By Shashank Kanodia, Mukta Sagar and Taher Ali, MBA capital Markets, NMIMS
NSE launched derivatives trading in Index Futures on 12th June 2000, trading in Index Options on 4th June 2001 and trading in Futures on individual securities on 9th November 2001. Currently derivatives’ trading is based on individual securities and indices like S&P CNX Nifty, CNXIT, BANK Nifty, Nifty Midcap 50, etc. But almost entire derivatives volume is with the NSE.
The stock market regulator's nod to physical delivery of equity derivatives could pave the way for major changes in the F&O (futures & options) segment. The Securities and Exchange Board of India (SEBI) is discussing the issue with stock exchanges and will announce detailed guidelines on derivative trading after the deliberations.
Settlements are currently done through the National Securities Clearing Corporation Ltd (NSCCL) on the NSE. The average daily turnover on the derivatives segment of the NSE for the month of June 2010 stands at Rs 92,527 crore.
Current Scenario: - Currently, derivative contract has to be settled against cash at the time of expiry of contract wherein only the difference between the current price of the asset (spot price) and the contract price has to be settled in cash between counter parties, though at the time of purchase of contract the investor is required to submit initial margin money to derivatives exchange.
Proposed Physical Settlement:-
Under Physical Settlement the derivate contract has an option to be settled against the physical delivery of underlying asset at the time of expiry of contract.
Effects:-
1) It will reduce the chances of manipulation in prices as the counter-parties can demand delivery if they artificially manipulate stock prices which was prevalent in case of cash settlement during fag end of the settlement
2) It ensures better convergence between the spot & future prices at the contract expiration date thereby reducing volatility.
3) Number of people buying in cash and selling in derivatives would decrease as there won’t be much of a difference in the spot and derivatives prices.
Consider, If on 1st August I buy one lot of future of buying 100 shares of ABC Co. (Whose current future price is Rs.100) by paying 20% margin and difference in mark to market i.e.: 20% of 100*100 =Rs.2000. After one month, price of the stock future during settlement (last Thursday of every month) becomes Rs. 90. During cash settlement the derivative product holder ( Buyer) has to pay only the difference between purchase price and final settlement price of the derivative i.e.: 100-90=10*100=1000 and in physical settlement after paying the mark to market price he has an option of taking delivery after paying the settlement price minus margin money,
i.e.: 100*100=10000-2000-1000=7000 and he will be saved from booking the loss.
4) As derivatives market will become more capital intensive it will encourage greater high net worth to individuals & institutional investors to hedge their investments through it. This, in turn, will help in raising the market capitalization of derivatives markets.
Challenges:
1) Transaction Costs/Security Transaction Tax
Currently in cash settlement STT is charged at rates applicable to a particular deal on the day of trade but once physical settlement is introduced then investors may have to pay STT once more when they actually deliver the securities at the time of settlement of contract. Also in case investors borrow or buy securities for delivering against the contract then such a transaction is also liable to pay STT.
2) Amendments to existing rules and regulations for successful implementation of physical settlement.
3) There should be specific criteria about the liquidity and the impact cost, delivery volumes, etc, in any stock and based on that the stock should qualify for physical settlement.
4) Absence of active stock lending and borrowing (SLB) mechanism and concerns of short freeze by short-sellers in illiquid stocks.
5) Education and knowledge dissemination
Investors will have to be empowered by educating them and making them aware of the intricacies of physical settlement which is relatively a new concept for Indian Capital markets
As per the SEBI Circular stock exchanges will have to introduce physical settlement in a phased manner so as to cover all stock options and futures within six months of start of physical settlement.SEBI hasn't clarified whether the physical settlement will be optional or mandatory. Also, it’s not clear whether the physical settlement for equity options is exercised only on the expiry of the contract or whenever the buyer chooses to exercise it.
The way ahead
Success of physical settlement is subjected to the completion of all logical steps. Nothing can be predicted with certainty in short term but in long run this is a step that is bound to bring stability to the market. It will not only help to minimize the speculative trading but will also take Indian bourses a bit closer to international practices.
About the authors
Shashank Kanodia is a 1st year MBA student at NMIMS, Mumbai. He holds a bachelor’s degree in Instrumentation and control Engineering from Bharathi Vidyapith University and can be reached at shashank.kanodia@gmail.com
Mukta Sagar Rakshit is a 1st year MBA student at NMIMS, Mumbai. He holds a bachelor’s degree in Mechanical Engineering from PESIT, Bangalore and can be reached at muktasagar@gmail.com
Taher Zoher Ali is a 1st year MBA student at NMIMS, Mumbai. He has completed his BE in Information technology from Mumbai University and can be reached at taher20@gmail.com
