BSE to start physical settlement for stock F&O

The Bombay Stock Exchange on Monday announced that it would be shifting from cash settlement to physical settlement on single stock derivative contracts.

“Effective February 1, 2011, trading on all existing single stock futures & options contracts expiring on or after April 13, 2011 will be delivery-based,” said a notice on the exchange website.

Contracts on single stock futures and options expiring in February and March would be the last ones to be cash settled.

A futures or options contract is primarily a bet between two people with opposing views on how a stock or index will move. Currently, the difference between the price at which the contract is entered into and the price of the security is settled by paying the difference in cash at the end of the period of the bet, called the time of expiry.

Under physical settlement, the settlement would have to take place by purchasing the stock and delivering it to the counterparty.

Physical settlement of trades could reduce speculative activity, according to experts.

“Physical settlement, if widely adopted, could reduce some of the volatility in the cash market that we have been seeing on the expiry day due to arbitrage position closures,” said Ketan Karkhanis, vice-president at ICICI Securities.

Its success may also depend on the pick-up in stock lending and borrowing mechanism (SLBM), which allows traders to borrow shares to meet settlement obligations.

The mechanism has failed to see significant participation since Sebi allowed it in 2007. Experts suggest that physical settlement may drive volumes on SLBM and vice versa. Either way, success or failure may very well be in tandem.

“BSE derivatives are still a small piece of the derivatives market, so it is unlikely that this would have a major impact on the overall market. If successfully adopted, one could see a structural change in the derivative participants. However, the strength of the SLB mechanism will also play a major role in determining how well it catches on,” Yogesh Radke, head - quantitative research at Edelweiss Securities, said.

The Securities and Exchange Board of India had allowed exchanges the freedom to choose their mode of settlement in a circular issued in July 2010.

The BSE had previously attempted to provide a differentiated offering in the derivatives segment by offering midmonth expiry, but with a negligible impact on volumes.

In December 2010, the exchange accounted for 0.001% share in the derivatives segment and 21.62% of the trades in the cash segment.

The average volumes in the derivatives segment during 2010 was Rs99,499 crore with the NSE accounting for nearly all of it.