RBI booster for F&O settlement reform

In its financial stability report, RBI has identified fall in equity cash segment volumes and rise in derivative trades as stress points.

The Reserve Bank of India’s (RBI’s) concern over the falling cash volumes in equity markets has strengthened the demand for a change in the derivatives settlement system. Stock brokers say this is the chief reason for shallow stock markets.

The existing derivatives settlement on the National Stock Exchange (NSE), which has around 90 per cent market share, is based on the cash mechanism and should be changed to a delivery-based system, say market players.

In its financial stability report yesterday, RBI identified fall in equity cash segment volumes and rise in derivative trades as potential stress points. “The equity derivative market requires monitoring,” it said.

Cash market volumes are down to record lows from 13 per cent of overall trading in December 2010 to eight per cent this month. Prior to 2010, the cash markets’ volumes were higher and they’ve been falling consistently since. This appears to show excessive speculation.

Stock brokers say after every big crash, volumes in the cash segment get dry, as genuine long-term investors are scared to enter.

On the other hand, volumes in the equity derivative market are rising, as traders are required to pay only 20-40 per cent as margin money of the total value of the stock for trading in many counters. A large number of these trades are proprietary, done by brokerage houses in their own accounts and not for clients.

According to market players, big traders and institutions often exploit the equity market in crises, when the sentiment is negative. Short-sellers come together when there is excessive bad news or negative sentiment and lack of buyers. They manipulate prices by taking large short positions in the futures market nearing contract expiry, and then depress the formula-based settlement price, making a windfall on futures positions. This results in a deeper cut in share prices, as there is no buying support for a falling stock.

Short-sellers can do this by paying small margin money. Such manipulation can be prevented by introducing physical settlement or a delivery-based system in derivatives. Under this, manipulators would know that if they artificially increased or decreased stock prices, counter-parties could impose delivery — and they’d have to come to the market to borrow stocks to deliver. This mechanism will provide a cushion to stocks which otherwise fall like a pack of cards. This will improve cash volumes and provide a level field between big and small traders.

“Physical settlement,” said Kishor Ostwal, managing director of CNI Global Research, “will reduce excessive volatility and improve cash market and delivery volumes.”

Another negative of cash settlement is that it exposes genuine hedgers to basis risk, which is the risk of the spot price and the futures price not converging on the expiry date.

When futures and options were introduced in India, cash settlement was allowed so that markets could develop. The Securities and Exchange Board of India (Sebi) in 2010 had given an option to stock exchanges to introduce physical settlement. It was based on recommendations of the derivatives market review committee, headed by M Ram Mohan Rao, former dean of the Indian School of Business, which has given a report on the subject in December 2008. The NSE is yet to implement the system, which market players believe it is not doing for fear of losing volumes.