MARKET participants are expecting that the much awaited cash settled single stock future contracts would finally be introduced at the KSE before end of 2006. It would be after a break of five years since launch of single stock futures with physical settlement in July 2001 that a new trading product or at least a new variant of an existing product would come to secondary market.

The need for cash settled contracts was felt in March 2005 crisis when reckless speculators were unable to offset or settle their open positions in futures at contract expiry amidst a dramatic market downturn.

In cash futures, there is no delivery at contract expiry and only profits and losses have to be settled which reduces final settlement obligations and therefore settlement risk for the clearing-house. Note that difference in settlement mode between the two types of futures is only relevant at contract expiry as all trades offset during the life of a contract have to be settled in cash in either case.

While reduction in settlement risk is the primary motive for introducing cash futures at KSE, it is important to point out that if overall risk management framework used by an exchange is sound, physical contracts can also be traded without any settlement problem.

In international markets, both cash and physical settlement are used for single stock futures and turnover has grown in both contract types. Internationally, choice of settlement method appears not to be based on settlement risk but on other factors such as whether or not underlying security has a domestic listing and peculiarities of depository and clearing infrastructure.

A majority of member exchanges of World Federation of Exchanges, which had cumulative notional traded value in single stock futures exceeding $1 billion in CY2005, uses physical settlement. The largest market for single stock futures is National Stock Exchange of India – thanks to elimination of ‘badla’ financing in India in 2001 - which uses cash settlement.

Initially, it was planned that single stock futures would be launched in India with physical settlement. Due to lack of sufficiently developed infrastructure, cash settlement was used with plans to shift to physical settlement at a later stage.

According to news reports, India’s securities regulator, Securities and Exchange Board of India, has announced its intention to shift to physical settlement after establishment of securities borrowing and lending mechanism that facilitates short selling and covers risk of delivery defaults.

Some exchanges, such as Euronext, are using both cash and physical settlement. In USA, OneChicago that started trading single stock futures in late 2002, that is, when this product had a number of international precedents, is using physical settlement from the beginning.

The key question facing cash futures is whether they would be successful in attracting speculative volumes from ‘badla’ and physical futures. It seems that cash futures are unlikely to attract significant volumes from other segments unless they are given advantage through regulation.

First, cash futures are set to be launched in an unfavourable environment characterized by low traded volume, renewed controversies, and heightening political uncertainty.

Volumes have declined substantially at KSE due to a number of factors including frequent market crises, high volatility, and doubling of transaction taxes by federal government. In Jul-Sep 2006, average daily turnover at KSE in regular segment was 175 million shares, less than half the average of 365 million shares in CY2005.

News media is raising expectations about disclosure of investigation reports by foreign investigators into March 2005 crisis and by SECP into June 2006 crisis. If these reports are indeed made public, controversies would follow crowding out other issues including cash futures.

The political situation in the country appears to be turning volatile and political situation in capital market may also heat up because scheduled tightening of risk management could shrink volumes further, which directly affects income of brokers and stock exchanges.

Second, cash futures would receive stiff competition from physical futures. As a trading instrument, cash futures have lesser arbitrage and hedging efficiency compared to physical futures, therefore competition with the latter would be difficult.

In cash futures, securities purchased in regular segment cannot be delivered to settle futures positions in cash-&-carry arbitrage, which increases execution cost and risk for arbitrageurs.

Similarly, hedging effectiveness is lower in cash futures as spread between regular and futures prices can be more volatile, although this may not be a significant concern at KSE due to pre-dominance of speculation.

Due to lack of settlement by delivery, cash settled contracts are also perceived to have greater risk of price manipulation, particularly through manipulation of final formula based settlement price. Generally, most of the activity in futures takes place in the near month contract but since cash futures are to be brought in a series of 30, 60, and 90 days contracts, it would be appropriate to have the same series for physical futures so that prices in the latter serve as a check on those in the former.

Third, cash futures, like physical futures, would also have to compete with ‘badla.’ Historically ‘badla’ has enjoyed many unfair advantages over stock futures, such as larger number of eligible tradable securities, relatively liberal margins, greater netting in calculating exposure, re-lending of financed securities, and lesser disclosure. Due to domination of ‘badla’, in both CY2005 and YTD2006 turnover in futures has only been about 30 per cent of that in regular segment.

Were it not for attempted ‘badla’ phase-out during CY2004 and CY2005 and a cap on ‘badla’ since the termination of phase-out, this ratio would probably have remained at its earlier CY2000-2003 average of about 20 per cent. Futures have also suffered from poorly designed position limits and discretionary restrictions on going short.

Moreover, while brokers holding large position in futures are disclosed, no such disclosure applies to ‘badla.’ After implementation of SECP’s new proposals, some of these biases favouring ‘badla’, such as re-lending of financed shares, would be removed but others such as cash free margins would remain in place.

In sum, short term prospects for cash futures attracting away significant speculative volumes from other segments are bleak. Their longer term prospects depend on the future of ‘badla’ financing. Despite all the controversies surrounding it, ‘badla’ seems well entrenched for now but even its staunchest supporters know that eventually it would have to give way to bring this market in line with international markets.

After elimination of ‘badla’, far more trading would take place in derivatives, particularly in futures, than in regular segment, as is the international trend.

The chances are that due to their efficiency in arbitrage and lower risk of manipulation, physical stock futures would outperform cash stock futures. Having said that, whether we should have physical or cash futures or both running parallel is a decision that is best taken by market forces by letting the two types of futures contracts compete on a level playing field.