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Harshal Chhabra and Shaswat Kashyap*
I. INTRODUCTION
The Securities and Exchange Board of India (“SEBI”)’s chairperson Madhabi Puri Buch, has outlined transformative initiatives for the Indian trading settlement scheme. In an attempt to increase market efficiency, SEBI has issued a Consultation Paper (“CP”) on December 22, 2023, wherein it has proposed a phase-wise implementation of a shorter trade settlement cycle. Currently, the trading settlement system operates on a T+1 basis, signifying that all market trade-related settlements must be cleared, one day from the actual transaction date (“T”).
Contrary to the initial plan of adopting a T+1 hour settlement system before moving to an instantaneous settlement scheme, Buch, influenced by market makers’ insights, advocates for a direct transition from T+0 to an instantaneous settlement scheme. This direct shift is rationalized by the belief that there is no discernible benefit in the intermediate T+1 hour trade settlement. Thus, SEBI is now focusing on implementing a T+0 (same-day) trade settlement scheme, followed by an instantaneous settlement system on an optional basis.
This article seeks to evaluate SEBI’s instantaneous settlement scheme in the Indian capital market, assessing the transition to a more efficient trading settlement system. It analyses historical changes, global trends with insights from China, and potential risks for market participants. To that end, this article is divided into five parts, including this introduction. Part II delves into the transformation of India’s stock market trade settlement system. Part III critically evaluates SEBI’s proposed instantaneous settlement scheme, weighing its benefits and potential market risks. Part IV draws insights from China’s experience in implementing a T+0 settlement cycle and examines its relevance to India’s proposed system. Part V concludes with a firm stance against the immediate implementation of the instantaneous settlement scheme at this juncture.
II. CHARTING THE EVOLUTION
The Indian stock market’s trade settlement system has undergone significant transformation. Originally, trade settlements (i.e., the delivery and payment of shares and stocks) on the Bombay Stock Exchange (“BSE”) occurred between Monday and Thursday, with the final settlement on Fridays. This entailed the manual transfer of documents, where transactions were finalized through the delivery of shares to the buyer and payment to the seller. Securities were physically transferred from the selling entity to the eventual purchaser.
The entry of the National Stock Exchange (“NSE”) in 1994 with tech-backed, screen-based trading revolutionized the trading landscape in India. NSE introduced a weekly settlement cycle initially on Wednesdays but later shifted to Tuesdays. This weekly settlement system increased market liquidity, enabling buying and selling without immediate payment, leading to speculative activities. These activities exposed system loopholes, such as default risks (the likelihood that a borrower will fail to meet their financial obligations), often extending settlement cycles due to cash or scrip shortages. The 1992 scam prompted the first resolution to securities market loopholes. In July 2001, SEBI introduced a rolling settlement, starting at the end of the trading day, known as “T”.
Initially, for limited scrips on a T+5 basis, rolling settlement expanded systematically. All scrips transitioned to rolling settlement in December 2001. This meant that all transactions would have to be settled within 5 days of the trading day. T+5 shifted to T+3 in April 2002, and eventually to T+2 in April 2003, aiming to reduce risks associated with fixed-day settlements. On January 27, 2023, India’s domestic equity market shifted to the T+1 settlement cycle, reducing the time frame to settle transactions to just one day from the trading day. In India, when one trades in stocks, the settlement process works through a rolling system. Previously, for many stocks, the cycle was T+2, indicating that the settlement happened on the second day of trading (excluding weekends and market holidays) following the day on which one made the trade (T). So, for instance, if one purchased or sold shares on a Tuesday (T day), the settlement used to take place by the end of Thursday (T+2 days).
However, SEBI is keen on transitioning to a T+0 trade settlement and eventually to an instantaneous settlement scheme. Incidentally, India is already way ahead of the world regarding the trade settlement cycle. Currently, there are only 2 countries in the world which follow the T+1 settlement cycle viz. China and India. China has even moved forward to implement the T+0 settlement cycle for A-shares. If India moves to a T+0 trade settlement and subsequently transitions to an instantaneous settlement scheme, it will become the only market in the world to adopt such a stringent and demanding, clearing and settlement schedule for stock markets. Thus, it is evident that SEBI is forging its path as a trailblazer, not emulating larger markets like the USA, the UK, or the EU.
III. ATOMIC SETTLEMENT: COST-BENEFIT ANALYSIS
Cost-benefit analysis is a scientific tool that consists of man basing decisions “on the cost to be incurred and the benefits to be reaped from any courses of action”. This article will now evaluate SEBI’s proposed instantaneous settlement scheme by analyzing the benefits and market risks associated with it.
There is an increased global preference for shorter settlement cycles as market participants seek to reduce settlement risk. This trend was accentuated by the volatility experienced during the COVID-19 pandemic and the subsequent meme stock trading episode. However, it is imperative to see whether the Indian market is ready for an instantaneous trade settlement cycle.
In essence, a narrower settlement timeframe minimizes risks to the financial system. It reduces risk of default by eliminating the backlog of unsettled trades. Further, a shorter settlement cycle implies less time for a counterparty’s bankruptcy to impact the trade process. It would also allow investors quicker access to their securities and funds. However, it is not immune from risks, which, as we argue, potentially outweigh the benefits explained above.
Firstly, transitioning to instantaneous settlement eliminates the only business day between trading and settlement, thereby reducing the scope for regulatory checks by SEBI. This change may exert considerable pressure on post-trade operations, especially for global participants, which is explained later in this article.
Secondly, market participants have raised their brows regarding the new settlement system as it may fragment liquidity. This has the effect of reducing overall transactions because the reduced liquidity for individuals would bar them from entering into transactions more frequently.
Thirdly, the ill-timed implementation could prove disastrous for brokers, presenting operational and financial challenges, as they may struggle to manage the associated heavy back-office workload, placing additional pressure on their financial resources. In fact, the instantaneous trade settlement system has seen opposition from domestic brokers, citing the high costs associated with modifying their back and front office operations.
Fourthly, substantial adjustments to the clearing mechanism would be imperative, potentially requiring significant transfers of securities and cash throughout the trading day. Currently, a multilateral netting procedure is used to calculate the net settlement obligations of clearing members, and determine whether they owe funds and securities separately. Real-time settlement eliminates the liquidity and risk-mitigating advantages of netting for the entire industry. This could lead to trade errors and settlement failures. This becomes crucial during periods of increased market volatility and trading volume.
Lastly, and most importantly, the prospect of an atomic settlement cycle may face significant resistance from foreign portfolio investors (“FPIs”). FPIs have expressed reluctance, citing difficulties in obtaining approvals for stock transfers and completing procedures across diverse countries and time zones. The real-time nature of stock and money transfers could pose a considerable challenge for them. Currently, when buying securities, FPIs pay foreign currency to their custodian, post which the custodian changes it to Rupees and, under the T+1 settlement, deposits it within a day to the FPI’s cash account. However, if the proposed settlement system is implemented, FPIs would face major constraints, as they would need to pre-fund transactions in advance to achieve instantaneous settlement. Additionally, this would require them to predict the purchase price beforehand, in order to account for possible price fluctuations.
Perhaps as a placatory measure, Madhabi Buch mentioned that the new settlement system will run alongside the current one and is entirely optional. However, this has proved counterproductive and has led to criticism from offshore investors due to fears that two settlement cycles would lead to a fragmented system and add to the cost of trading. There are also concerns that domestic investors may favour the new system and this preference for immediacy in the settlement could create a scenario where liquidity becomes divided, potentially leaving foreign investors with limited options.
IV. CHARTERING FOREIGN WATERS: LESSONS FOR INDIA?
China stands out as a pioneer in the global capital market in successfully implementing the T+0 settlement cycle, in contrast to the UK and the EU which are currently operating on T+1 cycles. In China, when a Qualified Foreign Institutional Investor (“QFII”) places a trade order, their local broker ensures that there is enough cash or securities in the custodian bank before executing the same. To prevent short selling, the trading system checks the QFII’s account at the depository. At day’s end, China Securities Depository and Clearing Corporation (“CSDCC”) transfers securities based on exchange data, automatically registering them in the buyer’s name.
While China’s approach aids in preventing short selling and ensuring transparency, there are potential drawbacks that may be analogous to the Indian settlement system. In China, post the implementation of T+0 settlement, rigorous checks before trade execution introduced inefficiencies and settlement delays. As argued in the previous part, if India adopts a similar settlement system, it could face similar challenges such as lack of regulatory checks and clearance mechanisms. Swift transaction processing is essential for capitalizing on financial market opportunities and delays due to stringent checks may hinder overall system efficiency.
The T+0 settlement in China poses operational challenges for global investors, custodians, and market participants to complete the settlement obligations. In contrast, China Interbank Bond Market (“CIBM”) Direct/Bond Connect offers flexibility with T+1 and T+2 settlements, eliminating trade confirmation issues. Thus, China, being cognizant of the limitations of the T+0 model, has taken effective steps to quell investor’s legitimate concerns. If at all SEBI decides to go ahead with this proposal, China serves as a precedent to exercise caution and thoroughly evaluate the potential impact on the Indian market.
Other notable measures taken by jurisdictions abroad include the UK Chancellor’s launch of the accelerated settlement taskforce to assess the feasibility and merits of transitioning to a T+1 standard settlement period (potentially T+0 in the future) for financial trades in the UK.
Similarly, the European Securities and Markets Authority (“ESMA”) initiated the process of soliciting comments. ESMA aims to gather stakeholders’ opinions and quantitative evidence to enhance its understanding of the matter. This information will assist ESMA in conducting an assessment of the costs and benefits associated with the potential reduction of the securities settlement cycle in the European Union. Likewise, it is imperative to thoroughly assess and address the barriers hindering timely settlement within the current model (T+1) before India can transition to an instantaneous trade settlement system. Implementing rushed or uncoordinated measures could heighten risks, expenses, and inefficiencies, particularly in light of the distinctive characteristics of Indian markets, which encompass diverse market infrastructures and legal frameworks.
V. CONCLUDING REMARKS AND THE WAY FORWARD
SEBI’s proposal to implement a same-day settlement system and subsequently transitioning to an instantaneous settlement system raises serious objections. The Indian capital market watchdog, which took nearly 20 years to transition from T+2 to T+1, is now advancing towards instantaneous settlement within a year. While there are considerable advantages linked to instantaneous settlement, the elevated risks show that such a measure make it a premature response to the Indian market.
In this article, the authors have done a detailed cost-benefit analysis scrutinizing the proposed instantaneous settlement scheme, shedding light on potential risks and benefits. The authors conclude that implementing the instantaneous settlement scheme at this juncture, without addressing and mitigating the concerns highlighted in the article, may not be prudent. While global trends favour shorter settlement cycles, concerns arise regarding regulatory checks, liquidity fragmentation, and operational challenges for brokers as well as investors. Further, the article draws insights from China’s experience with T+0 settlement, emphasizing the need for cautious evaluation before implementation.
It is proposed that India can create its technology, empowering investors with instantaneous settlement insights. Inspiration can be taken from China’s HKEX Synapse, a standardized system which provides real-time updates, enhancing transparency and efficiency. By adopting a simplified post-trade process, India can boost connectivity and operational efficiency, addressing current challenges with a homegrown technological solution.
† Harshal Chhabra is a second year law student pursuing his B.A. LLB. (Hons.) from Gujarat National Law University and Shaswat Kashyap is a third year law student pursuing his B.A. LLB. (Hons.) from Gujarat National Law University.
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