With a view to curbing speculation in the futures and options market, SEBI has proposed to shift select stocks (that are prone to volatility) from cash settlement to physical settlement. As per the SEBI announcement, out of the 208 stocks that are currently permitted to be traded in F&O, a total of 46 stocks will be shifted to the compulsory physical settlement mode. This list of 46 stocks includes some popular F&O names like Adani Power, Ajanta Pharma, Allahabad Bank, Andhra Bank, Balrampur Chini, BEML, Berger Paints, and CanFin Homes etc. But first let us understand how the physical settlement of stock derivatives will work versus the current cash settlement process.
How the cash settlement of derivatives works
Let us first look at how stock futures work. Currently, all derivative transactions in futures and options on equity and indices are compulsorily settled in cash only. That means; only the profits and the losses on the trade will be either credited or debited to the F&O account of the respective trader. Here is how F&O settlement currently works.
ParticularsIndex FuturesIndex OptionsStock FuturesStock OptionsProductNifty May FuturesNifty 10,800 CallRIL May FuturesRIL 1000 CallBuy Price10,60029.509717.25Lot Size757510001000Settlement Price10,69333.809453.35Profit / Loss (A)Rs.6,975Rs.322.50(Rs.26,000)(Rs.3,900)
In each of the above cases, the price difference multiplied by the lot size will be either credited or debited to the F&O account of the trader. In case of Nifty futures and options above, the profits will be credited while in the case of RIL Futures and options the losses will be debited to the trading account. Currently, even if you are holding on to RIL stock futures you cannot go to the exchange on the expiry day and insist on getting delivery of shares. You will only be able to adjust the profits or losses as part of cash settlement.
Why Stock futures took off in a big way in India?
Today, derivatives trading accounts for over 90% of the total value of trades on any average day with the cash market volumes accounting for less than 10%. SEBI has been worried that too much use of stock futures as a proxy for the cash market may be luring small and retail investors into F&O trading. Since these are leveraged trades, most retail investors may not understand the implications or may not have the capacity to bear losses. But why did stock futures become so popular in India. Firstly, India was long used to the system of Badla (carry forward on BSE). Most traders found the stock futures as a good alternative for the Badla System and hence stock futures trading strategies became quite popular. Secondly, large institutions and proprietary traders used to create risk-less arbitrage by buying stocks in the cash market and selling equivalent futures. By locking in the spread, they were assured of the return irrespective of whether the market went up or down. That is because; on the expiry date all cash positions and futures positions expired at the same price.
What will physical settlement look like?
Remember, a subtle difference here. When we talk of physical settlement, it only applies to stock futures that are settled on the expiry date. If you buy stock futures and reverse the position after 3 days then the physical settlement rule will not apply. On the other hand, if you buy stocks futures of a stock and then leave it to expiry, then this compulsory physical settlement will apply in case of the 46 stocks effective from the July 2018 contract.
What will be the key implications of physical settlement of stock future?
These may be early days yet but a few basic things could follow as a logical corollary to physical settlement of stock futures.
Currently just about 12-15% of all stock futures positions are left to expiry. The rest of the positions are squared off before the expiry itself. Hence this concept of physical settlement will only apply to the small percentage of stock futures that are left to expiry.
Normally, the F&O expiry is on the last Thursday of every month. To avoid the hassle of physical settlement most traders may prefer to unwind their stock futures positions well in advance. To that extent, it will reduce the expiry week volatility and more specifically the expiry day volatility in F&O markets.
For cash-futures arbitrage positions, a big chunk of the trade will be the VWAP trades. Now these VWAP trade will vanish in these 46 stocks, especially if the trader will have to give compulsory delivery against stock futures. Squaring off the cash and futures earlier may be a better deal.
There could be a very positive outcome of the compulsory physical settlement with respect to stock lending and borrowing mechanism. If compulsory physical settlement has to really take off, then it will call for a robust stock lending mechanism that can take care of shortfalls. This could actually catalyze the rapid development of the stock lending mechanism in India.