SEBI mulls steps to cut risk of physical settlement in derivatives

SEBI has proposed that in-the-money (ITM) single stock-option contracts be allowed to devolve into futures, one day prior to expiry.

Currently, all ITM options based on the last 30 mins VWAP on the expiry day are auto-exercised and converted to underlying deliverable obligations. It is proposed that ITM options instead of directly resulting into physical delivery obligation on expiry will initially devolve into stock futures on the day prior to expiry. On the expiry day, only futures will be tradeable. The open futures positions on the expiry day will be settled by delivery, as at present.

The change is intended to mitigate potential risks associated with scenarios where significant obligations may arise in the context of physical settlement requirements in single stock derivatives when an Out-of-The-Money (OTM) option unexpectedly becomes ITM due to sudden price movements near market close on expiry day, the regulator said.

An ITM option is one with a strike price that has already been surpassed by the current stock price. An OTM option has a strike price that the underlying security has yet to reach, meaning the option has no intrinsic value.

In the last six expiry months ending September, there has been no instance of an option contract turning OTM to ITM, after-market hours based on VWAP. However, there were 10 contracts which turned from OTM to ITM in the last 15 minutes.

Such instances, although few, may create a systemic risk to the clearing corporations if failure to honour the delivery obligation of an ITM contract triggers the default of the trading or clearing member.

In 2018, the regulator mandated the physical settlement of single stock derivatives, upon the expiry of such derivatives, in a phased manner. The facility of net settlement was introduced in 2023 to address the concerns of

OTM options turning into ITM on the expiry day and consequent delivery obligations on such ITM option holders. This was not found to be helpful for option contracts turning ITM based on closing price calculated as VWAP across exchanges. Such netting benefits are not available for institutional investors.