The Securities And Exchange Board of India (SEBI) makes headlines in financial newspapers for its straightforward and impactful actions. Recently, it released a discussion paper inviting views of all stakeholders on issues that concern the capital market regulator. SEBI seems focused on regulating the derivatives market, which, it feels, requires more regulations.
The level of speculation in derivative markets was one of them.
According to various media reports, SEBI is trying to change the settlement systems that have led to a proliferation of speculative trades.
The present contract system in the derivatives segment works on a minimum lot size basis. This means, someone interested in entering derivatives contract, in future as well as in options, has to make a contract for the minimum lot size prescribed for the stock or an index. The lot size is decided in such a way that the total value of contract falls in the range of Rs 5 lakh and Rs 10 lakh.
Suppose you were to buy a future contract of ‘XYZ’ Ltd. expiring next month on the last Thursday , you won’t have a choice to buy 100 or 200 or any number of shares. If the lot is 600 and the per share value in the future market is Rs 1,209; you will have to buy the minimum lot of 600 shares at 1,209 each. In this case, the total value of the contract will become Rs 7,25,000. You can buy two lots, five lots, or any number of lots keeping the ceiling prescribed for every category of investor in mind.
European vs. American settlement
In the European settlement style, the contract is executable only on the day it expires. For example, if you entered a contract to buy a lot (600 shares) of ‘XYZ’ Ltd. . On the last Thursday of the next month, you can execute the contract only on that day—not before or after. Compared to the American style settlement that offers you the choice to settle the contract any time before the expiry by reversing the position.
Current settlement practice
| Cheaper |
Settlement type |
| Index Futures |
Cash settlement |
| Index Options |
Cash settlement (European Style) |
| Stock Futures |
Cash/Physical Settled |
| Stock Options |
Cash/Physical settlement (European style) |
(Source: SEBI)
Continuing with the example of ‘XYZ’ Ltd., if a person who entered the contract as a buyer is betting on ‘XYZ’ Ltd. ending the next month’s contract above Rs 1,209, which is the buying price. But if for any reason, the price drops, to say, 1,180, s/he has an option of closing her/his position at a loss of Rs 29 per share. In this case, s/he can book the loss of Rs 17,400 (Rs 29 X 600 shares) and get out of the contract.
This is exactly what bothers SEBI.
Currently, since the positions can be settled in cash, speculator jack up (or drag down) prices artificially by manipulating stocks in the future segment. And as a remedial measure, it is considering the possibility of introducing the physical/delivery based settlement system. Under the system of physical settlement, a person can’t get away just by booking a loss of Rs 17,400. He will have to shell out Rs 7,25,400 from her/his pocket and receive the delivery of 600 shares at the market value of Rs 7,08,000.
SEBI believes this move can push volumes in the cash markets significantly up and the Government will have a chance to generate higher revenue on account of the Securities Transaction Tax (STT). As per the present statistics, the cash segment contributes nearly 60% of total STT collection of the Government despite constituting a mere 10% of total equity volume.
Commenting on this development, Mr Deven Choksey, promoter, KR Choksey Investment Managers said, “Bringing in delivery-based settlement shows SEBI’s seriousness in protecting the interest of small investors and curtailing speculation.”
“It is the need of the hour. Both cash and delivery settlement options should be given to traders to balance the markets”, he added further.
Here's a Reality Check:
In the past, SEBI has successfully introduced some of the toughest reforms. But, the one currently under consideration is of an unprecedented magnitude. Derivatives markets are a great source of price discovery and the sentiments in the derivatives market often decides the sentiments in the cash market. Change in the delivery system may lead to severe altercations between SEBI and the traders’ community—both foreign and domestic. Looking at the unfathomable scope for the positive feedback loop; SEBI will have to introducing changes of this magnitude carefully. These could boomerang.
Forget about enhanced liquidity, if traders shun the derivatives trading in individual stocks; some stocks may face tremendous volatility in the cash segment and may turn even more illiquid.
For the change in the delivery system to happen, SEBI will have to do away with the concept of minimum lot size. In the era of standardisation, it looks difficult that SEBI will discard the system of standard lot size contracts.
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