Understanding Physical Settlement of Derivatives

By Rohit Malik

The Securities and Exchange Board of India (SEBI) on December 31, 2018 said that all derivatives will be settled physically to curb volatility and promote borrowing and lending.

You can read the SEBI notification here.

This notification will be implemented in phased manner. The first phase will be implemented on 50 stocks in April 2019. 2nd and 3rd phase will be in July & October respectively.

What is physical settlement of derivatives?

Physical settlement of derivatives means that on the day of settlement, if a trader has an open position, then he has to take the delivery of the shares. Right now, it is settled in cash.

What this means is that right now, when you have an open position in derivative of a stock, long or short, you settle the MTM in cash. If you are short in future, then the position is closed on expiry day (new one is created in next expiry) and difference in Margin is settled in cash by depositing the required money in trading account.

The new guidelines state that you need to actually deposit the whole amount and get the delivery of the shares traded in your demat account. These shares you can not sell before they are deposited in your demat account. Which for now means total of 3 days.

How does it make difference to a trader?

With the introduction of physical settlement, you need to be careful about your positions on expiry day. If you are a trader for short to medium term, then the best idea is to shift your position to next expiry on one day prior to the expiry day.

Which means rolling your position on Wednesday rather than waiting till Thursday.

Despite all the hoopla, the participation of retail traders in Indian Stock market is not that much and hence this extra burden of brining other set of calculation into the picture is not worth it.

Will it effect the share prices?

It will definitely effect the liquidity of shares for which the physical settlement will be introduced. The results from NSE’s move in July 2018 shows so.

But, at this stage, it is hard to say with certainty. This process is being followed by US market. On the other hand, Singapore Nifty is still cash settled.

Why SEBI is introducing physical settlement, when the earlier effort has little response?

As per the notification itself, this move is being introduced to curb volatility and promote borrowing and lending.

Thus, people with shares in their demat account can benefit by lending their shares for short time.

Moreover, it is the move being followed by developed countries stock markets for same effect and it works well there. Thus, it seems like a step forward in making our stock market future ready.

Expert views on physical settlement of derivatives

The views of experts on this notification is divided. The views presented below are taken from various media sites ( a quick Google search was done :). One thing is quite clear though, no one is really sure about it being a good idea for the time being.

The views are more or less cautious.

“I think the jury is still out on that one. Physical delivery and SLB are developing markets and we will see increased participation in the coming days. The physical delivery so far was lacklustre, perhaps because of a smaller number of stocks and because the market was still not sure whether it will be applied to all stocks. Now with physical delivery being made compulsory it will lead to greater participation,”         ~Arindam Chanda, CEO, IIFL Securities Ltd.

“SEBI needs to open up more stocks to F&O trading as there is ample evidence to suggest F&O aids cash market volumes of such stocks. Therefore, to counter any fall in liquidity that may arise because of the big change, more stocks need to be brought into F&O. That will broad base our markets and give investors access to selling options in more stocks they hold in their portfolios.” ~Rajesh Baheti, president of the Association of National Exchanges Members of India


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