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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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