Futures processing 63
Procedures’. One of the key stipulations is that LCH.Clearnet proce-
dures must be read in conjunction with the rules of the exchange.
The exchange rules and administrative procedures will always take
precedence in cases of conflict.
LCH.Clearnet defines its delivery procedures, some of which are
common to all contracts which LCH.Clearnet clears. These address
issues such as:
• Nomination of Transferors and Transferees.
• How tendered lots are to be allocated to receiving members.
• House and client accounts are always treated separately.
• Making the EDSP available on the Clearing Processing System
(CPS).
• Margin remains held as both initial and VM on open contracts
subject to delivery.
• The method of delivery of information which needs to be commu-
nicated to LCH.Clearnet.
• The delivery timetables.
The LCH.Clearnet has introduced a stand-alone computer system
specifically for electronically communicating delivery information with
its members, applicable to Euronext.liffe deliverable bond contracts
only. A product called The Deliveries Package enables all Euronext.liffe
bond deliveries to be automated in this way. All clearing members
involved in Bund and Gilt deliveries must submit and retrieve delivery
information using this system.
Users of The Deliveries Package are issued with security passwords,
which are updated at every bond delivery period.
A key factor to note is that members must always be sure to meet
delivery deadlines, notwithstanding the performance or failure of the
electronic communication system. Therefore, LCH.Clearnet stresses
that members should allow sufficient time to fulfil deadlines as laid
down in the procedures. Failure to do so would constitute late deliv-
ery for which fines and other possible disciplinary actions could be
imposed by the Exchange.
The process of delivery
The exact process involved in delivery varies from exchange to
exchange and often from contract to contract. However, the process
can be followed by looking at key stages that apply in general. The
process used at Euronext.liffe for UK Gilt contracts is given as an
illustration.
Stage One
Once a short position has been tendered for delivery, the holder
advises the clearing organisation of the number of contracts, the
asset to be delivered and if relevant, whether it is from the
Proprietary (House) or Client Account. This may be communicated
electronically using the relevant delivery system.
Stage Two
The clearing organisation allocates the short position to a corre-
sponding long position and notifies the member which is the
holder of the long position.
For Euronext.liffe contracts, this allocation is always on a ran-
dom basis. The process that LCH.Clearnet employs gives each
clearing member’s account a sequential number according to
their mnemonic sequence. The system chooses a random starting
number then it begins to allocate the short positions to corre-
sponding long positions in sequence from the starting point.
Stage Three
The clearing organisation calculates the invoice amount and
advises both the short and long position holders of the amount it
requires to be paid/received. This calculation takes into account
the variation margin that has already occurred by incorporating
the Exchange Delivery Settlement Price (EDSP) on the day of
notice and a price factor.
The formula used for the calculation of the invoice amount for a
delivery of a Euronext.liffe Government Bond futures contract is:
(EDSP) (price factor) (unit of trading) (accrued interest)
Note: Euronext.liffe publish a list of the deliverable bonds together
with their price factors and accrued interest amounts prior to the
first notice day.
Stage Four
The short position holder delivers the quantity of asset to the
clearing organisation and receives the invoice amount. The clear-
ing organisation delivers the asset to the long position holder in
exchange for the invoice value.
The clearing members for the long and short positions need to
have accounts at the relevant depository, i.e., CREST to be able to
make and take delivery from the clearing organisation account at
the depository.
64 Clearing and settlement of derivatives
Futures processing 65
The Delivery Process for Government Bond Futures
Where futures markets offer a government bond futures con-
tract, it normally relates to a notional bond rather than an
actual bond which is available for trading. If the participant
wishes to enter into the delivery process for a government bond
contract then they need to study the contract specification care-
fully. For example:
Long Gilt Future
Unit of trading £100,000 nominal value notional
Gilt with 6 per cent coupon
Delivery Months March, June, September, December
First Notice Day Two business days prior to the first
day of the delivery month
Last Notice Day First business day after the Last
Trading Day
Delivery Day Any business day in the delivery
month (at seller’s choice)
Last Trading Day 11.00 hrs
Two business days prior to the last
business day in the delivery month
Quotation Per £100 nominal value
Minimum Price Movement 0.01
(Tick Size & Value) (£10.00)
Trading Hours 08.00–18.00 hrs
Contract standard
Delivery may be made of any gilts on the list of deliverable gilts in
respect of a delivery month as published by the Exchange on or
before the tenth business day prior to the First Notice Day of
such delivery month. Holders of long positions on any day within
the Notice Period may be delivered against during the delivery
month. All Gilt issues included on the list will have the following
characteristics:
• having terms as to redemption such as provide for redemp-
tion of the entire Gilt issue in a single instalment on the
maturity date falling not earlier than 8.75 years from, and
not later than 13 years from, the first day of the relevant
delivery month;
• having no terms permitting or requiring early redemption;
• bearing interest at a single fixed rate throughout the term of
the issue payable in arrears semi-annually (except in the case
of the first interest payment period which may be more or less
than six months);
• being denominated and payable as to the principal and inter-
est only in pounds and pence;
• being fully paid or, in the event that the Gilts issue is in its
first period and is partly paid, being anticipated by the Board
to be fully paid on or before the Last Notice Day of the rele-
vant delivery month;
• not being convertible;
• not being in bearer form;
• having being admitted to the Official List of the London Stock
Exchange;
• being anticipated by the Board to have on one or more days in
the delivery month an aggregate principal amount outstand-
ing of not less than £3bn, in the case of a Gilt issue which
was first issued more than 12 months before such delivery
month or £1.5bn otherwise, which by its terms and condi-
tions, if issued in more than one tranche or tap or issue, is
fungible.
Exchange Delivery Settlement Price (EDSP)
The Euronext.liffe market price at 11.00 hrs on the second busi-
ness day prior to Settlement Day. The invoicing amount in respect
of each Deliverable Gilt is to be calculated by the price factor sys-
tem. Adjustment will be made for full coupon interest accruing as
at Settlement Day.
As each Gilt issue trades in the cash market with varying
coupons and final maturity dates, the exchange must find a
mechanism by which these securities can be valued and traded
at one unique price prevailing on the exchange. This involves
the creation of an index with a value which can be uniformly
applied to all of the bonds making up the list of securities
which may be delivered. This list is known as the deliverable
basket. A price factor system is designed to reprice each of
these issues onto a uniform scale which can be used at the
Exchange. These price factors are determined by a formula
that calculates the price at which a specific issue would trade
to yield, 6 per cent in the case of Euronext.liffe Long Gilt
66 Clearing and settlement of derivatives
Futures processing 67
contracts, as of the delivery date. Euronext.liffe publishes the
price factor for each Gilt in the deliverable basket as delivery
approaches.
Delivery of the Euronext.liffe Long Gilt contract is physical at
maturity and as in other deliverable contracts the seller has the
choice of which Long Gilt is going to be delivered. However, the
seller does not have a free choice. The Gilt must be selected from
the List of Deliverable Gilts issued by the Exchange. This List of
Deliverable Gilts with their associated price factors and accrued
interest amounts is published by the Exchange ten days prior to
the Last Trading Day of the relevant delivery month and distrib-
uted to its members.
Gilt deliveries must take place through the London Clearing
House’s account at CREST, as LCH.Clearnet is counterparty to
each delivery.
As no single Gilt exists to meet the exact Euronext.liffe Long
Gilt contract specification, the buyers of the Gilt in the deliv-
ery process must pay an invoice amount in settlement which
takes into account the varying specifications of the Gilt which is
delivered.
We have already seen that the formula for the invoicing amount is:
(exchange delivery settlement price price factor unit of trading)
accrued interest.
Cheapest to Deliver
As we have already noted earlier, the seller has the choice of
which of the Gilts to deliver, from the deliverable list issued by the
Exchange. At delivery, the buyer should expect to receive the Gilt,
which will create the maximum profit or minimum loss for the
seller when assessing the fair price of the futures contract. This is
known as the Cheapest to Deliver Gilt.
In order to determine the Cheapest to Deliver Gilt, you need to
know the price, or conversion, factors which are applicable. These
price factors are issued by the Exchange. It enables the calcula-
tion of the price at which the Gilt would trade, for each 1 nominal,
to yield the notional 6 per cent coupon of the Euronext.liffe Long
Gilt futures contract during the delivery period. The use of the
conversion factor allows higher coupon Gilts to be deliverable,
when yields are below the notional 6 per cent coupon.
Source: LCH Clearnet.
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