DOUBT RELATED TO SETTLEMENT PROCESS IN FUTURE CONTRACTS.

[abhishek siwach]

Hi Everyone. I had a doubt related to the settlement process in future contracts.
Ques. 1) What will happen if a party wants to deliver a product in future market and no party exists on the other side of this trade, that is noone wants to get the product. So, in that case , will the clearing house take the delivery of the product?
Ques 2) In collateralization process in OTC market,it is basically mark to market process.So, the losses are settled daily. So, my doubt is if in case the losses are settled daily, is there any need for the delivery?

 

[David Harper CFA FRM]

Hi @abhishek siwach good questions for sure!

1. Please see my Reference #1 below because we just had a thread conversation about this. I have no direct knowledge but my understanding is that most exchanges won't fill the contract until the price mechanism finds a matching order (i.e., for every open interest, there is one long and one short). I will remind you of the power of the price mechanism, we often overlook this most fabulous invention: if you want to deliver (short the futures contract) but literally nobody wants to go long at your price, then the price will surely drop until somebody does! Although, as I mentioned, I believed I've read somewhere that some exchanges/clearinghouses do have the capacity to warehouse at the margin, but I'm assuming that's rare and, instead, as part of their own risk controls most exchanges/clearinghouse don't assume the risk of an unmatched futures contract. (but I can't find the source, whereas the below is IFM which is legit and previously assigned). Caveat: we have members with more direct experience here who know more than me and I defer ....

2. Collateral is separate transaction (and a separate/segregated account) with operational and legal issues attached, so this is very contractual. If there is a voluntary "break clause" (see http://www.barbicanconsulting.co.uk/collateral) then the in-the-money counterparty might be near to a scenario like you propose. But I think collateral is primarily a counterparty credit risk mitigant. Firstly there is the issue of which type of collateral transfer:

Gregory 6.3.3 Title transfer and security interest: In practice, there are two methods of collateral transfer:

• Security interest. In this case, the collateral does not change hands but the receiving party acquires an interest in the collateral assets and can use them only under certain contractually defined events (e.g. default). Other than this, the collateral giver generally continues to own the securities.
• Title transfer. Here, legal possession of collateral changes hands and the underlying collateral assets (or cash) are transferred outright but with potential restrictions on their usage. Aside from any such restrictions, the collateral holder can generally use the assets freely and the enforceability is therefore stronger.

... and note my reference #2 below where Gregory says "The collateral receiver only becomes the permanent economic owner of the collateral (aside from any potential legal challenge) if the collateral giver defaults." I assume he is referring to the security interest variation. Bottom line: I don't think it's quite so easy to use the collateral account as an ATM, or to just get paid by the counterparty I hope that's helpful!

Reference #1: https://forum.bionicturtle.com/threads/l1-t3-150-definitions-futures-contracts.4411/#post-48050

Hi @Roberto Hernández Thank you, it's been a long but interesting day! It is my understanding (based on an FRM reading which was dropped last year) that the number of open shorts must match the number of longs such that your outcome cannot happen. Because it goes into detail, I copied below the relevant section from Futures and Options by The Institute for Financial Markets (Washington, DC: The institute for Financial Markets, 2011; assigned FRM T3 in 2015). Please note emphasis mine.

This suggests so-called out-trades cannot survive the day. How can this be? If contracts have enough liquidity, the price mechanism ought to be able to clear markets (eg, if there only buyers, the price increases until "matching" buyers appear). If they aren't resolved, it sounds like the out-trades don't get filled. I thought I did read somewhere that some exchanges do have the ability to "market make on the margin" (my phrase) by which I mean, take the other side of selected "out trades" but I can't recall so don't trust that. It seems to me that if your scenario is possible, then effectively it would require the exchange to step in as the counterparty (they already do in terms of credit risk, but this would imply stepping in for the market risk, too). It seems conceivable an exchange with careful controls could do that, but personally I don't know if that happens. I hope that's helpful! Have a good evening

"FUTURES VOLUME AND OPEN INTEREST: Considerable importance is attached by futures market analysts to the daily trading volume and open interest statistics for each market.These figures are computed and published each day by the clearinghouse of each exchange from the trade data submitted by members.

Volume is defined as the total of purchases or sales during a trading session, not the total of purchases and sales combined. Since there is a buyer and a seller for each contract traded, the total of all purchases must equal the total of all sales each day, once any out-trade discrepancies have been resolved by the exchange or clearinghouse. (An out-trade is a futures buy or sell that the clearinghouse cannot match with a corresponding sell or buy.) For example, if Ms. B buys one contract of February heating oil and Mr. S sells one contract of February heating oil, the volume of trading between them is one contract, not two.

Open interest represents a tabulation of the total number of futures contracts in a market that remain “open” at the end of a trading session, that is, those contracts not yet liquidated either by an offsetting futures market transaction or by delivery. When a new futures (or futures options) contract is first listed for trading, there is, of course, no open interest. As trading proceeds, however, open interest is created. For example, if trader A buys one futures contract (for a specific contract month) from trader B and neither trader A nor B started with any position in that specific contract, one new futures contract has been created. That is, open interest in that contract has increased by one. This is illustrated in Figure 1.1, which reflects the case in which the FCMs are clearing members of the exchanges on which the trades are executed.

What happens to open interest when an existing holder of a long position liquidates that position? The answer depends on whether the sale is to a new buyer or to someone covering or offsetting an existing short position. If trader A in the example above liquidates his long position by making an offsetting sale to a new buyer, say trader C, there is no change in open interest, as illustrated in Figure 1.2. In this case, trader C has simply replaced trader A as the holder of a long position, and the open interest remains the same. On the other hand, suppose that trader A sold to a fourth person, trader D, who had held a short position in the particular futures contract. In such a situation, one long position and one short position would be extinguished by offset, reducing the number of open contracts (and thus open interest) by one.This latter case is illustrated in Figure 1.3. Remember, the number of open short positions always equals the number of open long positions.

The effects of trading on open interest may be summarized as follows:

• Open interest increases when the buyer and seller is each taking on a new position (long and short, respectively).
• Open interest remains the same when only one party, the buyer or seller,is taking on a new position and the other is offsetting an existing long or short position.
• Open interest decreases when both parties, the buyer and seller, are offsetting existing long and short positions.
• Open interest also declines when an existing short makes delivery to an existing long."

Reference #2: see also Chapter 5 of his previous version at https://forum.bionicturtle.com/reso...it-value-adjustment-2nd-ed-by-jon-gregory.37/

"A collateral agreement reduces risk by specifying that collateral must be posted by one counterparty to the other to support such an exposure. The collateral receiver only becomes the permanent economic owner of the collateral (aside from any potential legal challenge) if the collateral giver defaults. In the event of default, the non-defaulting party may seize the collateral and use it to offset any losses relating to the MTM of their portfolio ...
Collateral posted against OTC derivatives positions is, in most cases, under the control of the counterparty and may be liquidated immediately upon an event of default. This arises due to the laws governing derivatives contracts and the nature of the collateral (cash or liquid securities). Counterparty risk, in theory, can be completely neutralised as long as a sufficient amount of collateral is held against it. However, there are legal obstacles to this and issues such as rehypothecation" -- Gregory, Jon. The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and Capital (The Wiley Finance Series) (p. 67). Wiley. Kindle Edition.

 

[abhishek siwach]

Thanks a lot.