The Securities and Exchange Board of India (Sebi) has announced a regulatory framework for introduction of physical settlement in equity derivatives. Stock exchanges have been allowed to settle stock options and futures contracts either on the basis of shares or cash.
Physical settlement in derivatives has been an old demand. In India, the debate between physical and cash settlement in the arena has been on since these instruments were launched in mid-2000. It is said that introducing physical settlement is a lot easier now due to the existence of a stock lending and borrowing mechanism.
Under physical settlement, the derivatives contract has to be settled with the underlying shares, instead of cash equal to the price of these shares. Globally, there are a number of exchanges where single-stock futures and options are designed for physical settlement.
Meanwhile, the market regulator has clarified that a stock exchange can introduce physical settlement in a phased manner. However, once introduced, the facility for physical settlement for all stock options and futures has to be completed within six months.
According to a section of market players, physical settlement reduces chances of manipulation in prices. Once it is in place, intending manipulators will know that counter-parties can impose delivery if they artificially increase or decrease stock prices. Sebi, however, has it as an option and not a compulsion. The settlement of cash and equity derivatives segments will continue to remain separate, says the circular. Further, after opting for a particular mode of settlement for stock derivatives, a stock exchange can change to another mode of settlement, but after the regulator’s approval.