The derivative market is set for a makeover if Sebi has its way. If its recent proposal on physical settlement of equity derivative contracts is implemented, investors will soon have the option of doing so by delivering stocks, in addition to using cash.
Currently, the contracts are settled in cash by making adjustments in the purchase price and settlement price. For instance, a person who buys a future contract of 100 shares at Rs 100 will receive Rs 5,000 in cash if the price of the future is settled at Rs 150 on settlement date. This method is not beneficial for genuine investors like hedgers as they need to operate in two markets—cash market for offsetting their underlying position, and derivative market for offsetting their position in futures. Such dual operations create a basis risk, which arises when futures price does not converge with the cash market price on expiration. "The new system will reduce the basis risk, which is currently prevalent due to the imperfect link between the futures and cash market," says Rajan Malik, director, Anand Rathi Financial Services.
Also, currently, some participants can artificially control the prices on the settlement date. With physical settlement, the chances of such manipulation will be curbed substantially. This is because manipulators will face the risk of imposed delivery by counter-parties if the settlement price seems unjustified.
According to Siddarth Bhamre, head, equity derivatives, Angel Broking, "Often, stocks trade at a huge discount to the spot price. Once physical settlement comes into play, irrational pricing should reduce. But for it to happen, an active stock lending and borrowing mechanism should be in place." Though the securities lending and borrowing scheme exists, it has failed to make an impact since its launch. Hopefully, the new process will help in activating it.
However, some investors feel that physical settlement will bring down volumes in the derivative market. This is because the cost of delivering the shares will increase the overall cost of trading in derivatives. Also, the proposal lacks clarity on certain issues, such as whether an investor will be able to opt between the cash mode and physical delivery mode? But the majority is optimistic that the proposed scheme will make the derivative market more efficient.
