India Mandates Physical Delivery of Derivatives

The transition from cash settlement to physical settlement will be done in three phases.

The Securities and Exchange Board (SEBI), the Indian securities market watchdog, has decided for physical settlement of all derivatives to curb volatility and reshape the process of borrowing and lending.

The regulator will implement the new system in three phases by arranging them in descending order based on the average daily market capitalization of the firm, and the process will be completed by October 2019. The first 50 stocks with a smaller market cap will be moved by April this year followed by the next batch of 50 stocks by July. The final 50 stocks will be moved for physical settlement by October.

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Moreover, any new derivative instrument introduced on new stocks will be subject to physical settlement right away, according to circular issued by SEBI.

SEBI first announced its plans to mandate physical settlement in April last year but did not provide any timeline for the implementation.

The National Stock Exchange (NSE), one of the two primary exchanges in the country, which accounts for 99 percent of futures and options trades, lists 200 stocks in the derivative segment. The regulator has already moved 46 stocks listed on the NSE for mandatory physical settlement under the Securities Lending and Borrowing (SLB) program.

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A Welcome Gesture from the Market

Most institutional traders in the Indian market are taking SEBI’s decision in a positive way.

“I think the jury is still out on that one. Physical delivery and SLB are developing markets and we will see increased participation in the coming days. The physical delivery so far was lackluster, perhaps because of a smaller number of stocks and because the market was still not sure whether it will be applied to all stocks. Now with physical delivery being made compulsory, it will lead to greater participation,” Arindam Chanda, CEO of IIFL Securities Ltd., told Livemint, a local financial daily.

However, many are also concerned about the short-term impact of such a decision on the market.

The same newspaper quoted Nirmal Pareek, director and head of operations and technology at IndiaNivesh: “Physical settlement of stocks is a good idea, but it needs to be complemented by ensuring an increase in the depth of the futures market so that any liquidity issue that could probably arise because of a fall in cash market volumes can be compensated. The list of stocks in the F&O segment needs to go up as a preparatory measure to absorb any liquidity shock.”

“This might lead to short-term uncertainty as the market adjusts to new mechanisms for settlement. After the process settles, the stock-specific volatility around expiry would reduce as holders would be positioned much in advance for physical settlement,” Essel Finance AMC’s Viral Berawala told Bloomberg.

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