Vikram Limaye, managing director and chief executive officer of the National Stock Exchange of India Ltd. (NSE), at an event in Singapore. (Photographer: Vivek Prakash/Bloomberg)

Institutional Participation Must For Physical Settlement To Succeed, Says Vikram Limaye

The participation of institutions like mutual funds and insurance companies is essential for a successful transition to physical settlement in the derivatives segment otherwise traders will close their positions before the expiry of contracts, according to Vikram Limaye, managing director and chief executive officer of National Stock Exchange of India Ltd.

These institutions that are sitting on inventories need to participate actively to facilitate more liquidity, he said on the sidelines of Wharton India Economic Summit.

This comes after the market regulator said it will move all stocks that are cash-settled to physical settlement in descending order. This means the first 50 companies with the least market capitalisation will move to physical settlement in April contract. The next 50 stocks will move in July and then in October. The NSE in April 2018 released a list of 46 stock futures that would be settled physically after SEBI’s decision to move to physical settlement in derivatives in a phased manner.

“Based on the experience of 46 stocks, it has been a mixed bag,” Limaye said. “The exchange is yet to assess the impact of SEBI’s move to shift the derivatives market to physical settlement.”

The move to physically settle these 46 stocks lowered the speculative activity and volume in derivatives and cash markets, two exchange officials told BloombergQuint requesting anonymity.

While market participants don’t expect much impact on volumes initially, they said it’s possible that moving the last 50 stocks to physical settlement will impact volatility during the last week of expiry. The rollover of positions will be advanced and there is likely to be a short squeeze on stocks as investors who are short on stocks will try to either square off or seek stocks to settle physically, they told BloombergQuint.

Also, foreign investors who prefer to cash settle derivatives may look at Singapore Exchange as an option. SGX introduced stock futures in 50 Nifty stocks last year.

But Limaye said the volume of single stock futures in SGX is small. Besides, in the international markets, including CBOE, the contracts are physically settled and not cash settled, he said.

To put that in perspective, two exchange officials quoted above said, less than 2 percent of the derivatives contracts are settled physically in the international markets.

Limaye also said all contracts launched in the commodities markets are physically settled. Existing cash-settled contracts in commodities, too, are expected to move to physical settlement.

Higher Cost

Investors settling derivatives contracts physically will have to pay a tenfold higher securities transaction tax than those who settle in cash. That’s because the same securities transaction tax rate on delivery on securities will apply to physical settlement in derivatives and equity segments.

“Ultimately, traders will have to take the risk that they may have to settle physically,” Limaye said.

Yet, one of the exchange officials quoted above said, the successful transition to physical settlement will require lowering transactions costs. Currently, the physical settlement in derivatives and cash market is a parallel process. The market regulator should look at merging the two settlements. This will allow netting off positions and reduce the STT cost for traders, the exchange official said.

Securities Lending And Borrowing Programme

SEBI needs to improve the flexibility of the securities lending and borrowing programme, Limaye said.

The market regulator has intervened several times to improve the SLB programme—in which traders borrow shares that they do not own or lend the stocks that they own but do not intend to sell immediately—but it is yet to garner participation and liquidity, he said.

According to the exchange official quoted above, this programme is a standardised process and allowing flexibility to a participant to enter into non-standardised contracts is likely to bring in liquidity.

Also read: London Metal Exchange Is Changing How It Does Business In India

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