The Securities and Exchange Board of India (Sebi) has proposed allowing cash-based settlement in certain agricultural derivative contracts in a bid to boost liquidity and trading, particularly in thinly traded contracts. 

"The proposal to permit select delivery-based agricultural commodity derivatives contracts to initially trade as financially-settled contracts is grounded in the need to adopt a calibrated regulatory approach that supports market development without diluting the foundational role of physical settlement in agricultural derivatives," Sebi said on Tuesday. 

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Essentially, it is proposed that exchanges could be allowed to launch or revive certain delivery-based agriculture commodity contracts that will be initially cash settled and then migrated to physical settlement once they cash a certain threshold.

Cash or financially settled contracts mean they are settled by paying the actual cash difference in the price of the contract and the market price, instead of actual physical delivery of the underlying asset. 

"The phased introduction of physical settlement is particularly relevant for such agricultural commodity derivatives that have historically faced issues like contract discontinuation, thin liquidity, etc.," the market regulator said. 

"A selected agri commodity may be introduced under the framework, which would allow market participants to build familiarity and liquidity, while giving time for strengthening backend infrastructure. Once sufficient depth and participation are achieved, a gradual transition to physical delivery can help to reduce the risk of repeated contract failures," Sebi said. 

The regulator has proposed that, on a pilot basis, a couple of commodities like maize, groundnut or chilli could be considered under the framework.

Sebi stressed that physical settlement had been a cornerstone of the regulatory framework for farm commodity derivatives, as it ensured convergence between futures and spot prices and anchored derivatives trading to underlying physical market fundamentals

However, it added that in the case of newly introduced or thinly traded agri contracts, compulsory physical settlement from inception may unintentionally restrict participation to a narrow set of market participants who were operationally capable of taking or giving delivery. This could slow liquidity formation and weaken the price discovery function in the early stages of contract life, it noted. 

"International and domestic experience indicates that newly launched commodity contracts are vulnerable to failure if they do not achieve critical mass within a reasonable period. Low liquidity, wide bid–ask spreads, and limited participant diversity can create a self-reinforcing cycle of declining interest," pointed Sebi. 

It, though, emphasised that the proposed approach did not represent a shift away from physical settlement as a regulatory principle, and contracts will be designed as delivery-based instruments from inception, with full specifications for quality, delivery centres, and settlement procedures.