It’s heartening to note that the Securities and Exchange Board of India (Sebi) has initiated some important changes in the equity derivatives space. It has allowed stock exchanges to introduce physical settlement of single-stock derivatives. Besides, exchanges can introduce new contracts on volatility indexes and long-dated derivatives contracts with tenures of up to five years.
But ideally, each of these decisions should be left to the stock exchanges, which in turn would decide based on the needs of market participants. Even now, while Sebi has said it will allow stock exchanges to introduce physical settlement, it will still be involved in the nitty-gritty of how this will be achieved. When Sebi had given exchanges (limited) freedom to decide trading hours between 9am and 5pm, one had hoped that this was the beginning of a process where exchanges would be given increased freedom with product design. It seems like it will be a while reaching that stage.
One could be tempted to think that the current system of cash settlement needn’t be tinkered with, given the fast growth of the equity derivatives segment. Currently, the equity derivatives market is more than four times the size of the underlying cash market. But what often gets missed in this analysis is that a large part of this (about two-thirds) is on account of index derivatives. Single-stock derivatives haven’t done as well. Not all stock futures contracts are liquid. Single-stock options, even eight years after their launch, are very illiquid and account for less than 3% of the overall equity derivatives turnover. Globally, single-stock options are quite liquid instruments.
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One reason for this could be the relatively high cost for option writers, and cash settlement may be only adding to their problems. Consider an investor who writes a covered call, that is, writes a call option while having a long position in the underlying stock. Single-stock options are American style, in that they are settled on the day the buyer exercises the option. When the buyer exercises the option, the exchange system picks up a counterparty at random to settle the contract at the day’s close price. According to an exchange official, the writer is intimated after market hours about this settlement. In order to execute the second leg of the transaction, that is, sell the underlying stock in the cash market, the writer has to wait till the market opens the next day. This involves overnight market risk, and the proceeds from the sale in the cash market may well be lower compared with the price at which the options position was settled the previous day.
In a world with physical settlement, the option writer can simply hand over the shares and eliminate this risk. Physical settlement generally works better for all hedgers and arbitrageurs in that it removes this execution risk on one leg of the hedge/arbitrage position. It works against speculators, in that it introduces the risk of taking delivery in the derivatives market and then selling it at a favourable price in the cash market. Of course, speculators could well choose to square off their positions before expiry. In fact, only a small proportion of derivatives trades globally ends up in actual physical settlement. The majority of the open interest is either rolled over or squared off around expiry time. But given the slightly higher transaction costs, speculators would choose cash settlement given an option.
It’s not very surprising that the regulator has finally veered towards physical settlement, given that it favours genuine users such as hedgers, but it is rather interesting to note that it has taken so many years to come to this view.
Having come to this decision, the regulator should now take a hands-off approach on how exchanges want to implement this. Having the option of cash and physical settlement would give them some opportunity in product differentiation, and an attempt to standardize is best avoided.
One concern often expressed about physical settlement is that one needs to guard against a short squeeze by having low position limits. But the current market-wide position limit (20% of the free-float of a company) may not require a change if physical settlement is introduced, since it isn’t very high anyway. Besides, there’s a view that in the absence of an active securities lending and borrowing (SLB) market, the physical settlement process may come under strain. But it’s very likely that physical settlement may drive volumes to the SLB market.
All of these hypotheses will be tested when physical settlement is made available. It’s best when market forces decide which system suits best. It could either be only physical settlement, only cash settlement, a mix of both for different products/segments or even both settlement options for the same underlying stock.
Coming to the other proposals of the regulator, trading on derivatives based on volatility indexes will be lapped up by options traders to hedge and trade on volatility. Options trading has picked up considerably in the past two years and is now the largest segment in the equity derivatives market. Of course, this is largely restricted to index options, but even then the Indian markets have turned increasingly savvy in using options.
Similarly, long-dated options have done reasonably well with quotes available for three-year options. Extending the tenure up to five years will increase the flexibility available for market participants in hedging long-term risk. Even so, just as with the decision on physical settlement, it’s best for Sebi to leave these decisions to the exchanges and market forces.
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