SEBI and the stock exchanges are expected to reach a consensus on allowing physical settlement in derivatives by the end of July

Traders may soon be able to settle their derivates positions physically instead of cash as discussions between the stock exchanges and the regulators are in the final stages. Securities and Exchange Board of India (SEBI) chairman CB Bhave today said that the decision on physical settlement in derivatives is expected in a month.

"Various issues have been discussed with the stock exchanges and a final decision can be expected within a month's time," said Mr Bhave on the sidelines of the launch of the 'Certification Examination for Financial Advisors' at the National Stock Exchange (NSE). Mr Bhave also said that currency options will be launched fairly soon.

The Derivatives Market Review Committee headed by erstwhile Indian School of Business dean M Rammohan Rao had submitted its report on physical settlement in derivatives back in March 2008. SEBI gave an in-principle approval in March 2010 as per the recommendations of this committee. It is not clear whether the move would boost trading volumes.

"Having physical settlement of stock-related derivatives is a welcome step. It's an international practice. But it would not be good to put all the derivative stocks in physical settlement mode. There should be specific criteria about the liquidity and the impact cost, delivery volumes, etc, in any stock and based on that the stock should qualify for physical settlement. All index stocks could be brought into physical mode. The success would depend on all operational modalities. If the whole thing becomes successful, then they can liberalise the criteria and extend it to other stocks as well," said Sandeep Singhal, co-head, Institutional Equities, Emkay Global Financial Services.

Physical settlement in Indian markets was not allowed due to the absence of stock lending borrowing (SLB) mechanism and concerns of short freeze by short-sellers in illiquid stocks. Settlements are currently done through the National Securities Clearing Corporation Ltd (NSCCL) on the NSE. The average daily turnover on the derivatives segment of the NSE for the month of June 2010 stands at Rs92,527 crore. Unlike cash settlement, a physical derivatives contract has to be settled with shares. NSE launched derivatives trading with index futures on 12 June 2000. On 4 June 2001, it introduced trading in index options. Futures on individual securities were introduced on 9 November 2001. Currently, derivatives trading is based on individual securities and indices like S&P CNX Nifty, CNXIT,  BANK Nifty, Nifty Midcap 50, etc. Almost the entire derivatives volume is with the NSE.

"It is the way forward. All transactions have to be logically concluded so physical settlement will help. We can't say anything about the short-term but it will bring stability to the market," said Deena Mehta, managing director, Asit C Mehta Investment Intermediates.