Mumbai: The Securities and Exchange Board of India (Sebi) on Monday said that all derivatives will be settled physically to curb volatility and promote borrowing and lending.

In a physical settlement, traders have to take delivery of shares on the settlement day against the derivatives positions. All the stocks will be delivered physically in a phased manner in descending order, said the markets regulator. The first 50 stocks with smaller market capitalisation will move toward physical settlement by April this year, the next 50 in July and the next 50 by October. This comes despite a lacklustre Securities Lending and Borrowing (SLB) programme and a lukewarm response to 46 stocks that were moved by the National Stock Exchange of India Ltd (NSE) in April for physical delivery.

The regulator had in April announced that it will move stocks to physical delivery in a phased manner.

NSE, which accounts for nearly 99% of trades in futures and options (F&O), has 200 stocks in the derivatives segment.

“Most of the traders had preferred to roll over their positions in these stocks rather than take physical delivery," said a trader who did not wish to be named.

The regulator may also have to keep in mind the possibility of migration of liquidity to Singapore Stock Exchange Ltd (SGX), which is still a cash-settled market.

“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," said Arindam Chanda, CEO, IIFL Securities Ltd.

There is a need for more depth in the futures market for physical settlement of stocks, said Nirmal Pareek, director and head of operations and technology at brokerage firm IndiaNivesh.

“Physical settlement of stocks is a good idea, but it needs to be complemented by ensuring an increase in the depth of the futures market so that any liquidity issue that could probably arise because of a fall in cash market volumes can be compensated. The list of stocks in the F&O segment needs to go up as a preparatory measure to absorb any liquidity shock," he said.

Rajesh Baheti, president of the Association of National Exchanges Members of India, agreed. “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 broadbase our markets and give investors access to selling options in more stocks they hold in their portfolios," said Baheti.

Sebi initiated the review and issued a consultation paper in September 2017 after a detailed study indicating the ratio of turnover in the cash market as compared to derivatives was very low. “The turnover in equity derivatives is 15.59 times that of cash market," Sebi observed in the discussion paper.

Sebi also aims to curb speculative trading by using physical settlement.

“The pricing of various derivatives instruments will see tremendous change rather than anything else. As there will be physical deliveries required at the expiry of contracts, speculators who are not able to back up by delivery will start squaring of their contracts nearing expiry at an exorbitant price to avoid auctions and, therefore, contracts and instruments having high open interest not backed by huge free float market capitalisation will predictably see huge volatility in their pricing nearing expiry. This will also be reflected in equity spot as well during that period," said Kunal Sanghavi, chief financial officer, Metropolitan Stock Exchange.

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