I’ve been wondering about what exactly will happen in the scenario where the option strike is so illiquid that even the broker can’t square off the position in the case when the option seller fails to meet his margin requirements. e.g. somebody had sold Nifty 27000 put option. The liquidity of ITM option is already low and for the sake of this example let’s say that the expiry of this options was 2-3 years away(to further increase the liquidity concerns). Now suppose the market was to fall more than 20% and remain at that level till the expiry of this contract. I want to understand who will pay the buyer of this put contract at the time of expiry, if the seller of this option didn’t have enough money(e.g. he went bankrupt) and due to already mentioned liquidity issues even the broker wasn’t able to square off this contract.
The original seller would get liquidated by the broker when the losses exceed 50% of the margin blocked. So there’s never a chance of the broker being stuck with the losses. 
Can you give more details about ‘getting liquidated by the broker’? What’s the exact process? What are the timelines?
Depending on how much the vol increases and the severity of the market crash, such a deep ITM position would be underwater long before the market crashes 20%. 
Say at 10% the original seller gets a margin call from their broker to put up more capital but if they can’t in time, their positions get auto squared off at whatever price the market makers have asked. This is the original seller’s problem, but this “slippage” shouldn’t affect squaring off of position since the margin call is made when losses exceed 50% of total capital. So maybe the seller comes off with 40% of their balance instead of 50% after this forced liquidation. 
Anyway, the broker and original buyer won’t be on the hook due to liquidity issues. 
I think broker would be liable to the exchange, while the seller would be liable to the broker. Maybe @siva can confirm that. I think because broker is liable, Zerodha doesn’t allow trading in illiquid options.
The moment a trade is executed, the Clearing Corporation (NSCCL for NSE and ICCL for BSE ) steps in as the central counterparty. Legally, it becomes the seller to every buyer and the buyer to every seller. From that point on, your only exposure is to the Clearing Corporation, not to the individual trading counterparty.
If a seller defaults, settlement is still guaranteed. The first line of liability rests with the defaulting seller’s broker, who is required to meet the full obligation using their own capital. In the extremely rare event that the broker itself fails, the Clearing Corporation steps in. The payout is covered in a defined order: first from the defaulter’s margins and deposits, then from the Clearing Corporation’s own dedicated resources, and finally from the Settlement Guarantee Fund, which is funded by contributions from all member brokers.
As a buyer, you will receive the full intrinsic value you are entitled to without exception. The Indian clearing and settlement framework is specifically designed to ensure that non-defaulting participants are fully protected and never bear the loss arising from another party’s default.
What do you mean by Defaulters’s deposits?
Can CCL sell non-pledged holdings of defaulter?
In that line I was referring brokers. In simple line
If the client fails, the broker has to pay; if the broker also fails, then the Clearing Corporation pays.
Ah no, but broker can do to cover the risk if DDPI/POA is already given.
Later how does the broker or CCL recover their losses(if holdings of the defaulter were not pledged or enough to cover for the shortfall)?