margin calculations. This process has now been streamlined so that for any given group of accounts or contracts either one of the clearing houses calculates the margins.

Cross margining is an intuitively appealing concept. The following list is meant to provide some perspective on the potential benefits of cross margining:

• A potential reduction in clearing member and client initial margin requirements (and consequent savings in credit exposures and interest haircuts) without increasing the risk profile of the clearing house

• A potential reduction in the regulatory capital requirements for holding derivative positions for clearing members of multiple markets

• 24-hour trading potential

• A potential improvement in the security position of the clearing houses because of the 'collateral equivalent' of the cross-margined positions. This is because the offsetting positions will continue to offset each other even where market movements exceed initial margin levels. For example, in a stock market scenario, the losses on a bought equity position would almost be completely offset if it was cross margined with a put position on the same equity

• The potential for reduction in systemic risk in times of high market volatility because 'winning' and 'losing' trades are directly settled between clearing houses without passing through clearing members or clients

• A potential reduction in the number of daily settlement cash flows for clearing members which in turn offer savings in transaction costs and daily settlement credit exposures

• Choice of margin currency/securities and margin time zone

• More efficient centralised risk management and treasury operations for members

Cross-margining that involves two or more international clearing houses in different countries usually brings about cross-border issues, which have risk implications. Cross-border issues that arise:

• Foreign currency-denominated contracts
• Collateral held in foreign jurisdictions
• Clearing members that are units of foreign based firms
• Cross-border links between clearing houses

The implications for risk management are:

• Delays in completing settlements of foreign currencies
• Delays in liquidating margin collateral – clearing house rights to margin cash or securities must be enforceable in the country where the margin cash or securities are located immediately on a member's default
• Possible legal impediments to liquidation of collateral – clearing house set-off and use of margin is usually a statutory exception to operation of local insolvency laws – often without effect across borders
• May face credit, liquidity exposures to the linked clearing house, the linked clearing house's clearing members, or its own clearing members – clearing house rights to use and dispose of margin must be absolutely clear e.g. no conflict between two or more clearing houses as to rights to the same margin
• Links and associated risks are diverse and idiosyncratic
• There will be conflicts of law and complex insolvency procedures across borders

IV. The liability of the members is limited

Articles of Association

MEMBERSHIP

Eligibility for membership of the Clearing House

ii. Shareholder of this Company; and

Membership classes

Subscription

Lien

Loss of membership

a. By resignation;

b. By death;

c. By dissolution;

Resignation

Nomination

Declared defaulter

GOVERNANCE

Number of Directors

Nominees on the Board

Director to represent public interest

Directors elected by shareholders

Chairman of the Board of Directors

Managing Director

Operations of the Company

Standing Committees

Clearing house structure recommended for India: Clearing house should be an independent corporate body with limited liability. It should be owned and governed by commodity exchanges and clearing members. Should be structured, owned, governed and regulated in order to support large scale hedging.

Clearing house capital adequacy recommendation for India: Internal funds of clearing corporation should collateralise at least 10 percent of total risk borne because of open interest, daily trades and deliveries.

Clearing member capital adequacy recommendation for India: Clearing members should invest in the clearing corporation. Hence, the stipulation of capital adequacy is redundant. Such investment in the clearing corporation would act as supplemental resource towards collateralising risk induced by any clearing member.

Recommended scope of clearing house guarantee for India: Clearing house guarantee should reach the level of clearing members. It should be a guarantee of financial performance and should apply to net open positions and not to gross open positions cleared by clearing members. Clearing house should not guarantee physical delivery.

5. Operational requirements
Country/regulator	Position
USA, CFTC	Under CFTC rules, clearing houses clear contracts for the accounts of their clearing members. Clearing member should have separate accounts at the clearing house for customer trades and proprietary trades. Only matched trades are accepted; unmatched trades are rejected. (These rules were framed in the absence of online clearing.)
USA, SEC	OCC is the issuer of listed options on equities; it clears contracts for the accounts of its clearing members. Section 17A of the 1934 Act requires prompt and accurate clearance and settlement of transactions
UK, FSA	Clearing houses clear contracts for the accounts of their clearing members. Members should match all trades on the day of the trade. The relevant clearing house will only accept matched trades. The matching of trades occurs on an intraday basis and matched and unmatched trades are reported back to clearing members on a continuous basis without delay during the day
France, COB	Few operational requirements
Japan, MOF	Few operational requirements
Australia, ASC	Clearing members may alone submit contracts for clearing. Each clearing member has two accounts at the SFECH: a client account and a house account. Trades are processed through STACS (SFE Trading Allocation and Confirmation System). Members accept responsibility for registered trades. Novation of contracts occurs through STACS; SFECH becomes the common counterparty to the original buyer and seller, and is responsible for the performance of contracts
Canada, OSC	Few operational requirements
Canada, CVMQ	Few operational requirements
Hong Kong, SFC	Few operational requirements
Chile, SVS	Clearing house is the common counterparty. It administers margins; margins are registered in individual accounts. Clearing house must update broker-dealers' open positions and collect new margins requirements daily. They must also calculate price variations. Broker-dealers shall not close clients' open positions, even when in default, without the instruction of the clearing house
Sweden, FSA	Clearing house should have appropriate rules for clearing and settlement and should comply with all other statutory provisions including fair trade
New Zealand, NZSC	There are no statutory operational requirements. However, clearing house regulations require the approval of the Securities Commission
Italy, CONSOB	Transactions executed on the trading system should be notified to the clearing house; the clearing house becomes the counterparty to general clearing members and direct clearing members. Transactions may only be effected between the clearing house and clearing members. Every transaction involving a non-clearing member is effected between the latter and the general clearing member, and a corresponding transaction is effected between general clearing member and the clearing house
Spain, CNMV	The exchange, acting as a clearing house, becomes the counterpart to all registered contracts
Germany, BAWe	In accordance with the Rules and Regulations of Eurex, Eurex Clearing AG becomes counterparty to each contract. Cleared transactions are between Eurex Clearing AG and clearing members
Malaysia, SC	FIA mandates that the functions of the clearing house should include guaranteeing and being a counterparty. This is reflected in the clearing process where novation allows for the clearing house to assume the role of a central risk taker in the market
South Africa, FSB	Upon the trade being cleared, by novation, the clearing house shall replace the buyer and become the counterparty to the seller and it shall replace the seller and become the counterparty to the buyer; the guarantee contemplated by the regulator shall come into effect with respect to any positions resulting from such trades

Clearing house operations recommended for India: Online clearing and novation should be accomplished as soon as trades are matched. Onsite clearing at commodity exchange should lead to the clearing corporation becoming the counterparty to the trade. Onsite clearing should be backed by the assignment of clearing members' capital to clear the open positions created at the exchange. Clearing corporation should not assume counterparty risk if assigned capital is insufficient.

Recommended relationship of clearing house to payment system for India: Clearing corporation should effect money settlements among clearing members through the current account of banks with the RBI because the RBI will settle RTGS transactions through these current accounts. The clearing corporation should choose two or more settlement banks to diversify risk and to take advantage of regional familiarity of banks.