MF Global

The clearing process

One of the most important, yet least understood aspects of the futures market is the clearance and settlement of trades.

At the Sydney Futures Exchange all futures and options trades are cleared and settled on a daily basis by SFE's wholly owned subsidiary the Sydney Futures Exchange Clearing House (SFECH). Founded in 1991, the SFECH has full responsibility for the clearing and settlement of trades executed both on the SFE and on the New Zealand Futures Exchange (NZFOE) - another wholly owned subsidiary of SFE.

Like other exchange clearing houses, the SFECH has a diverse range of functions the most important of which include:

• To record and register all contracts traded on the SFE and the NZF0E and to provide SFECH Members with a record of all transactions executed
• To become the principal to all contracts traded thereby assuring financial performance
• To call initial margins on a daily basis on all contracts traded and to call or pay daily settlement variation margins. Intra-day margins can also be called during periods of high volatility
• To set minimum initial margins and to review these margins on a regular basis with reference to market volatility
• To monitor Clearing Member positions on a daily basis
• A more thorough explanation of these activities is given below.

Novation
One of the most important functions carried out by SFECH is a process known as novation.

Through novation SFECH interposes itself between the buyer and seller to effectively become the principal to all contracts traded. For example, if a trade occurs whereby say, Deutsche Bank sold a contract to ABN Amro, the SFECH will become the buyer to Deutsche and the seller to ABN when the trade is registered.

The benefit of novation is that it allows market users to deal with any market participant they so choose. Novation also means they are not required to revert to their original counterparty in order to negate or 'close-out' a futures or options transaction. The involvement of the SFECH also alleviates the need for SFECH Members to assess the credit worthiness of other market participants. This in turn helps to enhance both market access and liquidity.

Initial Margins
As well as performing novation, the SFECH is also responsible for the calculation and collection of initial margins.

An initial margin is the amount of money or collateral that is deposited on each futures contract held as security against adverse price moves in the market.

It is similar to a good faith bond that protects the Sydney Futures Exchange Clearing House (SIFECH) and its Members against the possibility of a position holder defaulting on their financial obligations. An initial margin must be lodged for every open contract in the market and is only returned once the position is liquidated.

Typically, the size of an initial margin will be around two to five per cent of the underlying contract value. In calculating the size of the margin, the SFECH takes into account what the maximum likely price move in a particular contract could be over a 24 hour time period (i.e. the period between daily margin collections). Other factors such as the liquidity of the contract, the extent of divergence between the futures contract and the underlying commodity and recent price volatility will also be considered before a final margin figure is determined.

It is important to note that the initial margin represents the minimum amount of money or collateral that brokers must collect from their clients. Brokers can and often do, ask for more than this amount. The reason for this is that brokers need to protect themselves and the clients from the risk of default and hence they will want their clients to maintain sufficient funds in their account to cover any future margin calls. These are explained in the following section.

Variation Margins
As well as calculating and collecting initial margins, the SFECH also has responsibility for the collection and payment of daily variation margins.

Variation or settlement margins, as they are otherwise known, are payments that must be made to cover price movements that occur in the market once a position has already been established. For example, a client would have to pay a variation margin on a bought futures position in the event that the market price for that commodity fell after the position was first established. Alternatively, if the market price rose, the client would receive a variation margin payment with the proceeds being credited to the account.

The process of daily position revaluation is known as mark to market. The following example illustrates how this works using a sample trade in the Share Price Index futures (SPI) contract.

As is evident from the table, initial margins have to be paid on each futures contract opened. In this example, the initial margin rate was assumed as being A$3,000 per contract which is around 4 per cent of the contract value of the SPI (i.e. SPI value of $76,000 i.e. 3050 x 25). It should be noted that the size of the initial margin is subject to regular review by SFECH and will vary depending upon changing market conditions.

It should also be evident that variation margins must be paid and received on a daily basis. During times of extreme volatility, it is even possible for these margins to be called on an intra-day basis. Should an investor not be able to meet their variation margin requirements, a broker may liquidate the client's position. The money owed will then be deducted from the initial margin monies that are refunded to the investor.

Contract Settlement Procedures
When a futures position expires, settlement will occur in one of two ways.

1. Through delivery of the underlying commodity or financial instrument on which the futures contract is based.
2. Through cash settlement.

An explanation of these procedures is given below.

Physical Delivery
The SFE has a number of contracts that are settled via physical delivery. Some of the contracts to incorporate delivery include 90 Day Bank Bill Futures, Individual Share Futures, Wheat Futures and Greasy Wool Futures.

For all of these products, an exchange of the specified underlying commodity will occur between buyers and sellers who hold open contracts at maturity. The exchange of the underlying commodity will take place during the specified settlement period with the SFECH re-linking parties on opposite sides of the market.

It is important to realise that only a small percentage of contracts traded ever proceed to delivery with most being liquidated ahead of expiry. The reason for this is that many investors use futures primarily for price insurance rather than as a vehicle to acquire delivery of the underlying commodity. Alternatively other investors may be dealing in a commodity that is similar but not exactly the same as that specified by the futures contract. In this case, they cannot deliver the commodity in satisfaction of their futures position, as it does not meet the criteria specified by the futures contract. The commodity may however exhibit a strong price correlation to the futures market and hence futures can be used to guard against potential adverse moves in the value of that commodity.

Cash Settlement
Cash settled contracts are settled on expiry by the receipt/payment of cash. The amount paid for received represents the difference between the price at which the contract was traded versus the final settlement price. The method of calculating the settlement price is determined by SFE and is set out in the contract specifications. For example, the SPI contract is cash settled, with the settlement price set as the closing quotation for the All Ordinaries Index on the last day of trading. The following example illustrates this process.

Assume that the SPI contract price on July 1 is 2800. By the time the contract expires on September 30, there are two possibilities - the price has fallen (scenario 1) to say 2580 or risen (scenario 2) to say 2850.

Scenario 1
Price difference = number of points x point value = 220 x $25 = $5,500

Scenario 2
Price difference = number of points x point value = 50 x A$25 = $1,250
Payment (-)/Receipt (+) Table*

* Note that these calculations are based on one SPI contract only. The amounts shown will increase by multiples of the number of contracts traded.

When studying the above examples, it should be remembered that the profit or loss made in a cash settled contract does not all occur on the final day of trading. Using the process of variation margins that were previously described, a trader who is showing a loss would have to pay up their losses progressively as the market moved against them.

Regulation

What You Should Know Before You Trade
Trading futures and options is not for everyone. Owing to the leverage and the high volatility that the market can exhibit, it is possible for a trader to lose more than the value of their initial deposit. Prior to trading futures and options, prospective traders need to consider a number of issues, some of which include:

1. Consider your financial experience, goals and financial resources. Only use capital you can afford to lose and keep your market exposures within your pre-defined risk parameters.
2. Understand futures and options contracts and your obligations in entering into these contracts.
3. Understand your exposure to risk and other aspects of trading by thoroughly reviewing the risk disclosure documents your broker is required to give you.
4. Know who to contact if you have a problem or question. In most cases, this will be your licensed client advisor.

Protection of the Client/Regulation
Futures markets operate under extremely strict risk management controls imposed by exchanges, internal treasuries, corporate laws, central banks, federal regulators and self-regulatory associations. The Australian futures industry is regulated and controlled by the Australian Securities and Investment Commission (ASIC) and the Sydney Futures Exchange (SFE) directly.

The SFE's role, in conjunction with the ASIC, is to oversee the activities of futures brokers and to safeguard the interests of both public and business users of its markets. Both SFE and SFECH are specifically charged with a duty, under the Law, to ensure that at all times the markets for dealing in futures contracts are both fair and orderly.

Other Client Safeguards
SFE's Compliance and Surveillance Department extends the client protection mechanisms contained in the Futures Law and SFE Business Rules.

Some of the duties undertaken by the Compliance and Surveillance Department include:

• Random inspection program of SFE Members
• Inspection of Members' monthly financial statements
• Analysis of Member trading activity and the investigation of any suspected breaches of SFE Business Rules

Investigation of any written complaints lodged with the SFE by a client concerning the activities of a Member.

Opening an account

Finding an Advisor
Prior to dealing in the futures market investors must open an account through a licensed private client futures broker. The Sydney Futures Exchange provides a list of these brokers on their web site www.sfe.com.au.

There are currently 18 firms around Australia offering services to the retail investor and the Your Trading Edge at web site www.yte.com.au provides a profile on each of these firms. Unlike the United States, there are currently no discount brokers as such; however, brokers' commission rates are negotiable.

Your Advisor
In Australia, all futures brokers and advisors must be licensed by the Australian Securities and Investment Commission (ASIC). Further to this, all employees of licensed brokers, who will be advising on futures trading must have registered representative status. Therefore, when an investor opens an account with a broker, the person they deal with will be a registered futures advisor. The advisor is the person with whom the investor will place the buy and sell orders and who is legally allowed to give advice on trading.

When selecting a broker, investors need to consider the skills and experience of their advisor. Ideally, investors should have a face to face meeting with their advisor before they open an account. This helps the investor to gain a better understanding of how the advisor operates while also giving the advisor a better opportunity to understand the investor's financial needs and objectives.

Minimum Account Size
The minimum account balance that most brokers will usually insist upon is A$10,000. Some brokers may specify more (generally A$25,000), however A$10,000 is considered an industry average.

It is important that investors recognise that a minimum account balance does not represent the amount of money they have to commit to the market. Rather, it represents the size of the account that must be maintained to support any trades that the investor wishes to make. How and when an investor utilises the account is up to them.

Many brokers give their clients the option to structure their account as a cash management account. This means that the investor will earn interest on any money deposited. By setting up the account in this way, the broker will also be able to automatically debit the investor's account for any variation margins payable. This saves time in having to write out cheques to cover any losses made.

If an investor's account balance falls below the minimum amount, the broker may request that the account be topped-up with additional funds. The broker will ask this because by law, they are not permitted to extend credit to any client.

Brokerage Rates
Investors like all consumers want to get the best available service at the lowest possible price. For this reason many will 'shop around' to find the broker that offers them the most competitive brokerage rate.

As a general rule, the brokerage that an investor pays will be a function of the amount of business they do and the range of services they receive from the broker.

For example, if an investor is a very active customer who trades frequently and in large quantities they obviously negotiate a more competitive rate than another customer who trades infrequently. When considering brokerage it is worthwhile to remember that unlike the stockmarket, where brokerage is charged on a percentage basis, futures brokerage is levied on a per contract basis. This means the larger the trading volume, the larger the total brokerage bill.

Obviously though, this can be tempered by an investor demanding a lower brokerage rate as a consequence of the high quantity of business transacted.

Broker Services
Like investors, brokers come in all shapes and sizes. Some of the services that brokers can provide include:

• Technical and Fundamental Research and Analysis
  Brokers can assist their clients by providing economic data for fundamental analysis and/or providing trade ideas generated by various forms of technical analysis.
• Internet Trading Facilities
  Some brokers give their clients the ability to place buy and sell orders via the Internet.
• Trade Recommendations
  Some brokers will issue trade recommendations to their clients to capitalise on market opportunities that the broker has uncovered. These can be for both domestic and offshore markets.
• Seminars/Education Programs
  Just as SFE offers education and seminars, many brokers will conduct specialised seminars and education programs as part of their service to clients. These can be offered at all levels (introductory through to advanced) and represent a good opportunity for clients to get to know their advisor better as well as learn more about the market.
• 24-hour service
  Most traders in Australia offer a 24-hour broking service. This allows clients to capture trading opportunities in offshore markets such as Chicago, London and New York as well as for SFE contracts traded outside of normal business hours.
• Managed Futures
  In addition to offering traditional broking services, some brokers also offer a managed futures service. These managed funds operate in exactly the same fashion as a conventional fund manager except they focus on futures markets as opposed to more traditional asset classes. They are useful for traders who want to gain some portfolio exposure to the futures market, but do not have the time, energy or commitment to trade the market on their own behalf.
• Historical and Delayed Data
  A number of brokers will provide historical data to their clients for the purpose of trade analysis.

Selecting an Advisor
Forming a sound relationship with a futures broker is one of the most important steps that an investor will ever take. As such, it is desirable for an investor to take the time and effort to find the right broker that offers the range of services required. Below are some typical questions that an investor may ask of a prospective broker:

• What services do you provide for your clients?
• What markets do you offer broking services for?
• What is the minimum size account you require?
• What orders do you accept?

For an investor to be successful in the market it is essential they feel comfortable and trust the broker with whom they are dealing. With this in mind, it is recommended that investors meet with at least 2 different firms before making their choice of broker. Of course, it is always possible for an investor to open accounts with a number of different brokers however owing to the expense and duplication involved, this would only really be worthwhile if the investor is an extremely active market user.

Client forms

Before a broker is able to transact business on behalf of a client, the broker is required to provide a number of documents, which include:

1. An explanation of the nature of futures and options contracts and the obligations of those who enter into these contracts.
2. A risk disclosure statement prescribed by the Futures Law, which must be read and acknowledged by the client.
3. A client agreement form setting out the contractual terms upon which the client and Member will deal. In accordance with SFE's Business Rules this document must be completed and signed by the Member and the client.
4. Specifications and essential terms of each type of futures contract in which the broker deals.

Risk Disclosure Document
This is a document that must be provided by brokers to all of their clients. The key features of this document are:

• It explains the nature of the obligations assumed by a client under a futures contract (i.e. margins)
• It sets out a risk disclosure statement
• It sets out the specifications and essential terms of all futures contracts in which the broker deals on behalf of clients.

The aim of the risk disclosure document is to make the broker's client fully aware of the risks and potential losses that can arise as a result of trading in futures and options contracts.

Client Agreement Form
The SFE requires that all investors sign a client agreement form that contains minimum prescribed terms. Futures brokers may also add further conditions to the client agreement form if they so desire.

By requiring clients to sign a client agreement form the broker is endeavouring to ensure that their client both knows and fully understands the obligations and risks of trading futures.

Some of the issues covered in a client agreement form include:

• Taking opposite position to client
• The client acknowledges that the Member may take the opposite position in a transaction from the client, whether this is for the Member's own account, or on behalf of another client.
• Initial and variation margins

The client must agree that he or she will pay initial margins for all contracts traded and may be called on to pay daily variation margins. The client is responsible to pay any deficit owing to the Member for margins. Should the client fail to pay or provide cover for margins, the Member is entitled (but not obligated) to close out the futures positions held by the client.

Acknowledgement of risk
The client must be made aware of the risk of trading futures and options and acknowledge that trading futures and options is suitable for their objectives and financial position.

Clearing House Guarantee
The Clearing House guarantee of performance (i.e., assumption of counter party risk) does not extend to the client unless he or she becomes a clearing member.

Segregated Accounts
The Member agrees that all money paid to him or her by the client will be put into a segregated account. These funds will be placed on deposit with the Clearing House or another approved corporation.

Commissions
A commission is charged per trade by the Member, at a rate agreed upon between Member and client.

Discretionary Accounts
If the client appoints the Member as an agent acting on his or her behalf, the Member is not required to refer to the client for trading decisions.

As mentioned earlier, further conditions may be added to the client agreement form should they be deemed necessary by the broker. Prospective clients should study these carefully before giving their consent.

Documentation after a Trade
Once the risk disclosure document and client agreement form are completed and the investor's funds are lodged, the broker can then execute business on behalf of the investor. When the investor executes a transaction the broker is required to provide the client with both a contract note and a monthly statement.

The contract note details:

• Date of the transaction
• Description of the futures or options contracts, including the name of the contract, the contract price, and where applicable, the contract being closed out.
• Name of client
• Name and address of broker
• Month and year for performance or settlement of contract
• Amount and rate of commission charge
• Amount of the initial margin
• In the case of an option, the amount of the premium and the exercise price.

The monthly statement details the opening and closing cash balance, all transactions on the client's account, particulars of contracts traded and current open positions.