The regulator announced the policy on Friday March 5 as part of a series of reform proposals. SEBI has also agreed to permit derivatives with five year maturities and futures and options on well-established and mature volatility indices.
“The Board has decided that we will discuss with the stock exchanges and institute an appropriate mechanism for physical delivery in the derivatives market,” said SEBI chairman CB Bhave.
Equity derivatives were introduced in 2000 but only with financial settlement.
The head of futures and options at a futures commission merchant in Mumbai said that while the proposals were “a good thing” for the development of India’s derivatives markets, they raised several issues about how the new system would be designed.
“There are questions around delivery,” he said. “Will the futures will be deliverable into shares? Which is obviously the easiest way for the regulators to go, but on the options side it is a little more complicated.
“Equity options are currently designed as positions over the underlying rather than futures. With the level of open interest in India’s equity options market, the question is, will there be enough stock to cover those positions?”
The FCM source said he also expected physical delivery to cause “disruption” around the expiry period as market participants seek the underlying shares to cover their positions.
“It’s already crazy in the last half hour on an expiry date, and I think it’s going to be even worse if this does come true,” he concluded.
However, despite the potential difficulties, the adoption of physical delivery could advance the market. “I think the market needs this, it has been an inhibiting factor for a lot of players,” the source said.
Physical settlement is popular with some equity derivatives traders as it reduces basis risk, the difference between the asset whose price is to be hedged and the asset underlying the derivative.
A second market source also welcomed physical delivery, adding that he believed it would boost the country’s nascent securities lending market.
A mechansim for stock lending and borrowing was initiated two years ago in April 2008, but has still not taken off.
SEBI’s proposal for longer maturities in equity derivatives was also warmly welcomed by the FCM executive. He said the development would not benefit most of India’s equity derivatives users, as they normally do not take views for that long, but that it would be an extremely valuable tool for the country’s structured finance market.
“What tends to happen,” he said, “is that issuers of structured products have issues hedging their exposure to the market and as a result struggle to provide longer dated products. Products that are available tend to be more expensive as issuers are forced to hedge on a month-by-month or year-by-year basis, adding extra transaction costs.”
However, the executive was less wholeheartedly enthusiastic about volatility-linked derivatives. While such products would allow participants to take a view on the market, he said the Indian volatility indices on offer now would be more suitable when liquidity in the underlying markets had improved.
He said this increased activity would come as a result of several initiatives unveiled by SEBI, including physical delivery, co-location and longer dated maturities, but until that date, the real benefits of volatility derivatives would be felt in the future.
Colin Packham, Sydney cpackham@fow.com