Indian Securities Market Settlement Process: Comprehensive Study Notes (Part 2)

1. Auction of Securities

An auction of securities is an exchange-driven mechanism initiated to rectify settlement defaults in the cash market.

• When It is Triggered: An auction is resorted to when there are shortages in delivery by a seller broker.
• The Process: The Clearing Corporation conducts a buy-in auction through the Exchange system to purchase shares from the open market, which are then delivered to the buyer broker.
• Primary Causes of Securities Shortages:
  1. A short seller fails to square up their position before the end of the trading session.
  2. A seller fails to deliver the required shares on time.
  3. A seller delivers bad or wrong shares that cannot be processed.

The Auction Tender Notice

When an auction is scheduled, the Exchanges or Clearing Corporations issue an auction tender notice to all trading members. This notice must contain:

• The names of the scrips that are short or have not been delivered.
• The exact quantity slated for auction.
• The date and time of the designated auction session on the Exchanges.

2. The Close-Out Procedure

If the Clearing Corporation is unable to buy the required shares from the open market during the auction, a formal close-out procedure is activated.

• Trigger Event: This occurs when there are no sellers for a particular short delivery on the auction day.
• Compensation Principle: Rather than delivering physical shares, the buyer is financially compensated.
• Close-Out Valuation Formula: The buyer is compensated by paying the value of the short delivered security based on the higher of the following two valuation benchmarks:
  • The highest price prevailing across the stock exchange from the day of trading till the auction day.
  • 20% above the official closing price on the auction day.

3. Corporate Actions Adjustments

Corporate actions can significantly alter a company's capital structure and share price. In the derivative segment, adjustments are made to option and future contracts to ensure that option holders and writers are not unfairly advantaged or disadvantaged.

Classification of Corporate Actions

Corporate actions are broadly classified into two categories:

1. Stock Benefits: These increase the number of shares held or modify the equity structure. Examples include:
   • Bonus issues
   • Rights issues
   • Mergers and De-mergers
   • Amalgamations
   • Stock splits and Consolidations
   • Hive-offs
   • Warrants and Secured Premium Notes (SPNs)
2. Cash Benefits: Direct monetary payments, such as dividends.

Timing of Adjustments

To maintain market equilibrium, any adjustment for corporate actions in the derivative market is executed on the last day on which a security is traded on a cum basis in the underlying equities market, specifically after the close of trading hours.

4. Derivative Adjustment Methodologies (Equity F&O)

When a stock benefit is declared, the strike prices, market lot sizes, and open positions of the derivative contracts are recalibrated using an Adjustment Factor.

A. Adjustments for Bonus, Stock Splits, and Consolidations

For these corporate events, the parameters are adjusted as follows:

• New Strike Price = Old Strike Price / Adjustment Factor
• New Market Lot / Multiplier = Old Market Lot * Adjustment Factor
• New Position = Old Position * Adjustment Factor

B. Adjustments for Rights Issues

For Rights offerings, the directional adjustments of strike price and lot sizes are modified to reflect the subscription price:

• New Strike Price = Old Strike Price * Adjustment Factor
• New Market Lot / Multiplier = Old Market Lot / Adjustment Factor
• New Position = Old Position / Adjustment Factor

C. Treatment of Dividends

• Ordinary Dividends: Dividends that are below 5 percent of the market value of the underlying stock are deemed ordinary dividends.
• No Adjustment Rule: No adjustment in Equity F&O strike prices is made for ordinary dividends.

D. Adjustments for Mergers

• Contract Restrictions: After the announcement of the Record Date for a merger, no fresh contracts on futures and options are introduced on the underlying stock.
• Contract Cessation: This applies to any underlying asset that will cease to exist subsequent to the completion of the merger.

Summary of Derivative Adjustment Formulas

Key Terms to Remember

• Auction: A buy-in mechanism conducted by the clearing agency when a selling broker fails to deliver securities.
• Close Out: A cash settlement process used to compensate a buyer when auction shares are unavailable.
• Cum Basis: Trading a stock where the buyer is eligible to receive an upcoming announced corporate benefit.
• Ordinary Dividends: Dividends representing less than 5% of the underlying stock's market value, requiring no derivative contract adjustment.