Physical settlement of F&O stocks – What is its purpose and what is the mode of operation?

There has been a lot of buzz over physical settlement of stock futures in 46 stocks. This kicks in from the month of July. What exactly is this physical settlement and how will it impact the traders in general and the stock futures in particular? Before we get into the specifics it needs to be understood that the lot sizes of the futures will remain the same. Before we understand the application of physical settlement for stock futures on these 46 stocks, let us first look at where it will not apply.

Where the physical settlement of stock futures will not apply for these 46 stocks

  • If you are trading intraday in stock futures then you will buy stock futures in the morning and sell by evening or vice versa. Really nothing much will change or you. Your trading will go on as it is and you don’t need to worry about physical settlements at all.
  • Stock futures can be reversed before the expiry date. So, if you bought 1 lot of Just Dial futures July 2018 contract, then you can close the position at any time before the expiry on the last Thursday of the month. Although Just Dial is the list of 46 stocks, since you are reversing the position, there will be no impact of physical settlement on you.
  • If you are trading in stock futures of any stock in the F&O list other than the 46, then you don’t need to worry about physical settlement at all.

So, who has to really worry about physical settlement of stock futures?

If you are trading in stock futures of these 46 stocks and you plan to carry the stock future into expiry, only then the issue of physical settlement of stock futures will apply to you. Currently, all stock futures are cash settled till the June expiry. Effective from July, if you leave a stock to expiry on the last Thursday of the month, that is when it will be deemed to have resulted in delivery of shares. The idea is to reduce the propensity of retail investors to keep buying highly volatile stock in the form of stock futures rather than in cash markets.

Why physical settlement of stock futures?

The idea is to curb speculation in the F&O market. Indians have been used to Badla for a long time on BSE and hence stock futures looked like a logical extension for them. That has led to speculation and SEBI wants to avoid retail investors getting caught up in this speculation. As per the SEBI announcement, out of the 208 stocks that are currently permitted to be traded in F&O, a total of 46 stocks will be shifted to the compulsory physical settlement mode. This list of 46 stocks includes some popular F&O names like Adani Power, Ajanta Pharma, Allahabad Bank, Andhra Bank, Balrampur Chini, BEML, Berger Paints, and CanFin Homes etc. But first let us understand how the physical settlement of stock derivatives will work versus the current cash settlement process.

Recapping what physical settlement is all about…

When we talk of physical settlement, please remember that it only applies to stock futures that are settled on the expiry date. If you buy stock futures of say Just Dial and reverse the position after 3 days then the physical settlement rule will not apply. But, if you buy stock futures of a stock and then leave it to expiry, then this compulsory physical settlement will apply in case of the 46 stocks effective from the July 2018 contract.

Will the physical settlement of stock futures in 46 stocks really make a difference?

We will have to really observe how the physical settlement shapes and the first indications will only be available once we complete the first physical settlement. But the following points may be of relevance.

  • As of now just about 12-15% of all stock futures positions are left to expiry. The rest of the positions are squared off before the expiry itself. To that extent, physical settlement will only apply to the small percentage of stock futures that are left to expiry. The impact on the overall markets may be limited to begin with.
  • There could be a rush to square up stock futures position ahead of expiry, especially in stocks that are very volatile in this list of 46. To avoid the hassle of physical settlement most traders may prefer to unwind their stock futures positions well in advance. It will reduce the expiry week volatility and more specifically the expiry day volatility in F&O markets arising from VWAP trades.
  • For cash-futures arbitrage positions, a big chunk of the trade will be the VWAP trades. Now these VWAP trade will vanish in these 46 stocks, especially if the trader will have to give compulsory delivery against stock futures. Squaring off the cash and futures earlier may be a better deal. This could have larger implications for the domestic arbitrage funds and global institutions that are into arbitrage transactions.

Finally, let us look at the greener side of the whole issue. Let us say I have sold futures and want to leave it to expiry. I cannot give delivery because I do not have these shares in my demat account. There could be a positive outcome of this compulsory physical settlement with respect to stock lending and borrowing mechanism. If compulsory physical settlement has to really take off, then it will require a robust stock lending mechanism that can take care of delivery shortfalls. This could actually catalyze the rapid development of the stock lending mechanism in India. That could be the one big positive take away from this announcement.

 

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