SEBI issues consultation paper on ITM options converting to futures to address settlement risks 

The Securities and Exchange Board of India (SEBI) is considering a new framework to manage risks linked to single-stock options that unexpectedly become “In-The-Money" (ITM) near expiry. This is particularly relevant in the derivatives market, where physical settlement is required. 

In its consultation paper released on December 5, SEBI proposed that instead of immediately triggering a physical delivery obligation on expiry, ITM options would convert into stock futures one day prior to expiry (E-1 day). 

On the expiry day, only futures contracts would be tradable, and the positions in these futures would be settled by delivery, as is the current practice. 

An “In-The-Money" (ITM) option occurs when the underlying asset’s market price is favorable compared to the option’s strike price. For call options, this means the strike price is lower than the asset’s market price, while for put options, the strike price is higher than the market price. 

Previously, a “Do Not Exercise” (DNE) option was available to mitigate the risk of physical settlement when an option became ITM, particularly to avoid obligations triggered by the Securities Transaction Tax (STT). However, the DNE facility was discontinued in October 2021, leaving concerns about sudden ITM conversions near expiry, which posed settlement risks. 

Currently, price movements on expiry day can cause options to shift from “Out-of-The-Money" (OTM) to ITM, potentially triggering large physical delivery obligations. 

In March 2023, SEBI introduced a net settlement mechanism to address these risks, but it did not fully resolve the issue of ITM conversions based on closing prices (VWAP). Significant market risks persist, especially if margins are not collected for OTM options that suddenly become ITM. 

Data from April to September 2024 showed frequent cases of options becoming ITM late in the trading day, heightening settlement risks. 

To reduce systemic risks and ensure smoother settlements, SEBI’s proposed solution is to convert ITM single-stock options into futures one day before expiry. This change is aimed at mitigating risks where sudden price changes near the market close could lead to unexpected physical delivery obligations. 

The market regulator has invited public feedback on the proposal, with comments due by December 26.