Market regulator Sebi (Securities and Exchange Board of India) on Monday issued much-awaited framework for making physical settlement of stock derivatives mandatory.
The same will be enforced in a phased manner.
As on date, out of 200 stocks traded in futures options segment, physical settlement mechanism already exists in 50 stocks.Now, Sebi wants to apply same mechanism to all stocks, which are cash-settled under existing framework.
Remember, a large share of FO volumes comes from index contracts, which will remain cash settled.According to Sebi, stocks shall first be ranked in descending order based on daily market capitalisation averaged for December 2018.Based on ranking arrived, bottom 50 stocks would move to physical settlement from April expiry onwards, next 50 would move to physical settlement from July expiry onwards, and remaining would move to physical settlement from October expiry onwards, market regulator said.Sebi said derivatives introduced in new stocks, meeting enhanced eligibility criteria specified by it, would also be physically settled.Derivatives in financial markets typically refer to forwards, futures, options or any other hybrid contracts of pre-determined fixed duration linked for purpose of contract fulfillment to value of a specified real or financial asset or to an index of securities.The Indian market is considered one of most speculative in world as far as derivative contracts go.
Currently, on a cash market turnover to derivative market turnover ratio basis, Dalal Street has highest level in world.The Sebi move is aimed at curbing excessive speculation, which creates too much volatility in market.
Under physical settlement, traders will have to compulsorily take delivery of shares on expiry day against their derivative positions.In cash settlement in futures options, seller of financial instrument does not deliver actual (physical) underlying asset upon expiration or exercise, but instead transfers associated cash position.
When such contracts require physical settlement, it forces traders to roll over positions ahead of expiry, thus averting lumping of rollovers at end of series, which leads to excessive volatility.Analysts say by forcing such physical settlement, Sebi is reducing distinction between cash market and FO market, which may eventually lead to a drop in volume in both cash and derivative markets.Thats not good news, as it may trigger a spike in bid-ask spreads, which can, in turn, cause impact costs to rise, as it all depends on liquidity levels.
Liquidity, in turn, is variable of derivative volumes.
Better liquidity facilitates more efficient price discovery and tightens spreads between bids and asks.Physical delivery could also reduce short selling.
Short sellers will now have to first borrow stocks under SLB (securities lending and borrowing) mechanism, which allows borrowing of securities from institutional investors.
But that space still remains shallow in India.Some of market participants would now have a relook at SLB space.
Globally, stock-specific shorting happens through SLB, and futures options are used more for index positioning.As more market participants start trading in SLB segment, liquidity will develop, leading to deeper a SLB market and more volumes in that space, said Viral Berawala, CIO of Essel Mutual Fund.Nirav Chheda, Technical Derivatives Research Analyst, Nirmal Bang Securities said FO rollovers, which happen near to expiry, will start happening a week early in stocks, and volumes will get channelled to indices during expiry week.I dont think there will be other major impact as such.
Just volumes might go dry in stocks during expiry week, he said.The new move is something Sebi has been talking about for some time, and market looks prepared for it.This is a long-awaited measure from Sebi and it has powerful indication, said Deven Choksey, MD, KR Choksey Investment Managers.However, market veteran calls move half-baked.
Unless you clear market lot system out of derivative market, even a delivery-settled derivative market will not be helpful in general.
It will end up extending volatility, he said.
On one side you are forcing people to continuously operate on a minimum market lot size and that too, you want to take to higher levels of Rs 5 lakh or Rs 10 lakh eventually.
This unnecessarily creates too much of pressure and volatility, including rollovers, during which you see sharp increase in volumes, which are not genuine, Choksey said.
When traders will have positions working for them on hedge side or on leverage side, probably delivery-settled derivative market would work favourably.
Over time, when Sebi brings down or removes market lots, volatility would come down significantly, he said.Choksey, however, said this is a welcome move from long-term investors perspective.Berawala of Essel Mutual Fund says during initial few expiry days, stocks might be volatile as market participants adjust to new mechanism.
As process settles and market participants realise approximate amount of physically-settled stock, volatility will normalise.