Why Stock Market Regulator SEBI Must Not Rush With Its T+0 Trade Settlement Plan?

SEBI has plans to switch to same-day trade settlement (by 4.30 p.m. on the day of trading if the trade is executed by 1.30 p.m.). But this seems to be an interim measure, and eventually, SEBI wants to switch to instant settlement (within one hour of trade execution). The T+1 trade settlement cycle, currently in force, will stay optional for now.

Is the market regulator moving too fast? It may appear to be, given the plan on same-day trade settlement was put on the table within months of India transitioning to T+1 settlement cycle in January 2023 from a T+2 cycle that had been in force for 20 long years. From 2003 to 2023, the market followed a T+2 cycle, wherein a trade was settled two days after execution. The stock market followed a T+5 settlement cycle until 2002, which was then shortened to a T+3 cycle and, a year later, to a T+2 cycle.

Shortening of the trade settlement cycle is a global trend and is in the interest of investors. For instance, on May 28, most stock market transactions in the United States will get settled on a T+1 basis from a T+2 basis currently. European markets, although slow in the transition, are expected to follow suit. It is worth highlighting that India moved to the T+2 settlement cycle in 2003, 14 years before the US.

While foreign investors were up in arms when India switched to T+1 settlement and are still grappling with operational issues, how would they react if same-day trade settlement becomes a reality in India? While a move to switch to instant settlement may be desirable from the perspective of domestic retail investors, there are challenges for foreign portfolio investors (FPIs).

Today for around 90 per cent of delivery-based trades on Indian bourses with value up to Rs 1,00,000 per transaction, investors make early pay–in of funds and securities. Simply put, these small investors have funds or securities ready for debit instantaneously. For retail investors, same-day trade settlement or instant trade settlement is a boon as it means lower counterparty risks, instant receipt of funds and securities, and freeing up of locked capital. And they can quickly move to the next trade instantaneously.

But for foreign investors, it’s a different ball game altogether with different time zones, necessity to convert money into Indian Rupee before taking a bet, aligning different stakeholders like custodians, foreign exchange brokers and banks. This and other aspects like record keeping, meeting margin requirements, and calculating net asset value (NAV) of different global funds with Indian components is a real challenge. All this will require a complete overhaul for same-day trade settlement. This will require additional costs for building operational efficiencies.

There are two big challenges for transitioning towards same day trade settlement that needs due contemplation.

Market Fragmentation

According to the consultation paper, investors can opt between two settlement cycles, T+0 and another on T+1. Given the benefits, retail investors would opt for T+0, while foreign investors would stick to the current T+1 cycle. Thus, two settlement cycles will give rise to bifurcation of the market and liquidity fragmentation. This would affect efficient price discovery, result in divergence in the price of the same security between two settlement cycles and increase impact cost for transactions due to lack of liquidity.

What Is The Way Out?

By SEBI’s own admission, made in the discussion paper, arbitrage operators could prove handy on days when there is a mismatch of liquidity between the different segments. Arbitrageurs will step in to transfer liquidity from one segment to the other. However, there is a cost associated with such a transfer.

Arbitrageurs typically step in to exploit price differential between markets only if there is enough entry-exit opportunity. Further, arbitrage operators in India typically complain about high securities transaction tax (STT) which currently is at 0.1 per cent of transaction value on each leg of transaction and for intra-day sell transaction STT stands at 0.025 per cent. They feel that this leaves little markup for them to undertake arbitrage operations. To highlight, today most of the arbitrage activities are automated.

Thus, to deal with market fragmentation, there could be some theory versus practical challenge for the regulator. If this is not dealt with in earnest, Indian markets could remain fragmented for a long time as FPIs are unlikely to opt for instant settlement anytime soon.

Pre-funding Of Trades

Another challenge for FPIs is funding. If trade settlements are to happen on the same day, FPIs will have to ensure that they fund their account in advance, that too in Indian Rupee. Only this way FPIs will be able to honour their buy commitment in time. This would require pre-funding of all orders. However, if they pre-fund their account but take time to make a bet on shares, they tend to lose as capital gets blocked in the custodian account.

"Pre-funding is less of an issue for domestic retail investors who can easily do it on the same day while FPIs will have to pre-fund at least one or two days before due to time zone differences and the need to go through multiple parties such as their broker, global custodian to local custodian and foreign exchange bank," said the Hong Kong-based Asia Securities Industry and Financial Markets Association (ASIFMA), which represents many leading offshore funds in a January 12 letter to SEBI.

ASIFMA highlighted that pre-funding is of particular concern to FPI’s which typically fund their investments in India with proceeds from the sale of investments in other markets that settle on T+1 or more commonly on T+2 or even T+3.

Pre-funding will increase the cost of transactions for FPIs. Further, it is not clear in what manner would same-day buy or sell transactions will get squared off (netting off). It remains to be seen if FPIs will enjoy any intra-day credit lines from their global custodians to reduce the impact of mandatory pre-funding. Or will SEBI along with the Reserve Bank of India carve out some arrangement for FPIs in general or for some categories of FPIs?

Wait And Watch Until March

SEBI has set March as the internal deadline to kick-start the same-day trade settlement reform, at least on a pilot basis. Indian securities markets have seen tremendous growth, both in terms of volumes, value, as well as number of participants in recent years. And India has been at the forefront of accelerated trade settlement in the stock markets. Shortening of the trade settlement cycle has been on the back of a robust payment system in the country providing real-time transfer of funds with UPI coupled with technological advancements in the market intermediaries space.

It remains to be seen if in the final regulation, SEBI extends any concessions to FPIs in the form of extended settlement period with brokers, newer credit lines or allowing FPIs to net-off their purchase with sale receipts. Market participants are eagerly waiting for any granular details from SEBI in this regard.

(The author is a Mumbai-based journalist and market analyst. Views expressed are personal)