Sebi to look into physical settlement for stock derivatives

As it gears up for an overhaul of equity derivative rules, market regulator Sebi today sought views from stakeholders on whether there is a need to make physical settlement mandatory for stock derivatives.
In a consultation paper, Sebi also asked market participants to submit their views on whether physical settlement should be done in a phased manner starting with stock options followed by stock futures.
The comments have been sought till September 25 and follows an earlier detailed consultation paper on an overhaul of the rules governing equity derivatives in India through which the regulator is looking to detoxify the 'high-turnover, high-risk derivatives trading'.

There have been concerns over suitability of these 'complex and risky' products for individual investors.
Sebi had initiated a public consultation in July for framing the new rules, while noting that the trading turnover in these products has seen a sharp surge of over ten-fold over the past decade and the ratio of trades in equity derivatives to that of equity cash market has risen to over 15-times.
Replying to the consultation call, the Association of National Exchanges Members of India (ANMI), a pan-India body of trading members across leading exchanges including NSE and BSE, has submitted that "the NSE publishes options data by stating 'notional' turnover (as opposed to premium turnover), thus grossly overstating the total quantum of business in the futures and options segment".

It has said that the turnover in equity derivatives is 15.59 times that of cash market, whereas this ratio after taking only premium is only 2.53 times, which "clearly falls within the global exchange norms".

Derivative in financial markets typically refers to a forward, future, option or any other hybrid contract of pre- determined fixed duration, linked for the purpose of contract fulfilment to the value of a specified real or financial asset or to an index of securities.
Broadly, there are two types of derivative contracts -- futures and options. A futures contract means a legally binding agreement to buy or sell the underlying security on a future date, while options contract gives the buyer or holder of the contract the right (but not the obligation) to buy or sell the underlying asset at a predetermined price within or at end of a specified period.

In fiscal 2016-17, the total turnover in equity cash market stood at about Rs 60.5 lakh crore, whereas the same for equity derivatives was a staggering Rs 944 lakh crore.
While the cash market has grown at an annual compounded growth rate of 11 per cent since 2004-05, the same for equity derivatives is over 35 per cent.
"Equity derivatives turnover is largely dominated by index options, followed by stock futures, stock options and index futures," the Securities and Exchange Board of India (Sebi) said, adding that the high trading volume in derivatives on individual stocks, especially stock futures, is unique to only few markets including India.

The other markets where stock futures are traded actively include Korea Exchange, Moscow Exchange and Eurex.
Sebi also enumerated the issues highlighted by various committees with regard to physical settlement of stock derivatives, with one being that the hedgers and arbitragers are in a better position to manage basis risk, if physical settlement is made mandatory for stock derivative contracts.
Another issue is that there may be a possibility of a short squeeze, in the absence of a vibrant mechanism for securities lending and borrowing.
Globally, cash settlement is more cost effective than physical settlement and introduction of physical settlement in stock derivative contracts in a phased manner, first with single stock option contracts and then extended to cover single stock futures, are also among the issues which have been highlighted.