SEBI Proposes Phased Physical Settlement for Agri Derivatives to Boost Liquidity and Market Depth

SEBI Proposes Phased Physical Settlement for Agri Derivatives to Boost Liquidity and Market Depth​

The Securities and Exchange Board of India (SEBI) has released a detailed consultation paper proposing a calibrated, phased approach to physical settlement for certain agricultural commodity derivatives. This move seeks to balance the foundational need for physical linkage with the necessity of promoting market liquidity, particularly for newly launched or illiquid contracts.

The proposal is designed to allow select delivery-based commodity contracts to initially trade as financially-settled instruments. These contracts would then be mandated to transition to physical settlement once predefined objective thresholds are met.

Rationale for Reimagining Commodity Settlement Models​

Commodity derivatives are crucial for India’s agricultural value chain, facilitating price discovery and enabling effective risk management. Historically, physical settlement has been emphasized to ensure futures prices closely mirror underlying spot and physical market realities.

However, SEBI acknowledges structural challenges within the market. It notes that imposing compulsory physical settlement from the contract's inception can sometimes inhibit liquidity formation. This limited participation is especially visible in the early stages of contract development, potentially slowing down the price discovery function.

Current Regulatory Framework and Challenges​

Currently, the SEBI Master Circular for Commodity Derivatives Segment dictates that physical delivery is the first preference for settlement type. Cash settlement exemptions are only considered under specific justifications, such as the commodity being intangible, difficult to store, or lacking adequate logistics infrastructure.

Despite the clear guidelines, the regulator has highlighted constraints. Issues persist regarding liquidity formation in several agricultural contracts, particularly at launch or relaunch. Furthermore, the utilization of existing accredited warehouses and assaying mechanisms remains limited for certain key commodities.

The Proposed Phased Settlement Mechanism​

The core of the proposal is the potential exemption from mandatory physical delivery for selected agri-commodities. This flexibility would allow contracts to commence trading as financially-settled instruments.

The transition to full physical settlement would be triggered only upon reaching specific objective thresholds. These triggers include achieving a certain Average Daily Traded Volume (ADTV) and/or Open Interest, or after the expiry of two years, whichever comes earlier.

This phased approach is intended to cushion new contracts. By providing an initial period of financial settlement, market participants can build familiarity and liquidity without immediate exposure to delivery obligations. This gradual transition aims to reduce the risk associated with historical contract failures.

Balancing Development Needs with Market Integrity​

SEBI emphasizes that this proposal does not represent a regulatory shift away from physical settlement. Instead, it is designed to be a calibrated approach supporting market development. The eventual outcome for all contracts remains physical delivery.

The regulatory rationale centers on the fact that a liquid market is essential for accurate price discovery. In the absence of adequate trading volumes, futures prices can become volatile and susceptible to episodic trading, weakening their representative nature.

The proposal meticulously incorporates objective and transparent triggers, ensuring that the flexibility provided is neither arbitrary nor open-ended. This ensures that while the early stage allows for wider participation, market confidence is eventually built upon the bedrock of physical settlement.

Key Areas for Stakeholder Feedback​

The consultation paper seeks detailed feedback from market participants on several critical dimensions. Stakeholders are asked to assess the overall appropriateness of the phased framework, the sufficiency of existing risk management protocols during the initial financial-settled phase, and suggestions for selecting suitable agri-commodities.

SEBI has invited comprehensive suggestions on these points to ensure the proposed framework is robust, practical, and supportive of deepening the Indian commodity derivatives market. Public comments must be submitted by June 02, 2026.