Friday, July 16, 2010

Physical Settlement in Derivatives Trading

Over a decade ago, when trading in derivatives was commenced on Indian stock exchanges, it was decided that such instruments must be introduced in a phased manner. This was following the recommendations in the L.C. Gupta Committee report. Consequently, various types of derivatives were introduced at different points in time – index futures, futures in specific securities, options and so on. Similarly, it was decided that all derivatives transactions on stock exchanges would initially be cash-settled. Those were truly “contracts for differences”. Physical settlement of derivatives contracts was not permitted because, if I recall right, the stock exchange mechanisms were then not in a state of preparedness to deal with such settlements.

The Economic Times explains the differences between cash settlement and physical settlement:

In physical settlement, the seller will have to deliver the underlying shares at the time of expiry, if his position has not been squared off till then. Similarly, the buyer will have to take delivery of shares, if his position is open at expiry.

At present, all trades in the equity derivatives segment are settled in cash, based on the difference between opening and closing prices. For instance, if a trader is long 1000 futures of DLF at Rs 300, and the price falls to Rs 280 on the day of expiry, the trader will suffer a loss of Rs 20,000 — the difference between the price at which he bought the futures and the price on settlement day.

Even if he is confident that the price could recover in a few days, he doesn’t have the option of taking delivery of 1000 DLF shares and holding on till the price moves up. Similarly, a trader, who has short-sold futures doesn’t have the option of delivering the underlying shares, even if he owns them.
Recognising the difficulties of a cash-only settlement and perhaps due to the sophistication that leading Indian stock exchange systems have now acquired, SEBI has now issued a circular providing flexibility to stock exchanges to offer physical settlement for derivatives transactions. All physical settlements must initially be completed within six months. This will bring settlement on the Indian exchanges closer to other leading markets.

While this development may be seen as encouraging greater use of derivatives (which have acquired the status of “weapons of mass destruction”), they do have several benefits if properly utilized. Transitioning derivatives transactions from the “over-the-counter” (OTC) market to the stock exchanges has the advantage of bringing about greater transparency to these transactions in addition to infusing liquidity in the markets. Others jurisdictions too are witnessing similar efforts to move derivatives from the OTC markets to regulated exchanges, with the prime example being the reform efforts in the U.S. by way of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

1 comment:

Sacha Singh said...

I do not understand how this move is in the direction of nudging derivatives away from OTC market towards regulated exchanges. Cash settlements are taking place on exchange traded contracts only and physical settlements shall continue to take place on the same exchanges.

This move would integrate the cash and derivative markets better. The longs at present get (pay) the difference between contacted rate and market rate. Now they will actually have to accept shares and shell out contracted price irrespective of the market price. It means for making delivery more orders will get placed in the spot market affecting the demand supply equilibrium and thereby spot price of the underlying. This would have the effect of integrating the future and spot markets better.