It is Easier said than done.....
SEBI has said, It will comulsory implement Physical settlement of Stock Futures in a calibrated manner. (Here) The intentions are noble and its a global practice.
The volumes on exchanges have extrapolated since the advent of Derivatives. It grew even more with advent of Stock Futures, Stock Options and Weekly Bank Nifty Options. One of the reasons for a rise in the volumes was simple product.
With change in Settlement process from cash to delivery, it may change the paradigm and valuation of derivatives product. We will here see regulatory challenges and possible remedial action. This discussion is to see a gradual transit without impacting volumes.
a) There is concept of Trading Members(TM), Clearing Members(CM) and Professional clearing Member(PCM). When there is a physical setlement, how would the billing be, also Pay-in / Pay-out of Funds and Securities. (Current systems involves only money but If stocks are added, Risk will be become bigger for CM and PCM).
b) Risk of Assignment : As of now only In-the-Money stocks are assigned / Exercised and So the writer is aware of probabilty of assignment, but when the delivery is physical, there will be an unknown probability of assignment in Out-of-Money options also. (It should be remembered that Stock Options was changed from American type to European Type exercise for the same reason).
MCX has a different way to mark delivery as delivery period is for a few days, which is not possible in Equities, so there will be a risk of assignment on option writer for OTM option and non-assignment for ITM options.
Corporate Action : As of now, Corporate actions are cash settled for Dividend, Rights, Bonus. There can be issues now, as participants may ask for shares or would be ready to give shares in corporate actions. (That can be taken care by defining rules, but that may lead to temporary mis-pricing.)
Settlement : As things stand, there can be different settlement for expiry, I dont think, there will be a bigger settlement on expiry, Which will also mean, there can be fall in volumes, which may also reduce liquidity.
Securities Transaction Tax: This is the trickiest thing for physical delivery, This will have to be tweaked by Finance ministry to align with delivery STT, else We will be able to buy / sell stocks using Futures and Options without paying STT.
Seller participants will pay only 0.01% on selling only and nothing on buying, Also only the participant exercising the option pays STT and writer won't. This anamoly would be used to reduce STT outflow. I am sure this anamoly will be fixed, but that will be at slower pace, as it involves Finance ministry and STT may appear only in the budget fot next year.
It is a welcome move, but These issues need to be resolved for smooth implementation of physical settlement.
a) let the settlement of stock futures be carried in next day trading in cash market, if that happens, all participants with open positions will have an opportunity to cover / close their positions.
There will issues in such implementation, but that will be only once. I am sure, it will help traders from not shying away in settlement days, inturn reducing volatility and mis-pricing.
PS: By bringing physical settlement, SEBI has closed the door for overseas stock futures mkt. If ever they are traded overseas , it will be a different product, just like NDF( Non deliverable forward) traded on Indian rupees.
Want to write more, but will do it via another blog.
I welcome your critical comments and suggestions.