On Sep 29, 2021 NSE issued this circular announcing the discontinuation of the DNE (Do not exercise) facility.
The DNE facility was introduced in 2017 to overcome the STT trap (rationalised from Sep 1, 2019). However, DNE was also an important risk management tool especially in the wake of compulsory physical settlement of stock options. The removal of the DNE facility has increased systemic risk for all capital market intermediaries.
STT Trap
Earlier, STT was levied at 0.05% on the premium while selling options. On the other hand, if options were exercised, the STT would be levied at 0.125% on the contract value. In some cases, this caused a tax charge that was exponentially higher than the option premium.
For example,
You buy a call option of Tata motors of strike price Rs. 500 for Re. 1 (with a lot size of 3000).
The closing price of Tata motors on expiry is Rs. 500.05. This means the call option has a value of Rs. 150 [0.05 x 3000]. The STT on exercising the option would be Rs. 1875 [i.e. 0.125% of 500.05 x 3000] which is 12.5 times the value of the option itself.
The DNE facility allowed stockbrokers to not exercise CTM (close to money) options i.e. the options with 3 strike prices above and below the settlement price. In this case, if you opted for DNE, you would lose just the value of the option i.e. Rs. 150 as opposed to receiving Rs. 150 and paying Rs. 1875 as STT (i.e. a net loss of Rs. 1725).
In the 2019-20 Annual Budget, STT computation was rationalised to a levy of 0.125% on the difference between the settlement price and the strike price (as opposed to the entire contract value). If you now exercise a CTM option, your STT outgo will not be higher than the option value.
Need of the DNE facility in Physical Settlement
Since October 2019, SEBI has made it compulsory for all stock options to be settled by the physical delivery of shares.
If an investor had insufficient holdings or funds for settlement, the stockbroker could use the DNE facility to avoid default. This is especially useful if an option becomes due for settlement in the last few minutes of market close on expiry. In such cases, exceptionally large physical delivery obligations can be created even with a few hundred rupees of trade size.
For example,
ICICIBANK 800 PE contracts (lot size 1000), with 28th October expiry, were trading in the range of Rs.0.05 - 3.7 between 3:15 - 3:30 pm, while the underlying price of the ICICBANK during the same time was Rs.798 - 800.
Post-market close, the adjusted settlement price of ICICBANK was Rs.798.70 rendering the 800 PE in the money. This meant that any client holding these put options is now liable to give delivery of ICICIBANK shares, the delivery value being Rs.7,98,700.
With merely Rs.8000 in the account, the client ends up creating an obligation of close to Rs.8,00,000. Short delivery on part of the client would result in an auction where the loss on auction could be anywhere in the range of Rs. 25,000 - 30,000. If the position were to be ‘closed out’, the resulting loss could be as high as Rs.1,60,000 (close out at 20% higher).
On the contrary, if the above scenario were to occur in a call option, there’s a possibility that the client ends up creating a fund obligation that is much greater than the available balance in their trading account. This obligation would inevitably fall on the stockbroker.
In such cases, the stockbroker may default on their obligations to the clearing corporations because it is impossible for any broker’s risk-management system to predict the settlement price of the underlying and square-off positions in options that would become ITM as a result. A default by stockbrokers also poses a significant systemic risk to the overall capital market ecosystem.
