Will SEBI's New Framework Reduce Market Risk? Exploring the ITM Option to Futures Shift
The Securities and Exchange Board of India (SEBI) is proposing a new framework where In-the-Money (ITM) options will be converted to futures one day before expiry. This change seeks to mitigate potential risks associated with Out-of-the-Money (OTM) options unexpectedly becoming ITM due to sudden price movements near the market close on expiry day. This situation could create significant obligations for option holders in the context of physical settlement requirements in single-stock derivatives.
Background of Physical Settlement and Net Settlement
Previously, SEBI introduced a "Do Not Exercise (DNE)" facility for cash-settled stock options. This allowed holders of Close-To-Money options to avoid exercising options that might result in a negative payoff due to the Securities Transaction Tax (STT) levied on the settlement price. However, with the shift to physical settlement for single stock derivatives and the change in STT calculation (levied on intrinsic value instead of settlement price), the DNE facility was discontinued.
To address the risks associated with OTM options turning ITM on the expiry day, SEBI introduced the net settlement mechanism for cash and derivative segments upon expiry. This benefits investors using the same trading member (TM) and clearing member (CM) combination for cash and derivative segments. However, this netting benefit isn't available for institutional investors, who are mandated to back all cash market transactions with delivery.
Need for Review and Data Analysis
The current net settlement mechanism, while addressing the issue of options turning ITM during the day, doesn't effectively handle situations where options turn ITM based on the closing price (VWAP across exchanges). This poses market-wide risk concerns as delivery margins are only charged on ITM options, potentially leading to a significant market impact if prices fluctuate in the last half-hour of expiry day.
Data analysis from April 2024 to September 2024 reveals that while no options turned OTM to ITM after market hours based on VWAP, there were instances of such conversions occurring within the last 15 minutes of trading. This, coupled with the potential for market participants to exploit OTM options near expiry due to capped margin requirements, could pose systemic risks to the market.
The Proposed Framework
The proposed framework involves converting ITM options into futures one day before expiry (E-1 day). Instead of directly resulting in a physical delivery obligation, ITM options would first be converted into stock futures. On expiry day (E-day), only futures would be tradeable, with open positions settled by delivery.
How the Devolvement Works:
- Long ITM call positions: Converted into long positions in underlying future contracts.
- Long ITM put positions: Converted into short positions in underlying future contracts.
- Short ITM call positions: Converted into short positions in underlying future contracts.
- Short ITM put positions: Converted into long positions in underlying future contracts.
All devolved futures positions would be opened at the strike price of the exercised options. This mechanism, similar to that used in the commodity derivatives segment, wouldn't require significant system-level changes for market infrastructure institutions or TMs/CMs.
Additionally, the margining system would remain largely unchanged, with delivery margins staggered from E-4 day to E-1 day.
SEBI is seeking public comment on the effectiveness of this proposal and its implications for market participants.