Sebi approves physical settlement in derivatives

Equity derivatives may soon have to be settled physically, rather than in cash.

In line with the recommendations of the derivatives market review committee headed by M Ramohan Rao, former dean of Indian School of Business, which had submitted its report in December, 2008, the Securities and Exchange Board of India (Sebi) has decided to grant an in-principle approval to stock exchanges for the introduction of physical settlement of equity derivatives.

The market regulator has also approved introduction of derivatives with five-year tenures and those based on volatility indices.
Equity derivatives were introduced in India in June 2000, with the launch of index futures. Over the years, newer types of equity derivatives have been launched. But all along, these transactions have been settled in cash.

“The board has decided that we will discuss with the stock exchanges and institute an appropriate mechanism for physical delivery in the derivatives market,” Sebi chairman C B Bhave said.
Going by experts, cash settlement is much simpler than physical settlement and has thus led to equity derivatives becoming fairly popular in India. But it also led to a situation where speculators needed to operate only in one market (i.e. the derivatives market) instead of two. In a market in which physical settlement will be required, this is not that easy, given that speculators will have to deliver the underlying stock.

Among the other negatives of cash settlement was that it exposed genuine hedgers to what is known as basis risk, which is the risk of the spot price and the futures price not converging on the expiry date, which now stands removed.

“This move will encourage greater hedging as opposed to speculation in the market. It is also likely to reduce leverage in the market and increase cash volumes,” Siddharth Bhamre, head of derivatives at Angel Broking said.

For February, average daily cash volumes were Rs16,388 crore, while derivatives volumes were Rs 78,494 crore.

Sebi’s decision does, however, raise questions about the absence of an effective stock lending and borrowing mechanism.
The L C Gupta Committee, which submitted its report in December, 1997, and set the scene for derivatives trading in India, had said that stock futures should only be brought in once a system for lending and borrowing of shares was put in place.
In the report submitted by the M Ramohan Rao Committee, Chitra Ramakrishna, a member, said the lending and borrowing mechanism “should be liquid enough so that borrowers have the confidence that they will be adequately meet physical settlement obligations.”

Development of the stock lending and borrowing mechanism was initiated two years back in April, 2008, but has still not taken off.
Experts suggest physical settlement could help the market develop.

“These are early days yet. The stock lending and borrowing mechanism will evolve as the derivatives segment gradually moves towards the implementation of these moves,” said Sandeep Singhal, head derivatives at Emkay Global.

The situation in the case of derivatives on volatility indices is simpler. The National Stock Exchange currently has a Vix index, started in April 2008, which could be the basis for the derivatives since the regulator emphasised the need for a track-record for the index.

“The Vix-based derivatives should help deal with excess volatility and can be expected to catch on quickly,” said Monal Desai, head of derivatives at Prabhduas Lilladher.

Longer tenure derivatives may not catch on immediately among regular market participants due to lack of liquidity. In fact, going by analysts, there is hardly any liquidity for three month contracts.
“Long duration contracts will not have much of an impact as most people do not take a long-term view,” Desai added.