Friday, 8 February 2019

How physical settlement of stock derivatives is going to impact you

Market regulator Sebi (Securities and Exchange Board of India) issued the 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 the 200 stocks traded in the futures & options segment, the physical settlement mechanism already exists in the 50 stocks. 

Now, Sebi wants to apply the same mechanism to all stocks, which are cash-settled under the existing framework. Remember, a large share of F&O volumes comes from index contracts, which will remain cash settled. 

According to Sebi, the stocks shall first be ranked in descending order based on daily market capitalisation averaged for December 2018. 

Based on the ranking arrived, the bottom 50 stocks would move to physical settlement from April expiry onwards, the next 50 would move to physical settlement from July expiry onwards, and the remaining would move to physical settlement from October expiry onwards, the market regulator said. 

Sebi said derivatives introduced in new stocks, meeting the 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 the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities. 

The Indian market is considered one of the most speculative in the world as far as derivative contracts go. Currently, on a cash market turnover to derivative market turnover ratio basis, Dalal Street has the highest level in the world. 

The Sebi move is aimed at curbing excessive speculation, which creates too much volatility in the market. Under physical settlement, traders will have to compulsorily take delivery of shares on the expiry day against their derivative positions. 

In cash settlement in futures & options, the seller of the financial instrument does not deliver the actual (physical) underlying asset upon expiration or exercise, but instead transfers the associated cash position. When such contracts require physical settlement, it forces traders to roll over positions ahead of the expiry, thus averting lumping of rollovers at the end of the series, which leads to excessive volatility. 

Analysts say by forcing such physical settlement, Sebi is reducing the distinction between cash market and F&O market, which may eventually lead to a drop in volume in both cash and derivative markets. 

That’s 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 the SLB (securities lending and borrowing) mechanism, which allows borrowing of securities from institutional investors. But that space still remains shallow in India. 

Some of the market participants would now have a relook at the 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 the SLB segment, liquidity will develop, leading to deeper a SLB market and more volumes in that space.

The new move is something Sebi has been talking about for some time, and the market looks prepared for it. 

This is a long-awaited measure from Sebi and it has powerful indication.However, the market veteran calls the move half-baked. “Unless you clear the market lot system out of the derivative market, even a delivery-settled derivative market will not be helpful in general. It will end up extending volatility.
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.

When traders will have positions working for them on the hedge side or the on the 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. This is a welcome move from long-term investors’ perspective. 

Stocks might be volatile as market participants adjust to the new mechanism. As the process settles and the market participants realise the approximate amount of physically-settled stock, volatility will normalise. 

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