Sebi floats consultation paper on ITM options devolving into futures to address settlement risks

Markets regulator Sebi is considering a framework to address risks associated with single stock option contracts that unexpectedly become "In-The-Money" (ITM) near expiry, particularly in the derivatives market where physical settlement is mandatory."

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 i.E., E-1 day," Sebi said in its consultation paper on Thursday.

Thereafter, the resultant stock futures positions can be closed on the expiry day. On the expiry day, therefore, only futures will be tradeable, it added.

The open futures positions on the expiry day will be settled by delivery, as at present.

In-the-money (ITM) options are those where the current market price of the underlying asset is favourable compared to the strike price. For call options, this means the strike price is lower than the market price of the asset, while for put options, it means the strike price is higher than the market price.

Earlier, ITM options could opt for a "Do Not Exercise" (DNE) facility to avoid physical settlement risks, especially when obligations arose from Securities Transaction Tax (STT).

The DNE facility was discontinued in October 2021, but concerns remained about sudden ITM conversions near expiry, posing risks to settlement processes.

Now, on expiry day, sudden price movements in the cash market can cause options to move from "Out-of-The-Money" (OTM) to ITM, leading to significant physical delivery obligations.

In March 2023, Sebi introduced a net settlement mechanism to reduce these risks, but it doesn't address ITM conversions based on closing prices (VWAP). Large market risks persist if margins aren't collected for OTM options that turn ITM at the last minute.

 Between April and September 2024, data showed frequent instances where options turned ITM close to or after market hours, amplifying settlement risks.

In its consultation paper, the regulator has suggested to devolve ITM single stock options into futures one day before expiry in a move to minimise systemic risks and ensure smoother settlement processes.

"This change is intended to mitigate potential risks associated with scenarios where significant obligations may arise in the context of physical settlement requirement in single stock derivatives when an OTM option unexpectedly becomes ITM due to sudden price movements near market close on expiry day," Sebi said.

The Securities and Exchange Board of India (Sebi) has sought public comments on the proposals till December 26.