Physical F&O settlement may be optional

Stock exchanges are likely to make physical settlement in equity derivatives optional after the green signal from the market regulator on allowing this mode to be introduced.

Instead, it seems that they will allow investors to choose between physical settlement and the present system of settlement in cash.

Last week, the Securities and Exchange Board of India (Sebi) gave in-principle approval to physical settlement. Sebi was acting on a Bombay Stock Exchange proposal that had been pending since 2002, when stock futures and options (F&O) were started.

According to sources, the exchanges are working on a system that will require investors to mention their choice of settlement at the time of entering into a contract. Since the F&O segment has grown exponentially over the years, it is believed the exchanges do not wish to move away completely from cash settlement, to ensure that growth continues.

“The board decided that we would discuss with the stock exchanges and institute a proper mechanism for physical delivery in the derivatives markets,” said Sebi Chairman CB Bhave last week. “(Option or compulsory) will be decided during discussions with the stock exchanges,” he added.

“The exchange would leave it to market forces,” said a source. “So, for instance, while one set of futures and options in X company would be cash-settled, another set of contracts would be available for settlement with the underlying shares,” he said. “Obviously you cannot tweak the index F&O market.”

Another person privy to the developments said the contracts to be physically settled would be an “entirely different instrument with distinct codes and a separate set of risk containment measures”.

“The exchanges will study global best practices and then make modifications to make them relevant in the Indian context,” he added.

Under physical settlement, the contract has to be settled with underlying shares instead of cash equal to the price of these shares. In India, the debate between physical and cash settlement in the derivatives arena has been going on since these instruments were launched.

It is said introducing physical settlement is easier now due to the existence of a stock lending and borrowing mechanism. Incidentally, the failure of this market to take off has been attributed by many to absence of physical settlement in single-stock futures and options.

According to industry players, another factor that will make introduction of physical settlement easier is the facility of cross-margining, wherein margin requirements in the derivatives segment are reduced if one holds shares in the cash market.