What will be the impact of physical delivery of stock derivatives?

The Sebi's decision to make physical delivery of stock derivatives mandatory will have multiple knock-on effects across cash and derivatives segments. Many of those consequences would be negative. 

India has an extremely active stock futures market, and a less-active but still-liquid stock options market, with all contracts cash-settled. High liquidity enables efficient price-discovery and leads to tight spreads between bids and asks.

This is beneficial to investors and hedgers. More derivative volumes also leads to more liquidity in the cash segment. The underlying stock has tighter spreads and it can be traded at a lower impact cost. (Impact cost is the amount a price is affected by a big trade. The more liquid the stock, the lower the impact cost for jumbo trades).  The lower the impact cost and the tighter the spread, the better it is for the investor.

Another advantage is the comfort of knowing that an adverse move can be hedged. The investor can take a covered short derivative position by selling the future or buying puts while holding the underlying. This enables investors to enter without fear.

A liquid derivatives market also enables traders to speculate. This is apparently what worries Sebi. But speculative traders perform a very useful service. If speculative volumes did not exist, the derivatives market would not be liquid. In a less liquid market, price discovery becomes less efficient and bid-ask spreads widen. This in turn, leads to lower volumes and wider bid-ask spreads in cash segment.  That raises the impact costs.

If the intention behind forcing physical delivery is to curb overheated speculation and manipulation, there are other, probably more effective means of doing that. Indeed Sebi has taken several other measures that should help curb excessive speculation.

For example, it has laid down more stringent criteria for stocks to be placed in the derivatives segment. The market wide position limit and median quarter-sigma order size has been revised upward from current level of Rs 3 billion and Rs 1 million, respectively to Rs 5 billion and Rs 2.5 million, respectively. An additional criterion of average daily deliverable' value in the cash market of Rs 100 million has also been prescribed. The enhanced criteria need to be met for a continuous period of six months.

The problem with physical delivery is that it is close to impossible to short-sell a stock in the Indian market. We have seen this in the cash segment. While a short-selling mechanism exists in theory, shorting stocks outside the F&O segment, except in day trades is impractical.

The short-seller must borrow stocks from some institution that holds it in the portfolio. This involves first, the willingness of such an institution to lend stock. It also involves paying interest, and having to buyback from the market to replace the stock and complete the trade.

The inability to short sell stocks in the cash segment causes less efficient price discovery. In stocks with low free-float, it can lead to a situation where trading stops, with near-zero volume and quotes that fail to reflect changes in the corporate's business situation. It can also lead to short-squeezes as in the bad old days of badla, where short-sellers cannot cover a trade. That is a classic manipulative situation where institutions with large holdings can control the price of a share.

The F&O segment was created to avoid such inefficiencies in large caps. This system has worked quite well. The premium/ discount between futures and cash prices are generally close to the cost of carry.  By forcing physical settlement, the distinctions between cash segment and F&O are being reduced.

The likely result will be a reduction in volumes across cash and derivatives segment and a rise in bid-ask spreads.  Impact costs are bound to rise. Institutions and large investors, which hold large portfolios of underlying stocks will also have an enhanced power to manipulate prices since they will effectively be the only short-players.

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