According to a report in The Economic Times, the derivatives committee appointed by the Securities and Exchange Board of India has suggested introducing physical settlement for trades in single-stock futures. Currently, all trades are settled in cash on the expiry of futures contracts.
There are strikingly divergent views on which form of settlement is superior for the equity derivatives market. Even if the regulator sides with the view that cash settlement is a better option for the Indian markets, it still needs to tweak the current system to ensure smooth trading and settlement.
Proponents of a physical settlement regime argue that market participants suffer from “basis risk” when there is cash settlement of trades. Basis is the difference between the futures price and the spot price of an asset. In an ideal world, this difference is the cost of carrying or holding a position in an asset. For equity shares, the cost of carry is the interest cost incurred to finance a long position minus the expected dividend from the company.
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If the basis deviates from this principle, arbitrageurs jump in to make a risk-free profit. Say, for example, Infosys Technologies Ltd shares are available for Rs1,000 in the spot market and for Rs1,140 in the one-year futures market. The implied cost of carry in the futures price is an interest rate of 14%. For someone who has access to a lower financing cost, say 10%, the strategy would be to borrow Rs1,000 and buy the share in the spot market and simultaneously sell the share in the one-year futures market for Rs1,140. Regardless of what level the share trades at on expiry, the arbitrageur can expect a profit of Rs40 after deducting the 10% interest cost. When many such arbitrageurs step in, the basis risk disappears.
But this theory of a classical cash-and-carry arbitrage is based on the assumption that the futures price coincides with the spot price at expiry. In the Indian equity market, it does in theory, but not in practical terms. The closing price of a share is the weighted average of all trades in the last half hour of trading. This is the price at which the futures contract will settle. Let’s say, at expiry a year later, the closing price of Infosys is determined as Rs1,100 based on the weighted average. In a cash settlement regime, the futures contract will settle at this rate and the arbitrageur will make a profit of Rs40 on this leg of the transaction.
In the spot market, however, one can’t buy or sell at the weighted average price. The other leg of the transaction will be closed out at one of the many traded prices in the last half hour of trading, which could deviate materially from the weighted average close depending on the volatility. In other words, the assumption that the futures price will coincide with the spot price at expiry is somewhat on shaky ground. It’s not to say that arbitrageurs will stay away completely because of this, but the fact remains that they, too, will face some basis risk at expiry. With physical settlement, this risk disappears as the arbitrageur can simply deliver the shares he owns to settle the short futures obligation. But then physical settlement comes with its own set of challenges, the chief among them being the risk of a “short?squeeze”.
This is when a trader takes large long positions in both the spot and futures markets, especially in assets where floating stock is low. For those who have a naked short position in the futures market, there would then be a scramble to buy shares in the spot market for the physical settlement around the time of the expiry. Naked short-selling is the practice of selling a stock short, without first borrowing the shares or ensuring that the shares can be borrowed, as is done in a conventional short sale.
Traders could choose to square off their short positions by buying in the futures market, but the hint of a short squeeze will send prices soaring. The short squeeze problem is very real and has consistently been observed in commodities. It was most evident last year in shares of Volkswagen AG, which temporarily became the most valued company after German car maker Porsche AG announced that it had secretly bought a 31.5% stake in the company. It already owned 42.6%, taking its stake to 74%. Hedge funds that were short on Volkswagen were cornered with little floating stock available in the market to settle their trades and are estimated to have lost €30 billion (Rs1.86 trillion) in the process.
If physical settlement is allowed, regulators need to put in place mechanisms to prevent short squeezes. One weapon that is commonly used is lower position limits. Critics of physical settlement are concerned that lower limits curb participation, hit volumes and hurt genuine users of the market. Another complaint is that the effort and cost required to have physical settlement and the safeguard mechanisms that need to be in place far outweigh the benefit, since a very small percentage of traders desire physical settlement.
It’s time the regulator decided one way or the other in order to eliminate basis risk from the futures market. Ajay Shah of the National Institute of Public Finance and Policy suggests that the basis-risk problem at expiry can be settled by having a call auction to determine the closing price of shares instead of the current weighted average rule. By giving a market order in the call auction window, a trader can ensure that the price he receives in the spot market matches the one at which the futures leg of his arbitrage transaction is settled. Conducting a call auction involves its own set of investments. But investments and changes in the equity derivatives settlement system are needed and it’s time the regulator took a stance one way or the other.
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