Market players favour physical settlement of derivative trades

Say this would prevent stock price manipulation.

Domestic stock market players are in favour of physical settlement of derivative trades as speculators and short-sellers are yet again trying to exploit current negative sentiment among investors following the lacklustre Interim Budget.

The Sensex has crashed by 599 points, or over 6 per cent, in the last two trading sessions. However, among emerging markets, China was up 3 per cent and Brazil and Russia were flat during the same time.

Market players say some of the top speculators come together to short-sell in the futures segment and put pressure on single stock futures using thin volumes to their advantage, which is why some real-estate and banking stocks have crashed 5-15 per cent in the last two days.

Physical settlement of equities is when an underlying stock is purchased from the cash market and delivered to the counter-party for a specified payment when the contract expires. Chances of manipulation are greater in cash settlement in the absence of physical settlement system. Once such a system is in place, manipulators would know that if they artificially increase or decrease stock prices, counter parties could impose delivery.

Currently, under the cash settlement system, traders manipulate prices by taking large short positions in the futures market near contract expiry and then depress the formula-based settlement price, thus making a windfall on futures positions.

According to Deven Choksey, Managing Director, K R Choksey Shares and Securities, physical settlement of derivative trades would be one of the finest steps in making the Indian market mature. “Time and again, big crashes have exposed how vulnerable our markets are. After every crash, volumes dry down significantly and the market loses depth,” said Choksey.

The Chicago Board of Trade, from where futures and options (F&O) originated, has physical settlement of derivatives trade. That apart, almost all the developed markets in the world follow the same practice.

Choksey is of the view that if physical settlement is allowed, volumes in the cash segment will increase as traders will buy shares to give delivery. However, one of the chief reasons that is holding back policymakers from implementing the physical settlement system is the fear of shrinking volumes in futures.

Manoj Vaish, former President of the Bombay Stock Exchange and current Chief Executive Officer of Dun & Bradstreet India, also believes that introduction of physical settlement in derivatives would add more depth to Indian markets. “Initially, when F&O was introduced, cash settlement was allowed so that our markets could develop swiftly. However, now I believe that Indian markets are no longer craving for attention as they are on the investment radar of the entire world. So, adoption of the physical settlement system now would be a good idea,” said Vaish.