The Securities and Exchange Commission of Pakistan (SECP) and the Karachi Stock Exchange (KSE) are considering switching final settlement of single stock futures from physical to cash. Unlike physical settlement, cash settlement involves no principal payments and delivery of underlying shares but mere settlement of differences or profits and losses.
Most transactions in futures market are not affected by final settlement method because they are reversed or squared during the life of future contract. However, open positions at or near contract expiry can become problematic in volatile conditions, as we saw in March crisis.
Before we switch from physical to cash, we have to determine which one serves investor interest better. Here we attempt to do that by discussing which settlement method, (i) carries lower settlement risk so that investors have an orderly market (ii) is less prone to price manipulation so that investors are not abused, (iii) offers more effective hedging for investors as hedging is core rationale for having futures, (iv) provides more efficient arbitrage because arbitrage maintains pricing efficiency for investors, (v) is more effective in segregating regular and futures market to reduce flight of liquidity from regular market for genuine, (vi) is less likely to become an issue in Shariah compliance that could cause confusion and disturbance in the market.
First, settlement risk is lower in cash settlement. In physical settlement, large open positions left at contract expiry could become unmanageable in case of defaults. In cash settlement, there would only be payments of profits and losses, therefore settlement risk would be much lower.
Open positions at contract expiry would be squared by KSE on a formula based settlement price. Since KSE collects daily mark to market differences from brokers in cash, there would be no additional obligation on settlement day. It is highly likely that both long and short would prefer squaring their positions themselves rather than letting KSE square their positions, further reducing final settlement obligations.
Second, perceived room for manipulation is greater in cash settlement. In physical settlement, manipulators know that if they artificially increase or decrease price of a security, counterparties could impose delivery.
Manipulators might have to take delivery of artificially hyped shares or give delivery of artificially depressed shares. Still, one way to manipulate price in physical settlement is to accumulate large holding in regular market compared to its free float, take large long positions in futures market and force the shorts to buy the underlying shares at a premium in regular market, to be able to deliver the shares in futures settlement. However, in reality it is easier said than done.
In cash settlement, manipulators have less to fear because counterparties cannot impose delivery. One way to manipulate prices is to take large long (or short) positions in futures market near contract expiry and then jack up (or depress) the formula based settlement price, thus making a windfall on futures positions. It has been reported that in March 2000, Sydney Futures Exchange changed the settlement method of ten individual stock futures contracts from cash to physical citing excessive speculation and market manipulation as the main reasons.
Third, hedging is more effective in physical settlement. In physical settlement, basis risk is reduced because the same underlying shares can be delivered in both regular and futures market which forces the prices in two markets to converge. In cash settlement, basis risk could increase because the underlying shares cannot be delivered. A number of factors could contribute to basis risk including the supply and demand situation in futures market.
Fourth, cash and carry arbitrage across regular and futures markets is more efficient in physical settlement. Arbitrage is facilitated in physical settlement because in final settlement arbitrageur can simply deliver the underlying shares in futures market which were purchased in regular market. In cash settlement, transaction cost and execution risk is increased as both legs of arbitrage transaction have to be reversed in both markets at contract expiry.
Fifth, regular market and futures market are more effectively segregated in cash settlement mitigating flight of liquidity from regular market. In physical settlement, futures can compete with regular market for trading volumes, particularly when contract expiry is nearby. In cash settlement, regular and futures market are fully segregated as only those involved in speculation, hedging, and arbitrage shall enter futures market and all investors seeking delivery would trade in regular market.
Sixth, compliance with Shariah could become an issue in cash settlement. In physical settlement, no issue of Shariah compliance has been raised since initiation of stock futures in 2001. In cash settlement, it is feared that there could be criticism of Shariah non-compliance as there is no possibility of taking delivery of underlying securities. It is not clear if delivery feature is the only factor for determining Shariah compliance, however, it is said that contrary to international trend, in our market, single stock futures were introduced before cash settled index futures to avoid objections of non-compliance with Shariah.
Lets now look at international practices in final settlement of stock futures in markets of different sizes, including the largest market for stock futures, National Stock Exchange of India. From the table, it comes out clearly that neither settlement method is dominating the other. Some markets are using both settlement methods either on different underlying shares or on the same shares by offering two different contracts.
We conclude that neither physical settlement nor cash settlement has a clear superiority over the other in serving investor interest. While cash settlement offers lower settlement risk and more effective segregation of markets, physical settlement provides lesser room for manipulation, more effective hedging, more efficient arbitrage, and lesser chance of attracting criticism for non-compliance with Shariah.
Decision makers may (i) continue with only physical settlement (ii) switch entirely to cash settlement or (iii) have both settlement methods run parallel until market forces reject one. Te decision taken would depend on the relative importance attached by decision makers to different aspects of investor interest discussed here.
As we understand, switching of settlement method would not be looked at in isolation but in the context of other measures being used to achieve the same policy objectives. If primary objective is to reduce settlement risk, then cash settlement would be only a complementary measure to the risk management measures already in place, such as margin deposits, clearinghouse protection fund, capital adequacy, price limits etc.
Settlement risk could also be reduced through by strengthening existing measure, say by modernizing margin regime, or introducing new measures, say by having a securities borrowing and lending mechanism to deal with delivery defaults. Any case, multiple contracts (30, 60, 90 days) should be offered, as planned, in line with international practices, which would improve hedging, spread out exposure and reduce need for position roll-overs. If cash settlement is going to be introduced, it should be carefully phased in.
KSE may start off by offering a cash settled contract on shares of a fundamentally strong company with low price volatility, say HUBCO. This cash settled contract should be run parallel to the existing HUBCO contract with physical settlement. When all issues are identified and resolved, then cash settlement should be spread to other contracts so that the switch involves minimum pain for investors.
