Physical settlement of derivatives : issues and solutions...

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.

Suggestions:
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.

Listing of NSE Nifty of CME

NSE had entered in pact with CME to list Nifty futures on CME and NSE can list futures on DJIA and S&P 500. CME is about to list NSE nifty and start trading on it from 17th July, 2010.

The Salient features of Listing are

a) Foreign Investors and NRI can take position on Nifty using CME platform.
b) It would mean you can trade on Nifty for about 23 hours in a day.
c) The listed NIFTY will be Dollar denominated, hence Foreign Investors need not hedge Rupee Exposure.
d) The Contract size of trading is about 10500 $ and 52500 $. (5 lakhs and 25 Lakhs)
e) The contract size of SGX nifty is also the same as the size on Lower denomination value futures on CME.
f) You can offset CME position on SGX and vice versa. It means the trader can take position in SGX and when SGX is closed he can simply close the position on CME.
g) There is no transaction charge on Nifty Futures on CME up to December, 2010.
h) Many FII and Hedge funds and unregulated entities need not register itself in India and can take position on Nifty.
i) The will be more arbitrage opportunities to global investors as same product is listed in different geographies.
j) They don’t have to pay STT in India which is a major transaction cost in Nifty trades done on NSE.
k) SGX has already signed a contract with NSE to provide Nifty Options, Hence Nifty option will also be traded globally.


Is there any concern of worry?
a) Price discovery will be better if the product is globalised. Nifty will also be looked upon as investment vehicle if there is sufficient interest, Volumes and Open Interest from other geographies.
b) Global Player can trade in Nifty anytime
c) I also perceive that combined Nifty volumes of all geographies will increase but the share of nifty trading in Indian Bourse will fall not only in percentile terms but also in Absolute terms. Because global player will prefer trading in SGX and CME as it will have lesser transaction cost and No STT and No Rupee Exposure.
d) Are many Indian Players equipped and have necessary Logistics and Infrastructure to trade in Global Markets. I guess the answer is No; Most of the Indian Brokerages, Banks and Prop Desk are not equipped. Nor do they possess the required Skill set also they are miniscule in size on global scale.  Also Indian Laws are tough for allow Indian Companies and Brokers to trade on Global Exchanges.
e) There is nothing in store for General Investor as he was always a price taker, but we will have to see Lead-Lag behavior of Nifty between Indian Exchange and Foreign Bourse.
f) 40% of Volume on NSE derivatives is for Nifty Options. As and when options will be traded on SGX we may see big shift in open Interests.


Will NSE lose its Market Share?
Yes NSE will lose volume to Foreign Bourse, but they will compensate fall in Transaction charges with huge license fee and charges from Listing of DJIA and S & P 500.



What will government lose?
Definitely STT, huge STT will be lost by government with shift in volumes, but Government may take solace in Lesser Tax litigation and less entry of unregulated entities.

Nifty View

Nifty has reached a crucial level, The Stochastic has reached oversold level & the fast line is above slow line signalling upward move. We can try going long at this price of 5255 but we can have committed move above 5307.

Stocks to bet will be NELCO, Unitech, M&M, RPower & Essar Oil. We may hedge it with short position in ZEE below 293/-

The SL for Nity would be 5235