86 Clearing and settlement of derivatives
The investor will have to pay a premium of £200, being 1000
shares the price of 20p, to secure the right to take delivery at a
day of their choice of 1000 shares at 330p until expiry in October.
If the buyer exercises their right they will then pay 1000
330p £3300 to take delivery of the 1000 BP shares irrespective
of the price BP might be in the stock market at that time.
Workflow road map
We can use the option shown in the above example to follow the work-
flow associated with on-exchange option transactions.
In the following text we describe the process from the point of view
of the broker, in this case a clearing member of an exchange, and also
make reference to the workflow from an institutional client’s position.
Trade capture
In the case of an electronic exchange these details are automatically
captured from the trader’s action on the dealing screen. In the case
of an open outcry market the details are either input into an
electronic matching system by the trader or alternatively a deal ticket
is completed, which is then passed to support staff for input to the
exchange matching system.
The actual clearing and settlement processes for markets differ as
do the procedures adopted internally by firms. However, the following
table illustrates the kind of option trade details that are likely to be
needed. These will be:
Data Detail Source
Option BP Trade ticket/Deal system
Market Euronext.liffe Trade ticket/Deal system
Maturity October Trade ticket/Deal system
Strike price 330 Trade ticket/Deal system
Call or Put Call Trade ticket/Deal system
Shares per contract 1000 Contract specification
Buy/Sell Buy Trade ticket/Deal system
Counterparty xxx Trade ticket/Deal system
Time of trade 00/00 dd/mm/yy Trade ticket/Deal system
Transaction reference xxxxxx System-generated
Client/Principal trade Client Trade ticket/Deal system
Execution broker N/A Trade ticket/Deal system
The institutional client that has placed the order with their broker
has in essence the same data requirements but obviously has no
reference to Principal Trading.
It is important to note that high-quality static data on options, like
all products, is crucial as today most firms use systems for the
processes involved from trade to settlement and beyond.
Trade validation
The transaction must be validated.
This process needs the confirmation of the trade details received
from the front office against the data being received from the market.
This may be via a system link to the exchange, for instance the TRS
used on Euronext.liffe.
The TRS provides details of transactions that have taken place in
the market. Each trade is shown whether the firm has transacted it,
it has been ‘given in’ by an executing broker for the firm’s account or
client account or it is to be ‘given up’ to another clearing member. It
is then accepted by the member and internally confirmed against the
order details.
As the trades showing are registered to the firm’s account at the
clearing house and are therefore due for settlement of any obligations
arising, it is important that any discrepancy between the trade details
and the order details is notified to the relevant dealer/trader and
resolved quickly.
Trade enrichment
To be able to process the trade internally we will need to:
1. Book the trade to the relevant client account or trading book.
2. Identify if the trade is an opening or closing transaction.
3. Perform the margin calculation (if applicable).
4. Charge the relevant commission.
5. Charge other fees (if applicable).
6. Perform the settlement of the transaction with the clearing house.
7. Effect the client settlement instructions.
Booking trade to the relevant client account or trading book
The details for this will be on the database and the posting will either
be automatically generated by the dealing system to the operations
system or need to be input from a trade ticket or similar document.
The accurate posting of the transaction is a vital function as the
Options processing 87
trade may have been done to close out an existing obligation, and a
failure to successfully post the trade and complete the closeout could
cause an unwanted assignment. The next section looks at this issue.
Identify opening and closing transactions
The trades booked to a client account will be either opening trans-
actions, i.e. creating a position, or closing transactions where there is
an existing position that is offset by the trade being booked. When
this occurs the two transactions are closed out to create a realised
profit or loss. If a successful closeout takes place it must happen in
the internal records and also in the Client Account of the Firm held
at the clearing house.
If the latter does not take place then there is a risk that an action
such as an assignment of the short side of the open position could
take place. The result could be increased settlement costs.
Principal trading accounts are usually settled net, automatically in
both the internal and the clearing house accounts and the same
closeout rules shown in Chapter 4 on futures apply.
Perform margin calculation
If the transaction undertaken is creating a short position then there
will be a margin requirement that needs to be calculated. In most
cases this will be either SPAN or TIMS, depending on the exchange
on which the trade has taken place. Both these margin systems are
described more fully in the Appendices 9 and 10.
The margin call will be covered by collateral in the form of either
cash or collateral or a combination of both. This collateral will be
needed for the margin call made by the exchange clearing house to
the firm and by the firm to its client.
Margin will be posted to a margin account in the ledger.
Charge the relevant commission
For client transactions, there will be a commission payable to the
broker. The commission may be a rate/amount per contract or some
other rate agreed by the sales desk and the client.
This rate can be charged on the opening trade, the closing trade or
split so that both the opening and the closing transactions carry a
commission.
The amount of commission charged on the transaction may include
what is called floor brokerage. This is the fee charged by an execution
88 Clearing and settlement of derivatives
broker who is giving up the trade to a clearing broker. It is described
in the chapter related to futures but it is worth reminding ourselves
how this works. The clearing broker will charge the client or trading
book the combined floor brokerage and clearing fee and then settle
the floor brokerage with the execution broker (Figure 5.4).
Commission will be posted to a commission account in the ledger
and floorbrokerage to a brokerage account pending settlement with
the executing brokers.
Charge other fees
There are several other fees that may need to be charged on a trans-
action. These will include exchange fees, regulatory fees and taxes.
Although the client may be charged an all-inclusive commission,
they may want to see the breakdown of commission and fees and the
data will need to be posted separately in the ledgers for accounting
and management information purposes.
Perform the settlement process with the clearing house
A clearing broker will need to settle the option premium and any
margin requirement with the clearing house. This will most likely be on
T 1. The amount to be settled will be included in the net settlement
figure for the clearing member and will be collected by the clearing
house through its normal settlement process. In many cases the option
settlement amount is netted with futures obligations by currency.
Options processing 89
A
B
C
Clearing
broker
Client/
Trader
Executing
broker
Executing
broker
Figure 5.4 Floorbrokerage Relationships
Notes:A Trade B Commission (inc floorbrokerage fee) C floorbrokerage.
The calculation for the option premium amount is:
Number of contracts number of shares per contract option price
In our earlier example of the purchase of one BP Oct. 330 Call option
@ 20 this was:
1 contract 1000 shares 20p £200
The transaction will need to be posted to the clearing house account
with the contra entry being the client account or trading book if it was
in the principal/house account.
Effect the client settlement instructions
The transaction will be posted to the relevant client account or trad-
ing book. If it is a client trade it will be booked either to their omnibus
account or to a designated account. In the latter case the client will
need to advise the broker of which account to book the trade to. This
could be done via the sales desk or via the operations team or may be
notified via both routes.
The client may maintain a monetary balance in their account(s), in
which case the transaction will update the balance. Confirmation of
the transaction and the revised open option position and cash bal-
ance on the account will be advised to the client.
There are several ways that this could take place.
1. Client access to accounts
2. By email
3. By fax
4. By telephone
5. Hard-copy report.
In each case the important thing is to establish that the client is aware
of the settlement requirement and the impact on their open position
and cash position. The process is also a fundamental control acting as
an affirmation or acceptance by the client of the transaction and asso-
ciated settlement. An audit trail for the trade is also established with
the transaction showing in the clearing account and backed off in the
client account.
90 Clearing and settlement of derivatives
Clearing account Client account
Buy one BP Oct. 330 Call @ 20p Buy one BP Oct. 330 Call @ 20p
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