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THE advisory committee on derivatives recommends that derivatives on individual stocks should shift to physical settlement. The committee also recommends that physical settlement be implemented for all stock-based derivative products simultaneously by giving at least 45 days notice to the market.

However, Mr Vaidyanath (member) stated that the BSE is apprehensive of short squeezes in absence of efficient stock borrowing and lending mechanism and would like the choice of implementing physical settlement to be left to the exchange.

The L .C. Gupta Committee Report took it for granted that physical settlement would be used for derivative contracts on individual stocks: "In the case of individual stocks, the positions which remain outstanding on the expiration date will have to be settled by physical delivery. This is an accepted principle everywhere."

However, when single stock derivatives were introduced in India, it was decided to use cash settlement to begin with because the exchanges did not then have the software, legal framework and administrative infrastructure for physical settlement. It was proposed that cash settlement would be replaced by physical settlement within a period of six months as

the exchanges developed the capabilities to achieve physical settlement efficiently.

In April 2002, the Advisory Committee of Derivatives (ACD) proposed a broad framework for physical settlement. The SEBI Board desired that the committee should present a report highlighting the risks and benefits of physical settlements along with possible risk containment measures.

Accordingly, the ACD reconsidered its recommendation on the risks and benefits of physical settlement. The ACD notes the principal issues involved in physical settlement:

* In the absence of a vibrant mechanism for securities lending and borrowing, physical settlement of stock-specific derivative contracts, especially stock options, may raise concerns.* Globally, cash settlement is cheaper than physical settlement, but the economics may be less clear-cut in India where the modernisation of the payment system has lagged that of the securities settlement system.

* Under the existing procedure of cash settlement, hedgers and arbitrageurs incur overnight price risk for liquidating one leg of the transaction in the cash markets.

A hedger (who by definition has a position in the underlying) would have to liquidate that position in the cash market and then bears the risk that the price realised in the cash market would differ from the settlement price used for cash settlement in the derivative markets. The same argument applies to arbitrageurs.

Speculators, on the other hand, would find cash settlement beneficial since they do not (by definition) have an offsetting cash market position and cash settlement saves them the burden of operating in two markets. Physical settlement of derivative contract helps hedgers and arbitragers avoid basis risk while imposing some additional costs on speculators. The committee is of the view that the regulatory regime should be more in tune with the requirements of hedgers and arbitrageurs than the needs of speculators. For this reason, it recommends physical settlement which protects hedgers and arbitrageurs from basis risk in the settlement process.

At the same time, the Committee recognises the concerns regarding short squeezes in physical settlement. To address these concerns, the committee recommends the following measures to reduce the risk of short squeeze:

* The exchanges should lay down limits on daily exercise and assignment of stock options. Since these options are American, the squeeze can arise at any time during the contract cycle. Daily limits on exercise and assignment limit the ability to squeeze the market in the middle of the contract month.

* That leaves the possibility of a short squeeze at expiry. One important defence against this is the position limits that apply in the derivative market. In fact, market manipulation can take place even under cash settlement and position limits

are the principal defence available to the regulator.

* The Committee also believes that there is greater need for surveillance as the contract approaches expiry. Large positions tend to be closed out or rolled over into the next contract month as the contract approaches expiry. Large positions that are maintained or enhanced during the last days of the life of the contract need to be monitored closely.

An alternative approach would be to examine changes in contract design and market microstructure that would eliminate the basis risk for hedgers and arbitrageurs even under cash settlement. Essentially, these would require that hedgers and arbitrageurs have the ability to achieve guaranteed execution in the cash market at the settlement price.

Edited excerpts from the SEBI Advisory Committee on Derivatives (www.sebi.gov.in)

If you have any queries relating to the futures/options markets and strategies that can be used in these markets, please mail them to Futures & Options, Kasturi & sons, 859-860, Anna Salai, Chennai 600 002 or email them to vaidy@thehindu.co.in with a mention of futures/options in the subject line of the mail.

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