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The BSE could change the derivative landscape with the introduction of physical settlement.

Rajiv Bhuva        Print Edition: Feb 20, 2011

What will happen
The BSE is getting ready to challenge the monopoly of the NSE in the derivatives market with the introduction of physical settlement. In a written response to a query from BT, the exchange said it is "... currently working on modifying its systems and processes to handle deliverybased derivatives." All futures and options, or F&O, contracts on BSE's equity derivative segment, barring the index contracts, will now be settled with the delivery of shares. Since the introduction of derivatives in June 2000, contracts have been settled in cash. The stock markets regulator, the Securities and Exchange Board of India (SEBI), had given an in-principle approval to physical settlement in March 2010.

What will change
Cash settlement is the current norm in equity derivatives, where on the last day of the contract the average closing price is the value at which contracts are squared-off with the underlying shares not changing hands. With physical settlement kicking in, on the expiry of the contract the underlying stock will have to be purchased or borrowed from the cash market, and delivered to the counter-party for a specified payment.

The Inherent advantages…
Cash settlement, experts feel, adds to market volatility. With physical settlement, huge price swings are less likely - counter parties can impose delivery if there is an artificial increase or decrease in stock prices, thus paring excessive speculation in the F&O market and encouraging hedging.

… and the disadvantages
In the absence of a vibrant mechanism for securities lending and borrowing (SLB), physical settlement of stock-specific derivative contracts, may be difficult. A vibrant SLB mechanism is necessary for participants to be able to meet delivery obligations. However, some market participants feel the introduction of physical settlement will give a big fillip to SLB.

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