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TRADING & SETTLEMENT WITH THE PHYSICAL DELIVERY OF SECURITIES

By Group No: 5 Rakesh Dodai F-06 Mayuresh Paralikar F-14 Madhumita Saha F-22

Road Map
Name Madhumita Saha Roll No F22

Rakesh Dodai

F06

Mayuresh Paralikar

F14

What is trading ‡ Trading securities is the act of buying and selling securities with the intention of making a quick profit. Brokerage firms and investment advisers recommend buying securities for the anticipated long-term appreciation of the company. .

. to fulfill contractual obligations. usually against (in simultaneous exchange for) payment of money.What is Settlement ‡ Settlement (of securities) is a business process whereby securities or interests in securities are delivered. such as those arising under securities trades.

to the holder at the contract's maturation date rather than send the cash equivalent (cash settlement).stock certificates. . ‡ Indian regulators had attempted to go a step further in 2002 to dissuade some of the speculation in its derivatives market of the Bombay Stock Exchange (BSE) and require that all single-stock futures contracts be physically delivered. stock futures and options contracts continue to trade on the BSE on a cash-settled basis. ‡ Currently it takes place in NASDAQ and Dow Jones. head of cattle . Nonetheless.Physical delivery ‡ Physical delivery in derivatives markets refers to settlement by receiving or sending the underlying assets .

PHYSICAL DELIVERY OF SECURITIES .

options contracts on individual securities are American style and are cash settled. . ‡ Leverage benefits in futures market encourage large volume. ‡ Better price discovery in the spot market.MAKES SENSE IN CASE OF OPTIONS ON STOCKS ‡ In India. futures contracts on shares are also cash settled. ‡ Equate options and futures markets and ignored the fundamental difference in these two instruments. Similarly. ‡ Higher margin will take care of speculative practices in the futures market. ‡ Exchange-traded equity options ‡ The present practice in India of cash-settling option contracts is fraught with danger and has on many occasions led to large speculative practices.

‡ Assets limited . ‡ In the absence of physical delivery.Futures contracts on many commodities have been moved to a cash settlement basis instead of physical settlement.(There is no logical conclusion to the futures trade). cash unlimited ‡ Fact . the system simply flushes out all trades at the end of the month when the contract expires.Physical delivery contd ‡ SEBI appointed derivatives committee has suggested to introduce physical delivery of securities. . ‡ This will limit the possibility of manipulation and also curb excessive speculation.

‡ The costs would go up if traders are forced to settle the contracts in shares as traders will have to borrow shares. ‡ It is believed that the issue was discussed in the secondary market advisory committee (SMAC) meeting held recently. . the volumes have hardly picked up. where physical settlement is followed. ‡ In the US.Physical delivery contd ‡ The volume would fall sharply if physical settlement is introduced. ‡ Brokers are unclear as to how securities transaction tax (STT) will be charged on the transactions settled in the physical form.

at the rates applicable for delivery-based transactions. Investors or traders may have to pay STT once more when they actually deliver securities in the physical form at the time of settlement. the seller will have to deliver the underlying shares at the time of expiry of F&O contracts. ‡ The buyer will have to take delivery of shares. . if he has not squared off his positions till then. STT is levied at rates applicable to non-delivery deals on the day of trade. ‡ For derivatives transactions. ‡ Brokers fear that investors and traders may end up paying STT more than once for a single transaction.Physical delivery contd ‡ In the physical settlement. if his position is open on the day of expiry.

‡ Currently. It is charged at 0.025% on the sell side of nondelivery-based transactions.017% for sale transactions in the F&O segment. ‡ Issue multiple taxation ‡ STT forms a large part of the overall cost of delivery-based transactions. STT is charged at 0.Physical delivery contd ‡ If they borrow or buy securities for the purpose of delivering in the market. such transactions will also attract STT. .125% of the turnover for delivery-based cash market transactions. on both buy and sell sides. The rate is fixed at 0.

.Physical delivery contd ‡ Sebi gave stock exchanges four choices o o o o cash settlement for both stock options and stock futures. particularly of the companies with low floating stock. cash settlement for stock options and physical settlement for stock futures or the other way round. Investors wanting to buy or sell large quantities and give or take delivery of the shares can take advantage of physical settlements. ‡ The new process is expected to reduce instances of manipulation in derivatives contracts. physical settlement for both stock options and stock futures. ‡ The derivatives market is more liquid than the cash market.

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‡ Physical delivery of the underlying would largely finish off the value weighted average price (VWAP) for arbitrage settlements. The market will see more roll-over and more close-out of existing positions because of two reasons:o One. o And two. very few people have the financial wherewithal to take delivery. the retail investor's mindset would take some more time to accept physical delivery of the underlying as a fact of life.Physical delivery contd ‡ Physical settlement of derivative trades good for price stability ‡ Volatility will increase in the last week prior to expiry. .

‡ The main reason for the delay: NSE.Physical delivery contd ‡ Market volatility that normally increases around the settlement date nowadays would get tempered once physical delivery ushers in. . ‡ The prerequisite for successful implementation of physical delivery is the presence of a robust securities lending and borrowing mechanism (SLBM) simply because it would enable entities with short positions to deliver the underlying. where about 99 per cent of all equity derivatives trading volume happens. has given a lukewarm response to the proposal. in case they do not possess them.

. a delivery-based settlement helps them as they do not have to square off their cash market trades on expiry.Physical delivery contd ‡ For investors doing strategy-based simultaneous trades in cash market and stock F&O. ‡ A system which dispenses with physical delivery is an unsound economic system because it severs the market s only link with the real economy. ‡ 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.

. These are : o It will facilitate arbitrage between the futures market and the cash market. ‡ Physical settlement of stock futures will have two more important advantages. delivery requirement automatically acts as an instrument of market discipline. thereby ensuring that the prices remain properly aligned. as they may find advantageous.Physical delivery contd ‡ Hence. o 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. It keeps the tendency towards excessive speculation under check.

‡ Cash settlement of futures in deliverable assets has nothing in its favour except the lobbying power of the speculators. ‡ The speculators today have all profit and losses settled in cash. arbitrageurs and hedgers. . 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. ‡ When derivatives contract are settled physically. there will be implications for all players in the derivatives segment speculators.Physical delivery contd ‡ There are several benefits which will flow from this. They are: o It will further help in price alignment.

The price discovery process will become more efficient by their participation with physical delivery of assets. They will have to extensively use lending and borrowing from the stock lending and borrowing platform to settle trades. exposing the fund to market risks during turbulent times. Hedgers will see the benefit of hedge. ‡ Many fund managers do not hedge today due to the absence of physical settlement in the segment. They will be able settle their hedge positions by physical delivery. Their active participation will create a vibrant market and better premium pricing in the scrip options. Arbitrageurs will be needed to take the lead in developing this segment of the market.Physical delivery contd ‡ Arbitrageurs will have to deal with the challenges of a physical delivery. .

RISK MANAGEMENT .

Risk Management ‡ Clearing Participant ship Standard ± Individual Clearing Participant ship ± General Clearing Participant ship ± Other Factor ‡ The company background ‡ Financial conditions ‡ Company¶s risk management system HK$ 5mn HK$ 25mn ‡ Efficient Clearing System ± Fully electronic ± Automated clearing and settlement system .

Risk Management ‡ Margining System ± Parameter to be considered ‡ Historical price volatilities ‡ Current and anticipated market conditions ± PRiME (Portfolio Risk Margining System of HKEx) ‡ Assessment of the maximum potential risk exposure of a portfolio over a one-day period under different realistically simulated market scenarios ± ± ± ± Movement in the prices Volatilities of underlying assets Time until expiration Risk-free interest rate .

20. . HKCC will increase the margin level by 20% on that Participant.Risk Management ‡ Daily Mark-To-Market ± All open positions are revaluated daily ± on the basis of their respective closing prices.g.000 contracts for HSI Futures. losses should be settled before opening of next trading day ‡ Additional Margin on Concentrated Positions ± HKCC can impose additional margins on individual Participants ± If a Participant holds positions that account for more than 30% of the market risk and the total net open interest exceeds a certain number of contracts e.

000 delta .Risk Management ‡ Holiday Margin Arrangement ± Mitigate the potential market risk on the reopening after the holiday break ‡ One day Holiday ± Mandatory to adjust the intra-day call before holiday ‡ More than one Holiday ± Mandatory intra-day adjustment ± Raises margin level for some major products ‡ Monitoring Client Exposure ± HKFE sets a position reporting level for each Market ± Not allowed to hold positions in excess of 10.

Risk Management ‡ HKCC Participant's Default ± HKCC managed Reserve Fund ± Customer positions are netted against each other ± HKCC Participant's margin money is applied to any deficits after netting ± Further deficit is withdrawn from the Reserve Fund in layers ± Under no circumstances will customer segregated margin deposits held by the Clearing House for one HKCC Participant be used to cover either a house or customer default of another HKCC Participant .

Risk Management ‡ Reserve Fund ± To meet its obligations as the counterparty in case of participant defaults ± Reserve Fund ‡ Participant contribution ‡ Interest on deposits ± Size of the Reserve Fund is monitored by stress testing ‡ Market movement assumptions ‡ Default assumptions ± 30% of the loss-making positions default ± Participant with the largest projected loss defaults ± Collateral provided by the clearing participants .