The Assayer's Rejection and a Bounced Cheque at Pay-in
A clearing member on an agri-focused exchange has two clients in soybean futures, where one lot is 10 MT. Client A has sold 15 lots (150 MT) and has submitted a delivery intention. Client B has bought 10 lots and is expecting delivery. On the tender day Client A tenders warehouse receipts for 150 MT, but the exchange's assayer rejects 40 MT because moisture exceeds the contract specification. Separately, Client A's cheque for its Rs 6.2 lakh mark-to-market loss is returned unpaid at the T+1 pay-in. The member holds Rs 4 crore in its own settlement account and has lodged a Rs 2 crore bank guarantee with the exchange. The exchange's bye-laws provide a penalty on a defaulting seller, a default pricing mechanism for buy-in, and a settlement guarantee fund standing behind the non-defaulting buyer.
1. Describe the settlement sequence for the 150 MT: which leg fails, what the exchange does with the rejected quantity, and how Client B is protected.
Read the worked answer
Settlement of a delivery trade is simultaneous: funds are paid in by the buyer's clearing member and warehouse receipts are paid out, with the exchange holding the receipts as the fulcrum. Client A can validly tender only 110 MT; the 40 MT rejected by the assayer is a delivery shortfall.
For the 110 MT, Client B's member pays in funds and receives the receipts, which are passed to Client B. Client B is not exposed to the assayer's opinion on quantity it did not buy.
For the 40 MT, the exchange invokes its default mechanism: a buy-in at the default price, or close-out of the unmatched position, with the differential, penalty and costs recovered first from Client A's margins and deposits, then from the member, with the settlement guarantee fund available to protect the non-defaulting buyer from loss caused by the default. Client B ends up with 110 MT plus a cash settlement for the balance, not with an unhedged long.
The member is liable to the exchange for its client's default, and recovers from Client A.
2. Client A's cheque bounces. What must the member do immediately, and which actions would be a regulatory violation?
Read the worked answer
The member must fund the exchange's pay-in from its own resources by the deadline. The clearing corporation looks to the member, not to the member's client, and a failed pay-in triggers default proceedings against the member, invocation of its Rs 2 crore bank guarantee, and possible disablement.
Immediately after funding, the member should square off or otherwise close Client A's positions, freeze the account, issue a written notice, levy the exchange-prescribed penalty (typically a percentage per day of the shortfall, subject to a minimum), report the client default to the exchange, and lodge the cheque-return with its bank.
Violations would include: using Client B's collateral or any other client's funds to make good Client A's shortfall; withdrawing from the client securities/commodity collateral pool without authority; delaying the report to the exchange; or allowing Client A to keep trading. Client funds must be segregated client-wise, and using one client's collateral for another is misappropriation, not a treasury decision.
3. Explain the respective roles of the member's own funds, the bank guarantee, and the settlement guarantee fund in this case, and whether the member can net Client A's shortfall against Client B's surplus.
Read the worked answer
The layers are sequential. First, Client A's own margins and deposits meet its obligations. Second, when these are insufficient, the member must meet them from its own settlement account: that is the meaning of membership. Third, the Rs 2 crore bank guarantee is a pre-lodged collateral that the exchange can invoke against the member's default. Fourth, the settlement guarantee fund is the mutualised layer that protects non-defaulting counterparties such as Client B when the defaulter and the member cannot pay.
Netting Client A's shortfall against Client B's surplus is not permitted. Client B's funds or collateral belong to Client B and can be used only for Client B's obligations, with its authorisation; set-off across clients converts a settlement shortfall into misutilisation of client assets. Intra-client netting across contracts and exchanges is also constrained. The member may net only its own proprietary position against its own obligations, and must report client-wise collateral accurately, including any pledge or lien.