What is a clearing house?
We are launching our new clearing house in September, and shortly thereafter New Zealand’s own derivatives market. The clearing house will be run by NZ Clearing Corporation Ltd, which is a wholly owned subsidiary of NZX.
We will kick off our derivatives market with the launch of the Global Whole Milk Powder (WMP) Future.
CLEARING HOUSE
Q: What is a clearing house?
A: A clearing house is a financial institution that provides clearing and settlement services for derivatives and securities transactions. It manages credit exposure after trades have been executed, but before they have been settled. Settlement is the process where securities are delivered, usually in exchange for funds.
Who runs a clearing house?
A: A clearing house is run by an agency or corporation. In New Zealand, NZX owns the New Zealand Clearing and Depository Corporation Limited, which operates the new clearing house.
Q: What is the purpose of a clearing house?
A: The clearing house stands between two member firms (called clearing participants). Its purpose is to reduce the risk of a clearing firm failing to honour its trade settlement obligations.
Q: How does it work?
A: A Clearing House operates as a central counterparty. Once two counterparties – for example, trading firms – have executed a trade, the trade is handed over to the clearing house.
The clearing house becomes the buyer to every sell contract, and the seller to every buy contract. Therefore the clearing house assumes counterparty risk for all trades. The clearing house then nets all of the trade obligations for a participant to arrive at a single receipt or delivery obligation for each security.
The main financial risk for the clearing house is replacement cost risk, i.e. the cost to replace the settlement obligation of a failed clearing participant. This risk is managed by imposing margin requirements – assets that each clearing participant must provide to the clearing house to cover the risk of default.
Q: What is the main benefit of a clearing house?
A: Basically a clearing house exists to reduce the risk for the trading participants. A clearing house makes sure all trading participants are able to settle their trades by requiring deposits from the participants, providing independent valuation of trades, and by monitoring the creditworthiness of clearing firms. Most clearing houses have a guaranteed fund that can be used to cover losses in case of a market participant default.
DERIVATIVES
Q: What is a derivative?
A: A derivative is a financial agreement between two people or two parties that has a value determined by the price of something else, most commonly from stocks, bonds, currency or commodities. It is a financial contract and its value is linked to the expected future price movements of the asset it is linked to – such as a share or a currency.
For example, a commodity derivative might give you the right to buy a particular commodity at a stated price up to a given date. If the commodity price – let’s say milk price – moves up, then the right to buy at a fixed price becomes more valuable. If it moves down, the right to buy becomes less valuable.
Q: What are futures and options?
A: Futures and options are two commonly traded types of derivatives. An options contract gives the owner the right to buy or sell an asset at a set price on or before a given date. On the other hand, the owner of a futures contract has an obligation to buy or sell the asset.
A futures contract is a legally binding contract to buy or sell a standardised product, at a fixed price, for cash settlement or physical delivery on a given date in the future. For example, in the case of Dairy Futures, the standardised product is the dairy commodity from which it is derived.
An option is the right, but not the obligation, to buy or sell something at a fixed price in the future. This price is called the “strike price”. There are two types of options:
- A call option gives the holder of an option the right, but not the obligation, to buy the underlying asset at the strike price.
- A put option gives the holder of an option the right, but not the obligation, to sell the underlying asset at the strike price.
Who runs these markets?
A: NZX will be the central marketplace in New Zealand that facilitates the trading of futures between participants. It will be an efficient, robust market supported by a world class clearing system, New Zealand Clearing Corporation Limited. Participants can be assured of transparency and security when they trade with NZX.
Q: What is the purpose of derivatives?
A: Derivatives can be used to manage risk, smooth out volatility and are intended to create price certainty, transparency and a forward view of market sentiment. They allow parties to manage risk by creating opposing positions in the futures and physical market, effectively neutralising any movement in price. Participants can open a position by buying or selling and close a position by carrying out an opposing trade, i.e. open with a sell, close with a buy.
They allow parties to transfer the price risk of an underlying asset from one party to another – for example from seller of a commodity to the buyer of a commodity.
Q: How do they work?
A: In any market there is a buyer and seller. A buyer is facing a risk of a price going up and a seller is at risk of a price going down. Rather than take a risk on the price moving unfavourably between now and actually making a purchase or sale, participants will “hedge” or fix a price in advance of the physical transaction being completed.
For example, a dairy farmer and a dairy producer could sign a futures contract to exchange a specified amount of cash for a specified amount of milk in the future. Both parties have reduced a future risk: for the dairy farmer, the uncertainty of the price, and for the producer, the availability of the milk.
Q: What are NZX Dairy Futures?
A: NZX will launch Futures and Options markets in September with Dairy Futures. The first product to go live is the Global WMP Futures contract, which is the global dairy industry’s first risk management tool for Whole Milk Powder.
NZX Dairy Futures will be exchange listed and cash settled to globalDairyTrade (gDT) prices. Cash settlement of a futures contract means trading is much simpler and easier. Participants do not have to use complicated delivery mechanisms or risk having to make, or take, delivery of the underlying product to which the future relates. Cash settlement is particularly preferable for dairy commodities where food safety criteria, and the actual delivery process, are complex and not globally standardised.
Further reading:
Herald articles:
“Cut dairy risks or suffer, says US expert”
http://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=10662887
“Global dairy futures market on the way”
http://www.nzherald.co.nz/business/news/article.cfm?c_id=3&objectid=10642361
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Posted by Merja on August 20th, 2010 :: Filed under Dairy, General
Tags :: dairy derivatives, Dairy Futures, Dairy Options, derivatives, NZ Clearing Corporation, NZ clearing house, NZX clearing house, Whole Milk Powder
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