BSE set to shift to physical settlement in derivatives

Should help check market volatility & shorting; NSE mulls response.

To attract more volumes, the Bombay Stock Exchange (BSE) is all set to replace the decade-old cash settlement procedure in the equity derivatives segment with physical settlement. The National Stock Exchange (NSE), on the other hand, has decided to wait and watch.

According to top BSE officials, the exchange has set a deadline before Diwali and after expiry of the October derivative series.

The system was approved by the Securities and Exchange Board of India (Sebi) in July and BSE is trying to take the first-mover advantage, as its rival, NSE, with over 99 percent market share, still follows cash settlement.

Under the system, a seller of stock futures or options will have to deliver shares to the counter-party when the contract expires. However, if the positions are squared off before the expiry, only then there will be an option available for cash settlement. The pattern is followed by all leading derivative exchanges around the world.

When asked, an NSE spokesperson said, “We are studying it in detail and also seeking market feedback on the products and modalities of implementation.”

Deven Choksey, managing director of K R Choksey Shares and Securities, said: “Physical settlement may double the delivery-based volumes in the market and bring down excessive speculation in derivatives.”

At present, delivery-based volumes are 15 per cent of the daily average in Indian equity markets. Brokers are also of the view that physical settlement will lead to introduction of some new products.

“Physical settlement will lead to revival of the stock lending-borrowing mechanism, as more people will borrow to give delivery. This will also improve the market depth. Financing for borrowing stocks (the old system known as ‘badla’) will get encouragement and large institutions will effectively churn their portfolio,” said another Mumbai-based stock broker.

Some stock market crashes over recent years had exposed the vulnerability of domestic markets. After every crash, volumes dried significantly and the market lost depth, due to which benchmark indices Sensex and Nifty hit the lower circuit, resulting in market closure. This mainly happened when a cartel of big traders created huge short positions in derivatives, by paying only small amounts of margin money, bringing down the market, as there was no obligation to deliver shares.

With the launch of physical settlements, a big crash and subsequent closing of the market can be prevented, as the counter-party to the short seller in derivatives will have the option of asking for delivery. The new mechanism should also reduce market volatility, as it will not be possible to artificially suppress price of shares. There are a little over 200 shares in NSE’s derivative list.

BSE’s move to bring in physical settlement will be followed by the implementation of smart order routing. It means traders can choose to execute trades on the exchange that quotes a better price. Smart order routing, combined with physical settlement, may shift some derivative volumes from NSE, it is believed.