SOCIETY FOR CAPITAL MARKET RESEARCH & DEVELOPMENT

SCMRD

 

FINANCIAL EXPRESS. DECEMBER 5,2003. NEW DELHI.

 

Futures Settlement: Physical Or Cash?

LC GUPTA & NAVEEN JAIN

 The Indian single stock futures system is cash-settled, meaning settling just the difference between the contracted price and the actual spot price on the settlement date. Physical delivery can neither be given nor demanded on contract expiry. In the US, which introduced single stock futures in early 2003, physical settlement system was adopted from day-one.

 

The Indian authorities, at the time of introducing stock futures, had rightly thought that there should be physical settlement and promised to implement it within six months. The promise has not been fulfilled even after two years.

There are several reasons why requiring physical settlement of futures contracts in all deliverable type of assets makes economic sense. A system which dispenses with physical delivery is an unsound economic system because it severs the market’s only link with the real economy.

This can be best understood by looking at commodity futures, which began trading in a standardised form around 1850 in the newly created Chicago Board of Trade in the US. The futures scheme required that the contracts outstanding on the expiry date will have to be settled by actual delivery of the commodity. This is still the requirement.

The important point is that the market’s link with the real economy must be maintained. If the market operators know that they would never be required to deliver the asset underlying the futures contract sold by them, many of them are tempted to indulge in excessive speculation or to create artificial prices unrelated to the real economic factors. All well-functioning futures markets apply the principle of physical settlement in the case of deliverable type of assets underlying the futures. An exception is made in the case of certain non-deliverable assets, like broad-based index futures but only after the regulatory authorities are convinced that prices of such products cannot be easily manipulated and their supply cannot be cornered.

In the securities markets, in their primitive stage in UK and US, there was much speculation in the form of so-called “time bargains” which used to be settled by payment of only the difference between the contracted price and the price at the end of the week or some other fixed period. Towards the closing decades of the 18th century, speculative manias and bubbles became a frequent feature of the securities markets in the UK and the US and caused much headache to the governments of the day.

Hence, contracts not settled by actual delivery of securities were outlawed in both these countries. The courts also declared them as wagering contracts. That is why in the US and UK, settlement by delivery became the rule for securities market transactions as long ago as 150 years. It is widely accepted by the public and the market participants as the only sound principle in these countries.

In India, the stock market never achieved much significance in relation to the economy. It remained dominantly speculative and was despised by the ordinary savers, as indicated by the popular term, “satta bazaar”. The system of settlement by paying only the price difference had survived till recently through a turbulent history of recurrent market crises. It was only much after independence that the Indian government began to look more seriously at the problem of developing the capital market on sound lines.

The government evolved a rule in 1983 to limit the carrying forward of a transaction to a maximum period of 90 days and to require that any unsettled trade at the end of this period must be settled by delivery of securities. However, this rule was not properly enforced.

After the introduction of economic liberalisation in 1991, many economic scholars began analysing the Indian stock market in economic terms. An almost unanimous view which emerged among the economists is that the market’s link with the real economy has remained very weak. One well-known scholar, R Nagaraj, called the Indian stock market only a “side show”, having no strong link to the real economy.

In the case of the financial system, the objective should be to harness speculation to enhance economic performance. The regulatory skill lies in being able to achieve this objective which goes much beyond simply risk-control. Even casinos use risk-control devices! Financial markets have to serve an economic purpose which should be enhanced as much as possible.

The danger of excessive speculation, particularly short selling, is heightened by the cash settlement system because it is easier for speculators to arrange cash than to arrange shares for settling a position. Hence, delivery requirement automatically acts as an instrument of market discipline. It keeps the tendency towards excessive speculation under check.

Although the prescription of market-wide limits on open positions has been of great help in keeping the genie of speculation bottled up but it is a rather blunt instrument, unable to distinguish between operators who really have high speculative positions or proclivities and those who have very small positions with no speculative disposition. Why not implement the physical settlement system as a market discipline along with market-wide limits and individual investor-level limits? Physical settlement of stock futures will have two more important advantages. These are : (a) It will facilitate arbitrage between the futures market and the cash market, thereby ensuring that the prices remain properly aligned.

(b) It will help to attract genuine long-term investors into the futures market by enabling them to acquire securities either from the futures market or from the cash market, as they may find advantageous. There are several benefits which will flow from this: it will further help in price alignment, make the futures market investment-oriented to some extent rather than remaining purely speculative and will increase liquidity in the distant month contracts which presently have no liquidity.

The main hesitation on the part of authorities to implement physical settlement is based on the argument that the market for lending/borrowing of shares has failed to develop in India. This is a very weak argument and reflects lack of will. If so many other countries could develop lending/borrowing of shares long ago, even before the demat system was adopted, there seems to be no reason why India cannot do it today.

Cash settlement of futures in deliverable assets has nothing in its favour except the lobbying power of the speculators.

          


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