Sebi mulls physical settlement of stock derivatives

Move to help improve alignment between cash and derivative markets

The Securities and Exchange Board of India (Sebi) on Thursday sought market feedback on moving to a physical-settlement system in stock derivatives. Currently, all derivatives contracts are cash-settled.

“Market participants are requested to provide their comments on whether there is a need to have compulsory physical settlement in stock derivatives contracts, and whether physical settlement should be done in a phased manner starting with stock options followed by stock futures,” the capital markets regulator said in a discussion paper.

In the past, Sebi, through various committees, and even stock exchanges, has tried implementation of physical settlement in stock derivatives. However, cash settlement has proved to be more popular. 

Most exchanges across the world use cash settlement. Some exchanges offer both options, while a few offer physical settlement. Under physical settlement, the trader gets delivery of the underlying security. For instance, a trader dealing in Infosys stock futures or options would get the shares of the company on expiry day.

The method is said to help hedgers and arbitrageurs manage risk better and helps curb excessive manipulation. On the flip side, physical settlement can lead to disruptions if there is a lack of vibrant mechanism for securities lending and borrowing, 

necessary for shorting.

“A prerequisite for successful introduction of physical settlement of derivatives is efficient and transparent stock lending and borrowing (SLB) mechanism in cash segment,” Sebi said in the discussion paper. The SLB mechanism is yet to develop in the domestic market. “Physical settlement in stock derivative contracts may be introduced in a phased manner, first with single-stock option contracts and then extended to cover single-stock futures,” it said.

The regulator said physical settlement could help in better alignment and convergence between cash and derivative markets.

Interestingly, the discussion paper was issued as an addendum to “discussion paper on growth and development of equity derivative market in India”, which was floated in July.

In the paper, the regulator has expressed concerns over high equity derivatives turnover vis-à-vis cash turnover. It has also raised worries on whether small investors are participating in the derivatives market without understanding the risks. Sebi has now extended the deadline till September 25 for feedback on the discussion paper.