[Smruti Kulkarni and Manas Rohilla are 3rd year students at Gujarat National Law University, Gandhinagar]
On 22 December 2023, the Securities and Exchange Board of India (SEBI) issued a consultation paper on “Introduction of optional T+0 and optional Instant Settlement of Trades in addition to T+1 Settlement Cycle in Indian Securities Markets”. The paper analyses feasibility and desirability of introducing shorter settlement cycles for equity cash segments, on an optional basis, in addition to the existing T+1 settlement cycle. It proposes to implement the new mechanism in two phases: Phase 1 – optional T+0 settlement cycle and Phase 2 – optional instant settlement cycle.
This blog post aims to provide a backdrop of the development comparing the Indian scenario with the international practices and standards in settlement cycles, offer comprehensive overview of the proposed mechanism, its benefits, challenges, feasibility and potential mitigating measures, followed by a way forward.
Regulatory Roadmap and International Practices
A settlement cycle refers to the time period between the execution of a trade in the securities market and the exchange of funds and securities. A shorter settlement cycle reduces the time gap between trade execution and settlement, thereby mitigating counterparty risk, market risk, and liquidity risk for market participants. It also facilitates the efficient utilization of capital and enhances market turnover and efficiency.
Over the years, the Indian securities market has witnessed a gradual reduction in settlement cycles. In 2002, the settlement cycle was shortened from T+5 (five days after trade) to T+3, and further reduced to T+2 in 2003. In 2021, SEBI introduced the T+1 settlement cycle, which was fully implemented from January 2023, making India the second nation to introduce a shorter cycle. Currently, India follows a T+1 settlement cycle for the equity cash segment, meaning that trades are settled on the next working day after the trade date.
Globally, China has already transitioned to shorter settlement cycles such as T+0 or same-day settlement. Some countries, including the United States, United Kingdom and Singapore and Japan follow either T+1 or T+2 settlement cycle. Moreover, there are initiatives to introduce instant or real-time settlement in certain markets, for instance, the Depository Trust and Clearing Corporation’s Project Ion in the United States, which leverages distributed ledger technology for instant settlement of trades.
The Proposed Framework
Phase 1 of the proposed framework in the paper introduces optional T+0 settlement, allowing clients (excluding those settling through custodians) to settle funds and securities on the same trading day for trades executed until 1:30 PM. The settlement will be completed by 4:30 PM on the same day. T+0 settlement will be available for the top 500 listed equity shares based on market capitalization, migrated in three tranches. Margin requirements and risk management will follow existing practices, with UPI blocks or re-pledged securities considered for margin calculations. Pre-trade validation of funds or securities will not be required for T+0 orders.
The clearing and settlement process for T+0 trades will involve early pay-in of securities through a mandatory block mechanism. Funds pay-in will be facilitated through UPI blocks or direct collection from the clearing member’s bank account. Securities pay-out will be credited to the client’s primary demat account (for UPI clients) or the clearing member’s depository pool account (for other permitted clients). In case of securities shortfall, a direct close-out mechanism will be implemented.
Phase 2 introduces optional instant settlement, allowing all clients (including those settling through custodians) to opt for immediate trade-by-trade settlement of funds and securities. Trading hours will be from 9:15 AM to 3:30 PM, similar to the T+1 segment. Risk management for instant settlement will be conducted on a pre-trade basis. Prefunding of funds and securities will be mandatory before placing an order, and margin adequacy will be validated by the clearing corporation. Only limit orders will be allowed to ensure proper prefunding. Client code modifications will not be permitted, and order modifications or cancellations will be transmitted by exchanges to clearing corporations.
The clearing and settlement process for instant settlement will involve an API-based interface between depositories and clearing corporations, enabling real-time transfers of funds and securities. Instructions for funds pay-in and pay-out will be sent to sponsor banks or clearing member bank accounts, depending on the client type. Securities pay-in and pay-out instructions will be communicated to the depositories for crediting or debiting securities to the respective accounts. Inter-depository or inter-clearing corporation settlements will be handled accordingly.
Decrypting the Implications for Stakeholders
Investors benefit from greater flexibility and choice with the option of shorter settlement cycles. They can tailor their settlement preferences based on risk appetite, funding availability, and personal preferences. Shorter settlement cycles offer advantages such as faster pay-out of funds and securities, reduced exposure to market fluctuations and counterparty defaults, and increased control over assets.
However, investors should also be aware of the associated challenges. Shorter settlement cycles may result in higher funding costs, lower liquidity, increased impact costs, and greater operational complexity. It is crucial for investors to have a clear understanding of the rules and requirements for each settlement cycle and the potential consequences of failing to meet their obligations. Providing adequate education and information dissemination is essential to help investors make informed decisions and effectively utilize the benefits offered by the proposed mechanisms.
Intermediaries, including brokers, custodians, banks, and asset managers, face significant operational, technological, and regulatory challenges in adapting to the proposed settlement cycles. Upgrading systems, processes, and procedures to accommodate shorter settlement cycles is necessary, along with ensuring interoperability and coordination with other market participants. Adhering to legal and regulatory changes, such as amendments to the SEBI Act, the Depositories Act, the Income Tax Act, the Stamp Act, and relevant circulars and guidelines, is crucial. Intermediaries also need to manage increased funding and liquidity requirements while mitigating settlement failures and penalties. Effective communication and awareness about the proposed mechanisms and available services are vital to assist clients in understanding their options and making informed decisions.
Regulators and market infrastructure institutions, such as SEBI, the Reserve Bank of India, stock exchanges, depositories, and clearing corporations, have a pivotal role in implementing and overseeing the proposed settlement cycles. They must ensure a smooth and seamless implementation while monitoring and supervising their functioning and impact. Harmonization and alignment with international settlement frameworks and addressing cross-border issues are essential for a well-functioning system. Regulators should provide guidance and support to market participants, actively seek feedback, and incorporate valuable suggestions to refine the mechanisms over time.
Navigating Feasibility and Mitigating Strategies
Implementing a shorter settlement cycle, such as instant settlement, requires a thorough analysis of its cost-benefit dynamics and risk-reward trade-offs. While instant settlement has the potential to enhance market efficiency, reduce risk, and protect investors, it also introduces operational risks, increases funding costs, and exerts liquidity pressure. The suitability and feasibility of a shorter settlement cycle may vary across investors, intermediaries, and securities. Therefore, a meticulous assessment of its benefits, costs, challenges, and potential solutions is necessary. Market participants’ readiness and the preparedness of the market infrastructure should also be considered. Regulators must ensure that the decision to embrace a shorter settlement cycle aligns with the best interests of market participants and the securities market.
To effectively implement a shorter settlement cycle, various measures can be taken. Coordination and consultation among central and state governments and relevant authorities are needed to address the impact of taxation and stamp duty. Streamlining and automating corporate actions and investor entitlements are essential to accommodate the shorter cycle. Margin and collateral requirements should be optimized and rationalized, and possibilities for netting and offsetting should be explored. Dispute resolution and grievance redressal mechanisms need to be simplified and expedited, with the help of technology and automation. Phased implementation, rigorous testing, and effective communication and education to market participants are crucial. Regular monitoring and evaluation, along with necessary adjustments, will ensure continuous improvement. The mechanism should be reviewed and revised in response to changing market conditions and international practices to align with global standards. By addressing challenges, implementing mitigation measures, and incorporating suggestions, a shorter settlement cycle can enhance market efficiency and boost investor confidence in the securities markets.
Conclusion and Way Forward
The consultation paper by SEBI on the introduction of optional T+0 and instant settlement in the Indian securities market presents a forward-thinking initiative that aligns with global best practices and addresses the evolving expectations of investors. This proposed mechanism has the potential to enhance market efficiency, liquidity, and safety, attracting a wider range of investors, particularly retail investors seeking faster and more convenient transactions. However, operational, technological, and regulatory challenges need to be effectively addressed through a coordinated and collaborative approach. A comprehensive cost-benefit analysis and risk-reward assessment are necessary to optimize outcomes. Gradual and phased implementation, supported by testing, clear communication, and education, is crucial for a successful transition. Regular monitoring, feedback incorporation, and periodic reviews will ensure ongoing improvements and alignment with changing market conditions and international standards. By addressing these considerations, the proposed mechanism can bring significant benefits to the Indian securities market, fostering growth, liquidity, and investor confidence.
– Smruti Kulkarni & Manas Rohilla