Physical segment throws up some interesting opportunities

Physical segment throws up some interesting opportunities

The Bombay Stock Exchange (BSE) hasn’t had success yet with physical settlement of single-stock derivatives. But it’s early days yet, and the option of settling single-stock derivatives positions with physical delivery of shares and cash does throw up some interesting opportunities for market participants.

Also Read | Mobis Philipose’s earlier columns

For those who engage in delivery transactions, one irritant in the cash segment of the markets is the securities transaction tax of 0.125% of the transaction value. For a round trip, the STT cost works out to 0.25%. Transactions in the futures market, however, attract STT at the rate of only 0.017%, and that too on only the sell leg of the transaction.

Of course, for long-term investors these charges won’t make much difference. But in the case of short-term trades, savings on transaction taxes can be rather beneficial. One could argue that short-term traders would be much better off with the cash-settled futures segment on the National Stock Exchange. Even so, there are traders who engage in delivery transactions, and for that category, the STT savings can be an incentive to trade in physically-settled single-stock derivatives.

There seems to be an anomaly in taxation rules which distinguishes between delivering shares or cash in the cash segment of a stock exchange and the derivatives segment of an exchange. This could be because derivatives transactions have been cash-settled for around 10 years now, and only starting this year, physical settlement has been introduced. The anomaly will likely be corrected in the future. But as long as the differential exists, traders can benefit from the tax advantage.

Besides, until volumes pick up to meaningful levels, BSE’s single-stock derivatives segment can be used effectively as a platform to make block trades. The current block trading window is open only for half an hour each day, besides which it puts limitations on the price at which these block trades can be done. These trades can happen at prices that fall with a +/- 1% band from the preceding trading session’s closing price. Institutional investors or traders who want to deal in large blocks of shares can easily use the physically settled derivatives platform to make their trades.

Not only will the platform be available through the day’s trading session, but there would also be the benefit of trading at prices that are suitable to the traders/investors involved without the +/- 1% band limitation. Of course, there is the limitation of the delivery taking place only on the expiry date of the futures and options contract, unlike the cash segment where delivery takes places two days after the transaction date.

Also, this opportunity would last only until volumes pick up in this segment. If there are meaningful volumes, traders would prefer doing synchronized trades (also known as 1-2-3 trades) on the cash segment, given the faster settlement mechanism.

These aren’t the only benefits of having physically settled derivatives contracts. In fact, the above mentioned benefits are just incidental. As pointed out in this column before, the most important distinction between physical and cash settlement is that the former works to the advantage of hedgers and arbitrageurs, while the latter works to the advantage of speculators. This is because physical settlement removes the execution risk on one leg of the hedge or arbitrage position, while it introduces the risk of taking delivery for speculators.

Especially in the case of single-stock options, which are still quite illiquid, option writers with an underlying hedged position can breathe easy with physical settlement.

Having said that, and while all this sounds good on paper, it remains to be seen if volumes will indeed pick-up on BSE’s derivatives segment. One major principle that’s working against the exchange is liquidity pulls liquidity. But this is not insurmountable.

If the exchange is successful at getting its proposed market-making schemes off the ground, it should find some success in building volumes. If some traders and investors join the fray for tax or some other advantages, the much needed momentum would fall in place.

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