Why we need central counterparty clearing house

In India, futures contracts in commodities are required to be settled through clearing and settlement department of the commodity exchanges and there is no separate central counterparty clearing house. In the light of the recent “exchange collapse”, there is an impending need to guarantee execution of settlements on behalf of the respective counterparties in the exchange where a chain reaction of defaults (breaches of contract) can be prevented.

Execution venue It is important to understand that an exchange-trading requirement has nothing to do with clearing and they are completely separate issues. The exchange is just the trade execution venue. The only thing that an exchange-trading requirement adds to the clearing requirement is “pre-trade price transparency.”

In India, people tend to think of exchanges as synonymous with clearinghouses as the transactions are cleared through exchanges’ clearing and settlement department, unlike in the US or Europe where mitigation of counterparty risk is achieved by contract “Novation”. This is a process through which a Central Counterparty or the clearing house acts as a buyer to all sellers, and vice versa.

Similar to banks’ role 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.

Thus, clearing house reduces complexity by reducing the number of counterparty relations and increases efficiency by establishing the margin and collateral requirements for its members, centralising the necessary calculations, automatically collecting or paying the respective amounts and preventing disputes (e.g. over the amount and quality of collateral).

A clearing house addresses operational risks by means of adequate auditing procedures (i.e. compliance with technical infrastructure requirements) that ensure the necessary operational know-how of their current and potential members.

The clearing entities’ discipline and independent roles from the exchange is indispensable for the purpose of improving commodity market credibility and develop an environment enabling trading activities by market participants with a stronger sense of security.

It is important to appropriately secure financial resources to cover breaches and reinforce the financial base of the clearinghouse (as an entity separate from the exchange) from the perspective of developing an environment in which market participants are able to participate in trading with a sense of security and reinforcing creditworthiness.

Shyamal Gupta is the Chief Business Officer of NCML .

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