The Securities and Exchange Board of India (Sebi) decision to introduce physical settlement in equity derivatives would lower volatility in the stock market and increase trading volumes, market experts said. It is feasible and would make the borrowing and lending markets more active.
In physical settlement of equity derivatives, a seller of stock futures or options has to deliver the shares to the counter-party when the contract expires. In cash settlement, the difference between the selling price and price at the time of expiry of the contract has to be settled in cash.
Sebi said on Saturday its board had approved the move after consulting stock exchanges. Stock brokers had been demanding physical settlement in equity derivatives for a long time. A decision on whether physical settlement is to be compulsory or in addition to the existing arrangement for settlement is due for discussion soon.
“Big crashes have exposed how vulnerable our markets are. After every crash, volumes dry down significantly and the market loses depth, due to which indices hit the lower circuit. Short sellers, who do not have any obligation to give delivery of shares, and take huge positions by paying only a certain margin, form a cartel and exploit the negative sentiment. Post implementation of physical settlement, it will become difficult for such players to operate,” said Deven Choksey, managing director of K R Choksey Shares and Securities.
Indian stock markets have stopped trading four times in the past five years because benchmark indices hit the lower or upper circuit filters.
By contrast, the last time the Dow Jones Industrial Average, which has a circuit filter mechanism on the index, halted trading was 12 years earlier, on October 27, 1997. There have also been cases here of intra-day volatility, especially in the last 30 minutes of trading.
T S Harihar, Head-Institutional Derivatives, ICICI Securities, said: “With physical settlement, the concept of value weightage average price of the last 30 minutes in the F&O segment gets eliminated and it increases the market depth.” Also, chances of manipulation are greater in the cash settlement in the absence of a 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,” said Choksey.
But, experts said there had to be proper borrowing and lending of securities for physical settlement to take-off. Currently, BSE and NSE have a borrowing and lending system, but there are hardly any takers.
“While government will have to allow insurance companies to lend or borrow stocks, market participation and volumes will increase substantially as promoters, high net worth individuals and foreign players will come forward to lend and borrow stocks, which will revive the stock lending and borrowing scheme,” said the head of one of the largest derivative broking houses.
A former top executive of the BSE said when stock futures were introduced, cash settlement was allowed so that our markets could develop swiftly.
