Mixed impact expected of delivery-based settlement in stock F&O:
Come July, exactly 17 years after trading in it started, the single stock futures and options segment of the National Stock Exchange of India will witness delivery-based settlements, albeit in 46 of 207 stocks.
As head of NSE, Limaye has to be prepared since his exchange attracts 99% of the country's equity derivatives trading takes place, and his competitor, the BSE, already settles single stock derivatives through delivery and not cash.
In early April, the Securities and Exchange Board of India issued a directive to the stock exchanges to move stocks which did not fulfil newly enhanced eligibility criteria for being in the single stock derivatives list into delivery-based settlement.
So, as the April-end derivatives contracts expired and new contracts for July expiries were introduced, the NSE announced that the July expiry contracts of single stock derivatives in 46 out of 207 stocks will be physically settled.
These 46 stocks did not meet the newly enhanced eligibility criteria which included higher limits for recent average daily market capitalisation, median quarter-sigma order size, average daily delivery value and market wide position limits.
A majority of these stocks are mid-cap stocks and it included names such as Just Dial Ltd, NHPC Ltd, NIIT Technologies Ltd, Reliance Power Ltd, Siemens Ltd and Wockhardt Ltd.
But what follows afterwards is more significant for the market. The SEBI directive also said that even stocks which meet the enhanced eligibility criteria would be moved to physical settlement in a phased and calibrated manner.
It has not set a date for that, though.
According to NSE's Limaye, more stocks could be taken to physical settlement when the experience of the first lot of stocks provides the evidence that the change in settlement methodology led to a marked improvement in market quality.
In a physical settlement, at the end of the expiry date, all open long positions in single stock derivatives have to result in the investor effecting the final market to market margin payment and taking delivery of the shares. On the other side, all open short positions have to result in the investor taking delivery of shares and making payment of the final marked to market margin call.
This procedure is different from a cash settled mode where the longs and shorts do not take or give actual delivery shares. They have to pay or receive the final settlement profit or loss in case, when the expiry takes place.
The final settlement profit or loss is computed as the difference between the previous day's marked to market settlement price and the final settlement price of the relevant single stock derivatives contract.
Given the difference in modality of physical settlement from that of cash settlement, the market participants expect new risks to emerge.
For one, some participants think physical settlement creates a risk of short squeeze for short sellers.
In this case, investors with open short positions have to deliver shares if they let their contracts expire. Most short positions are pure short positions but are a part of any of several strategies deploying simultaneous trades in derivatives and cash market.
Thus, the short investor most likely will not have shares to deliver. He has to borrow the shares first.
And, here the importance of the securities lending and borrowing mechanism on the stock exchanges comes into play.
NSE's Limaye said traders usually cover their positions and have been using the securities lending and borrowing mechanism irrespective of the settlement methodology.
In fact, in a physical settlement system, there could be some positive impact on securities lending and borrowing mechanism's usage by market participants, he said.
However, some traders are worried since lending of shares is usually from institutional investors and the physical settlement will create a dependence on them for the supply of shares in the securities lending and borrowing mechanism.
Besides, securities lending and borrowing is not a preferable option for many as its involves paying interest, and having to buy the shares back from the market to replace the stock to complete the trade, a dealer with a mutual fund said.
"The physical settlement step by the regulator is to increase the internal strength of the equity derivatives market by ensuring only strong participants participate," said Sahaj Agarwal, vice president and head of derivatives at Kotak Securities.
At the same time the idea is to deter those who speculate heavily without financial capacity to incur heavy losses when things go wrong, he said.
In the last two years, single stock futures has contributed 9-12% of the total equity derivatives market turnover and single stock options has contributed another 6-7%.
Bulk of the total turnover is in index options trades which make up for 77-82%. Index futures' contribution in the last two years has been in the 3-5% range.
So, whatever the impact on volumes physical settlement will have on single stock derivatives, it won't shake up the overall derivatives market.
Index derivatives make up for bulk of volumes, and physical settlements are not possible in index derivatives. They will always be cash settled.