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Time to Settle: Implications of the T+1 Settlement Cycle

Sandeep Parekh

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Co-authored with Rahul Das, Senior Associate, Finsec Law Advisors

SEBI recently issued a circular permitting stock exchanges, on an optional basis, to introduce a T+1 settlement cycle, for trading in shares of listed companies.T+1 is market jargon to say that the time elapsed between the date when a buyer and seller meet on the exchange platform to decide on a deal and money and securities changing hands is one day. At present, in India (as is the prevalent global practice), a buy/sell order that gets executed on an exchange platform will get settled two business days after the trade got executed. This may sound a little unusual, because when we go to buy tomatoes, we pay for them and get the delivery within seconds. Financial markets follow a different system for multiple reasons, including the ability to net-off buy and sell orders. When you buy two kilos of tomatoes, you are unlikely to attempt to sell it back to the shop later in the afternoon, but in the financial markets, that may be possible, in which case you only pay for what you bought in net. While the longer cycle has its benefits, it also brings in risks. Unlike the tomato market, the other side may get insolvent before its obligations are fulfilled.In addition, unlike the tomato market, the securities marketplace guarantees the trades and thus takes on the risk of default of either party.

In 2002, SEBI had reduced the settlement cycle for trades from T+5 to T+3 and thereafter, in 2003, it shortened the cycle to T+2. The provisions of the present circular, which lay down a broad framework for exchanges to transition from one settlement cycle to another, will come into force from January 1, 2022. This has been done to give all stakeholders of the securities market,including exchanges and brokers, time to upgrade their technology infrastructure and other operational systems to adapt to a trading environment with a shorter settlement cycle.

Transitioning from a T+2 to a T+1 system will have far-reaching consequences for the entire securities market and except for certain market participants, such as foreign investors, shortening the settlement cycle should bring several benefits for the investor community at large.

Ina 2013 discussion paper, SEBI had explored the option of introducing the T+1 settlement system to lower the risk of one of the parties to a trade becoming insolvent and unable to fulfil its obligations. A T+1 settlement system will continue to allow netting of trades as described above, make the markets more efficient and bring down operational and systematic risks. Shortening the settlement cycle by a day will automatically reduce the risk of counterparty pay-in/pay-outdefaults, lower margin requirements and give investors more liquidity as they will be able to access their funds and securities one day earlier.

At the same time, shortening the settlement cycle will bring with it its own complexities. For instance, a T+1 settlement cycle will naturally put pressure on all stakeholders to improve their systems and processes to adapt to as horter trading cycle. Funds and securities need to move quickly from one account to the next, calculations on netting and bank transfers too need to catch up. Further, FIIs, which positively contribute to the growth of the Indian securities market, have raised concerns about certain operational difficulties that they will face under a T+1 settlement cycle. Issues such as increased operational complexities on account of operating in different time zones and the need to pre-fund their trades may discourage some foreign investors.

However,the benefits of introducing a shorter timeframe for the settlement of trades may outweigh the difficulties that certain market participants may face. Taking into account the concerns of all stakeholders, SEBI has not mandated exchanges to implement the T+1 system across the board, and exchanges have been given the discretion to implement the shorter settlement cycle for any number of scrips that they deem appropriate. Therefore, instead of outrightly discounting the new rule, it would be prudent to implement the T+1 settlement cycle for a limited number of scrips and see how investors including foreign investors respond to the same.

In the international sphere, to date, stock exchanges in major markets such as the USA, UK, Japan, Singapore, Australia and Hong Kong continue to follow the T+2 settlement cycle, with the Chinese markets being the only exemption. However,the talks towards moving towards a T+1 settlement cycle is gathering momentum in different jurisdictions. For instance, in February 2021, the United States Depository Trust & Clearing Corporation, a financial services corporation that settles one the highest number of securities transactions in the USmarkets, issued a white paper championing the move towards a T+1 settlement cycle for equity trades in the US by 2023.

Principally, moving to a shorter settlement cycle will be in the interest of a majority of investors including the retail investors and will reduce system risks. However,given the magnitude of the fundamental changes that need to take place in the market, it is to be seen in how much time will stakeholders including, exchanges,clearing corporations, brokers and banks will be able to upgrade their technology infrastructure and operational systems to collaborate seamlessly with one another to complete settlement cycles at double the pre-existing speed. Further, it would be prudent for all exchanges to consult each other and introduce the T+1 settlement cycle for selected scrips in a coordinated and phased manner.

(This article was first published in Financial Express)