Pakistan Mercantile Exchange Limited (PMEX) is the first futures commodity market in Pakistan. It is the only organization in Pakistan to provide a centralized and regulated place for commodity Futures trading and is regulated by Securities and Exchange Commission of Pakistan (SECP).
Being a new electronic exchange, PMEX was able to take advantage of recent advances in technology when building its systems. One major feature has been the ability to perform pre-trade checks before orders are accepted for trading by the system. Most developed exchanges of the world still don’t have this functionality as they rely on post-trade margining and reliance on clearing brokers. However, given the specific nature of local participants and their practices, having a pre-trade check that does not allow orders to be entered unless there are sufficient margins with the exchange is a crucial functionality.
Segregation of Client Accounts at Exchange-Level:
PMEX is one of the world’s first exchanges to implement a system of segregated reporting of individual end-customer ledgers and accounts at the exchange and clearinghouse level. While this feature was necessitated by the absence of strong institutional clearing brokers in the country, it has also resulted in better risk management, greater investor protection and more efficient broker operations.
Direct Market Access
PMEX is a pioneer in providing direct market access to all participants. Normally, this is a service only provided to large clients by other exchanges but using technology to the fullest; PMEX provides direct trading terminals to all participants free of cost.
One important aspect of being a demutualized exchange is that membership of the exchange is separate from trading rights on the exchange. Membership of the exchange does not entitle one to share in the ownership of the exchange and hence the important separation of ownership and trading is preserved. In order to eliminate potential conflicts of interest, it is also necessary that membership of the exchange is kept open for new entrants. Maintaining such an open membership model is an important measure to ensure the true spirit of demutualization. Restrictions on new entrants results in a closed culture of a club where the inherent vested interests of maintaining barriers to entry affect the behavior of members. Such a setup is generally considered to be suboptimal and counterproductive to the higher objective of having deep and liquid markets.
There are two kinds of memberships at PMEX:
- Universal Membership
- Commodity Specific Membership
Universal Membership allows brokers to trade all listed contracts on the exchange whereas commodity specific membership gives access to trade contracts on just one specified underlying commodity. There are certain differences in financial requirement for both types of memberships. Other than that, all other rules and regulations are equally applicable to both categories.
Trading, Clearing & Settlement:
Most futures exchanges have separate trading and clearing roles for brokers. This separation is considered more efficient in terms of risk management and operational efficiency. However, being a new exchange and given the nascent state of future trading in the country, PMEX operates a unified, trading-cum-clearing membership model. Under this model, all PMEX brokers are responsible for clearing their own trades. ’Own trades’ also means all trades of broker’s clients. Under the regulatory relationship between a member-broker and the exchange, as written in PMEX General Regulations, broker is the primary obligor to the exchange for all his as well as his customer trades.
Current regulatory setup of PMEX implies that all members of the exchange are clearing as well as trading members. In future, the exchange may create clearing-only and trading-only memberships but current regulations stipulate that brokers must clear all trades done through their brokerage house. This also makes it important for all brokers to be well acquainted with rules, obligations and procedures regarding trading, clearing and settlement. In order to do this, a clear understanding of the definitions of these functions is a first step.
In the context of the current discussion, trading can be defined as the act of placing orders in the market and their subsequent execution. As a function, it can be separated from what happens after a trade happens, which will be discussed later. If a broker only provides a service whereby he or his clients make orders to be executed in the market, he can be said to involve in trading-only activity. This functionality can be segregated within a trading-cum-clearing brokerage firm as well as where trading is handled separately by the trading desk of the member.
Clearing is defined as the process of processing details of buyers and sellers once a trade has been executed. It involves the transfer of ownership and cash between the buyer and seller and the debit and credit of respective accounts of buyers and sellers. This matching between the accounts of buyers and sellers is essential in order to complete the obligations of buyers and sellers arising out of the trade.
With advances in technology and operations, it now seems an automatic step from trading to clearing. However, the two steps can be divided distinctly if separate entities are handling the processes. Many exchanges around the world rely on other clearinghouses to process trades executed at own systems. Equally prevalent is the system of own clearing. PMEX falls under this category where it has its own clearinghouse. Having own clearinghouse, along with a unified system and database, the exchange is able to operate straight-through-processing. This eliminates discrepancies and risks that were possible in older, manual trading systems.
In terms of futures trading, clearing also involves the inherent process of central counterparty novation. Novation involves the clearinghouse becoming counterparty to all trades, i.e. a buyer to every seller and a seller to every buyer. The clearinghouse has no net position and all participants face the clearinghouse as their counterparty.
Settlement is the third part of the transaction which completes the whole trade process. It involves the closure of all obligations arising out of the initial transaction results in payment and delivery of cash and asset. In modern, straight-through-processing systems trading and clearing are often integrated with robust pre-trade checks, margining regimes and other risk management measures. Settlement, however, can involve certain element of manual or out-of-the systems reliance. This can be due to dependence on banking systems that may not be fully integrated with the trading and clearing systems of the exchange and clearinghouse.
On the delivery side, often the underlying assets are traded and settled according to trade conventions of the spot market. Depending on how well an exchange’s delivery system is integrated with the underlying market, the settlement process can be as efficient or cumbersome.
At PMEX, the cash settlement process is very advanced in that it is linked through the CSR system with online banking networks of the exchange’s designated clearing banks. Transfer of funds is affected in real-time between the broker and the exchange if done through exchange designated clearing banks.
One required input for all orders is the information regarding how long the order will remain active in the market. PMEX currently offers two types of parameters for orders:
This parameter value is the default setting at PMEX and makes all such orders valid till day end. As the trading day ends, all standing (or working) orders will be cancelled.
Good Till Cancelled Orders (GTC)
If a trader flags an order as GTC at the time of entering, the order will remain active in the market till it is cancelled or the contract in which it is placed expires. This category is useful for traders who want to maintain a given order till execution and do not want orders to be cancelled automatically at close of trading day.
PMEX margining regime works on an efficient paradigm which aims to maintain a balance between margins and needs of participants. Margins should be set according to the underlying risks of the traded contract. Lower margins can lead to defaults whereas excessive margining also harms market liquidity and can be catalyst for defaults. While the exchange requires same level of minimum margins from all participants, brokers have the authority to charge higher margins from clients according to their risk profile of the client. Brokers can also distinguish between clients in terms of margins and are allowed to have different margins for different clients. This is based on the view that a broker is the best person to judge the riskiness of a client as opposed to the exchange. Exchange requires minimum level of margins from all brokers as all brokers are treated equal by the exchange. Brokers, on the other hand, can distinguish between clients.
There are two primary levels of margins at PMEX that a broker has to deposit, Clearing and initial. Apart from that, there are other margins also listed below:
Clearing margins, also referred to as clearing deposits, are required from all active brokers of the exchange. The minimum level of clearing deposit required is Rs 500,000. Brokers can deposit higher clearing margin as well. PMEX specifies a clearing margin for each commodity. A broker’s clearing deposit held at the exchange should always be enough to cover the overall exposure taken by all clients of a broker on a gross basis. There is no netting across clients or with broker’s own proprietary positions. Under the regulations, a broker is the primary obligor for all his as well his clients’ trades. Adequate clearing deposit paid to the exchange is a testimony to a broker’s ability to carry out business and financially support the exposures of all his clients.
As clearing margin is different for each commodity contract, the amount of exposure a broker can take will also vary according to what commodities are being traded.
Initial margins are specifically designed to cater for market risk of open positions. Initial margins are required for each trading account separately with no netting across clients. Initial margins are considered the first line of defence in clearinghouse risk management, with clearing margins acting as the second line of defence. Initial margin is the minimum amount the exchange expects all participants to pay to the clearinghouse. It is the obligation of the brokers to collect margins from clients and pass on to the exchange. In order to help brokers in managing client risks, exchange regulations provide powers to brokers for asking higher margins according to their own assessments.
Initial margins are required before an order can be accepted for trading in the system. The automated pre-trade verification of NEXT makes it impossible for an order to be accepted unless the exchange holds minimum margins for that order in the specific account.
All accounts are marked-to-market according to exchange specified rules and times. After mark-to-market calculations are complete, the value of each account is updated in the official ledgers of the exchange. The purpose of mark-to-market exercise is to determine the correct value and profit & loss of each account. Once losses have been identified and applied to loss-making accounts, their margin requirements are recalculated. Losses are debited straight away from account value, after which the margin requirements are recalculated and wherever there is a shortfall in margin requirement, a margin call is issued. The official issuance of margin call is through a margin call report available in CSR (Corporate Social Responsibility) as opposed to any specific, physical communication from the exchange. The latest margin call statement in CSR is the official notification from the exchange and brokers are required to view and monitor this report after each MTM. The requirement to pay the extra amount in order to keep the minimum level of initial margin is effectively the variation margin.
For certain contracts, the exchange specifies extra margins nearer the expiry. This is especially the case in deliverable contracts where risks associated with physical delivery are greater and the exchange wants to curb excessive speculation. In order to ensure that genuine traders who are interested and capable of making and taking delivery of commodities are active towards the end of the contract. For those participants who are only interested in price risk management, imposition of delivery margins acts as a catalyst for rolling over positions to the next contract month. This practice also ensures that prices correctly reflect the underlying market and a natural convergence occurs at the expiry of the contract. Delivery margins can be imposed towards the end of the trading of a contract or after expiry but before final settlement. Delivery margins can be in addition to initial margins or they can replace initial margins, depending at what stage of a contract they become applicable. Applicability of delivery margins is mentioned in contract specifications document and other relevant circulars issued by the exchange.
The exchange can impose other types of margins as well if required by specific circumstances. These can relate to periods of excessive volatility, price inconsistencies, illiquidity, demand-supply mismatch or any other factor deemed by the exchange as warranting additional margins. PMEX General Regulations give the exchange powers to impose additional margins as deemed appropriate. These are further defined through contract specifications or circulars.
In order to provide better risk management tools to brokers, PMEX also provides an auto-liquidation facility. This essentially performs the same function as a stop-loss order. The difference is that in a stop-loss order, the trader specifies a specific price at which the order is activated. In auto-liquidation, brokers assign a specific account value (either in rupee terms or in percentage terms) at which all positions are liquidated. Auto-liquidation can be considered as an overall, account-level stop-loss order which liquidates all open positions of an account in order to preserve its value and stop it from going into negative.