Sebi unlikely to meet the F&O physical settlement date

The Securities and Exchange Board of India (Sebi) is likely to miss the April 1 2005 deadline for introduction of physical settlement in derivatives contracts as the initiatives for a stock lending scheme have floundered, since not enough entities are coming forward to participate in the scheme.

The secondary market advisory committee of Sebi at its last meeting in November 2004, had recommended that in the first phase only the clearing houses and corporations would be allowed to participate in the stock lending and borrowing scheme. Other entities would be allowed later.

However the clearing corporations of the two major exchanges are reportedly finding it difficult to come up with a scheme which would not be open to misuse.

Sources familiar with the developments said, "the scheme will have to be totally fool-proof as we do not want to be caught in a situation such as NSE's automated lending and borrowing mechanism (ALBM)".

Without an efficient stock lending system in place, it would be virtually impossible to have physical settlement in derivatives transactions and this is one major reason why derivatives contracts in India are still cash-settled.

Incidentally cash settled transactions work to the advantage of speculators while making it risky for those wishing to hedge and arbitrage. Further it would also reduce counter-party risk, which is always present in any derivatives contract.

Without a lending and borrowing mechanism physical settlement would result in what in market parlance is known as a `short squeeze' that is a situation is created where as the price of the stock rises investors who sold short rush to buy it to cover their short positions and cut their losses.

As the price of the stock increases, more short sellers feel compelled to cover their positions. This creates an artificial scarcity in the stock.

Other entities will be allowed to participate in stock lending only a year after the clearing corporations scheme have implemented their schemes.