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Physical Settlement in Equity Derivatives - Oct 2019 review
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 SEBI in 2018 had issued framework for making physical settlement of stock derivatives mandatory, and planned to enforce it in a phased manner. Traders have to compulsorily take delivery of shares on the expiry day against their derivative (F&O) positions. An earlier post on details about physical settlement in equity derivatives is here.

For this purpose, stocks were ranked in descending order based on daily market capitalization averaged for December 2018. Based on the ranking arrived, it was decided that the bottom 50 stocks would move to physical settlement from end of April 2019 expiry onwards, the next 50 would move to physical settlement from end of July 2019 expiry onwards, and the remaining would move to physical settlement from end of October 2019 expiry onwards. In addition, SEBI said derivatives introduced in any new stocks, meeting the enhanced eligibility criteria specified by it, would also be physically settled. There have been no new stocks introduced in F&O since April 2019.  34 stocks were removed at the end of June expiry and another 12 are removed today with the end of Sept expiry. We now have 149 stocks remaining in F&O.

The stocks that are moving to physical settlement from end of Oct expiry or start of Nov expiry (effective 1 Nov, 2019) onwards are as below: 

1 ADANI PORTS AND SPECIAL ECONOMIC ZONE LIMITED
2 ASIAN PAINTS LIMITED
3 AXIS BANK LIMITED
4 BAJAJ AUTO LIMITED
5 BAJAJ FINSERV LIMITED
6 BAJAJ FINANCE LIMITED
7 BHARTI AIRTEL LIMITED
8 BOSCH LIMITED
9 BHARAT PETROLEUM CORPORATION LIMITED
10 BRITANNIA INDUSTRIES LIMITED
11 COAL INDIA LIMITED
12 DABUR INDIA LIMITED
13 EICHER MOTORS LIMITED
14 GAIL (INDIA) LIMITED
15 GODREJ CONSUMER PRODUCTS LIMITED
16 HCL TECHNOLOGIES LIMITED
17 HOUSING DEVELOPMENT FINANCE CORPORATION LIMITED
18 HDFC BANK LIMITED
19 HERO MOTOCORP LIMITED
20 HINDUSTAN UNILEVER LIMITED
21 HINDUSTAN ZINC LIMITED
22 ICICI BANK LIMITED
23 INDUSIND BANK LIMITED
24 INFOSYS LIMITED
25 INDIAN OIL CORPORATION LIMITED
26 ITC LIMITED
27 JSW STEEL LIMITED
28 KOTAK MAHINDRA BANK LIMITED
29 LARSEN & TOUBRO LIMITED
30 MAHINDRA & MAHINDRA LIMITED
31 MARUTI SUZUKI INDIA LIMITED
32 NESTLE INDIA LIMITED
33 NTPC LIMITED
34 OIL & NATURAL GAS CORPORATION LIMITED
35 POWER GRID CORPORATION OF INDIA LIMITED
36 RELIANCE INDUSTRIES LIMITED
37 STATE BANK OF INDIA
38 SHREE CEMENT LIMITED
39 SUN PHARMACEUTICAL INDUSTRIES LIMITED
40 TATA CONSULTANCY SERVICES LIMITED
41 TECH MAHINDRA LIMITED
42 TITAN COMPANY LIMITED
43 ULTRATECH CEMENT LIMITED
44 VEDANTA LIMITED
45 WIPRO LIMITED

In cash settlement in futures & options, the seller of the financial instrument does not deliver the actual (physical) underlying asset upon expiration or exercise, but instead pockets out the losses or pockets in the gains (depends whether he is on the losing position of gaining position).

When such contracts require physical settlement, it forces traders to roll over positions ahead of the expiry, thus averting lumping of rollovers at the end of the series, which leads to excessive volatility. SEBI’s move on physical settlement of derivatives is aimed to curb the excessive speculation on individual stocks that creates huge volatility.

Pros:

  1. F&O rollovers, which happen near to expiry, might witness rollover a week prior to expiry to avoid lack of liquidity.
  2. Volumes will grow on the indices during the expiry week (as indices still remain under cash settlement).

Cons:

  1. Reduction in liquidity impacts price discovery and broaden bid-ask spread. Generally, 90% of traders use to rollover their position on the day of expiry, now due to physical delivery; they may do that before expiry. Few brokers are putting restrictions 3-4 days ahead of expiry to stop trading in such scripts.
  2. Physical delivery could also reduce short selling. Short sellers will now have to first borrow stocks under the SLB (securities lending and borrowing) mechanism, which allows borrowing of securities from institutional investors. But that space still remains shallow in India

Note: Please do not consider this blog as a recommendation; it is purely for informative purpose only. The author(s) and Adroit research team may have some positions based on this analysis and may have recommended to clients. Please assume we are biased and do consult your financial advisor before taking any positions. There is no other relationship between the author(s) and Adroit research team; and the above company.

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