ULIPs: A holistic risk management tool Market regulator Sebi Securities and Exchange Board of India on Monday issued the much-awaited framework for making physical settlement of stock derivatives mandatory.
The same will be enforced in a phased manner.
Now, Sebi wants to apply the same mechanism to all stocks, which are cash-settled under the existing framework. According to Sebi, the stocks shall first be ranked in descending order based on daily market capitalisation averaged for December Based on the ranking arrived, the bottom 50 stocks would move to physical settlement from April expiry onwards, the next 50 would move to physical settlement from July expiry onwards, and the remaining would settlement option and deliverable to physical settlement from October expiry onwards, the market regulator said.
Sebi said derivatives introduced in new stocks, meeting the enhanced eligibility criteria specified by it, would also be physically settled.
Derivatives in financial markets typically refer to forwards, futures, options or any other hybrid contracts of pre-determined fixed duration linked for the settlement option and deliverable of contract fulfillment to the value of a specified real or financial asset or to an index of securities.
The Indian market is considered one of the most speculative in the world as far as derivative contracts go.
Currently, on a cash market turnover to derivative market turnover ratio basis, Dalal Street has the highest level in the world. The Sebi move is aimed at curbing excessive speculation, which creates too much volatility in the market.
Bottomline What is Cash Settlement? Under this method, the contract seller does not deliver the underlying asset but transfers the net cash position. In case of a Futures contract, it is mostly cash settled unlike a forward contract which is generally settled by physical delivery since exchange monitors the contract ensuring smooth execution. Cash Settlement Example — Say you go long on 10 wheat contracts whose current market price is Rs per contract.
Under physical settlement, traders will have to compulsorily take delivery of shares on the expiry day against their derivative positions. When such contracts require physical settlement, it forces traders to roll over positions ahead of the expiry, thus averting lumping of rollovers at the end of the series, which leads to excessive volatility.
Liquidity, in turn, is variable of derivative volumes. Better liquidity facilitates more efficient price discovery and tightens spreads between bids and asks. Physical delivery settlement option and deliverable also reduce short selling.
Short sellers will now have to first borrow stocks under the SLB securities lending and borrowing mechanism, which allows borrowing of securities from institutional investors. But that space still remains shallow in India. Some of the market participants would now have a relook at the SLB space.
The new move is something Sebi has been talking where you can honestly make money for some time, and the market looks prepared for it. However, the market veteran calls the move half-baked.
When traders will have positions working for them on the hedge side or the on the leverage side, probably delivery-settled derivative market would work favourably.
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Over time, when Sebi brings down or removes market lots, volatility would come down significantly, he said. Berawala of Essel Mutual Fund says during the initial few expiry days, stocks might be volatile as market participants adjust to the new mechanism.
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As the process settles and the market participants realise the approximate amount of physically-settled stock, volatility will normalise. Read More News on.