Exchanges differentiate as regulator offers flexibility

Exchanges differentiate as regulator offers flexibility

NSE to pitch European options against BSE’s physical delivery", Business Standard newspaper’s article from late last week, heralds an interesting development in the stock exchange space. It’s arguably the first time that the design of any product traded on the two stock exchanges will differ materially from each other’s.

Also read | Mobis Philipose’s earlier columns

The National Stock Exchange has already decided to shift its single-stock options from having an American-style exercise option to a European-style option. In the former, an option can be exercised at any time before the expiry of the contract, while in the latter, the exercise happens only at expiry. The Bombay Stock exchange, according to sources, is likely to introduce European style options as well, but ones which will be physically settled. NSE’s options will be cash settled.

For all other products traded on the National Stock Exchange and the Bombay Stock Exchange, the Securities and Exchange Board of India lays out the exact specifications of how the product should look. The regulator decides the contract size, the expiration date, the tenure of the contracts, the underlying stocks and indices that qualify for trading. As a result, so far, exchanges have had to complete almost solely on pricing, which ironically enough doesn’t provide much leeway since exchange fees form a minuscule portion of total trading costs.

But under C.B. Bhave, Sebi seems to gradually moving away from making all the decisions related to product design. Late last year, the regulator said exchanges can set its trading session anytime between 9am and 5pm. There was a mad scramble after that circular, with each exchange trying to outdo the other; nonetheless, it was heartening to see the regulator providing exchanges some room to make decisions in areas it has traditionally kept a tight grip on.

This was followed by a circular earlier this year, allowing exchanges to choose between cash and physical settlement for single stock derivatives. And just last week, Sebi gave exchanges the option to also choose between American and European style options. As a result, there are four combinations to choose from—the existing cash-settled American style contract; a physically settled American style contract, which is the norm in developed markets such as the Chicago Board Options Exchange; a cash-settled European style option or a physically settled European style option. Further, exchanges have the freedom to choose between cash and physical settlement for single stock futures, irrespective of their choice of settlement for single stock options. So even if BSE decides to have physically settled stock options, it can continue to have cash-settled stock futures contracts.

This change is refreshing, considering that exchanges have had no freedom whatsoever in making such decisions in the past. Needless to say, this will foster competition and will drive some product innovation. Of course, in an ideal world, there should be much more freedom given with product design. But the pace of progress is encouraging.

The development is also important because liquidity in the single-stock options market hasn’t picked up as well as other product segments. Of late, volumes have risen, but the options market is less than a fifth of the size of the stock futures market. Worldover, options are the preferred derivatives contracts to take/hedge exposure to stocks.

One of the reasons for the relatively low interest in stock options in India is that option writers carry undue risk. With the existing American-style options, they face overnight price risk. To understand this better, consider an investor who writes a covered call, i.e. writes a call option while having a long position in the underlying stock. Since the options are American style, they settle 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. But the writer is intimated after market hours about this settlement. In order to execute the second leg of the transaction, i.e. sell the underlying in the cash market, the writer has to wait till the market opens the next day. This involves overnight market risk, and the sale price in the cash market is likely to differ substantially from the price at which the options position was settled the previous day. This situation can arise not only with covered calls, but any strategy with two related transactions, where one of the legs involves writing an option. For e.g.; it could be a short straddle position where a trader writes both a put and a call option to pocket the premium from both contracts, on the assumption that a stock would be range-bound until the expiry of the contracts. But if the buyer of one of the legs exercises the option, the strategy could come undone, unless the straddle writer is able to exit the other leg at a favourable price the next day.

Having European options takes away the uncertainty of early exercise, since it allows buyers to exercise their options only at expiry. Since both exchanges are likely to offer European options, the product differentiation will be between cash and physically settled contracts. Physical settlement generally works better for all hedgers and arbitrageurs and cash settlement works better from a speculator’s point of view. Hopefully the differentiation would lead to some market share gains for BSE’s moribund derivatives segment. It would be ironic if it doesn’t since some of the above-mentioned changes seem to be happening at their behest.

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