[Sakthi is a student at School of Law, Christ University, Bangalore.]
The Securities and Exchange Board of India (SEBI) has been implementing multiple breakthrough reforms for the efficient functioning of the securities market since the market has been witnessing humongous growth due to the rise of new participants in the market. In December 2023, the SEBI floated a consultation paper that dealt with the introduction of optional T+0 and optional instant settlement of trades in addition to the T+1 settlement cycle in Indian securities markets. The development of the securities market resulted in the reduction of the settlement cycle from T+5 to T+3 in 2002 and to T+2 in 2003. The T+1 settlement cycle was implemented in a phased manner from 2021, and in 2023, India became the second country after China to fully implement this settlement cycle. In addition to this, SEBI is considering implementing T+0 and instant settlement mechanism as an optional settlement cycle. This article provides a prudent analysis of the proposed optional system by SEBI by highlighting its features, advantages and drawbacks succinctly. It also focusses on the risk management strategies through which implications caused by the proposed settlement cycle can be mitigated.
What is T+0 and Instant Settlement Mechanism?
The Indian securities market currently follows T+1 (trade plus one day) settlement cycle in which the traded funds and securities are settled by the next day. In addition to this, the proposed mechanism from SEBI is to be implemented under two phases in secondary markets for equity cash segment. The optional T+0 settlement cycle is to be implemented in phase 1 where the trading period will be up to 1:30 PM and the funds and securities traded will be settled by 4:30 PM on the same day. The optional instant settlement will be implemented in phase 2 where the trading period will be up to 3:30 PM and the settlement will be completed at the earliest by the process of trade-by-trade settlement. The top 500 listed equity shares based on the market capitalization will be divided into 3 portions of 200, 200 and 100 where the proposed T+0 settlement mechanism shall be made available from lowest to highest market capitalization. The consultation paper mandates the exchanges to publish a common list of securities and calendar for migration under the T+0 mechanism. The T+0 settlement cycle is to be subjected to the surveillance measures as of the T+1 mechanism. The T+0 settlement cycle is exempted to the securities that are traded under periodic call auction sessions and trade-for-trade settlements. After the implementation of optional instant settlement under phase 2, the T+0 settlement cycle (phase 1) will be discontinued. According to the regulator, the widespread use of the UPI system in the secondary market also provides a way for implementing this same-day settlement mechanism.
SEBI's consultation paper adds that the proposed mechanism will enable instant receipt of securities and funds, it eliminates the risk of settlement shortages and risk for participants in the market by strengthening investor protection. It also transforms the Indian equities class imbibed with superior futures of resilience, low cost and time-saving.
Advantages of Implementing T+0 and Instant Settlement Mechanism
Instant access to funds and securities
This mechanism provides flexibility to the market participants in terms of faster pay-out by allowing the buyers to access their securities and sellers to access their funds immediately. By eliminating the T+1 waiting period, it assists investors in having better control over their funds and securities.
Enhanced market efficiency
T+0 and instant settlement mechanism provide a way for immediate settlement options on the same day which can assist the market participants in quicker price discovery by displaying the concurrent market conditions. This lowers the room for manipulation by enhancing the efficiency of the securities market.
Liquidity enhancement
Instant settlement can boost the market liquidity since funds are available to the traders at the earliest which can be infused for newer investments. This transforms the market into a dynamic one which can contribute to a more efficient allocation of capital.
Reduce counterparty risk
Counterparty risk arises when one of the parties involved in the transaction fails to fulfill its part of the deal and that failure results in default on its contractual obligations. By reducing the time of trade through instant settlement, the proposed mechanism lowers the risk of counterparty default and this can also contribute to the overall stability of the market.
The other potential benefits include freeing up capital, protecting the integrity of the market, improving overall risk management of clearing corporations and increasing overall trading activity and competition in the market by attracting new participants.
Drawback of Implementing T+0 and Instant Settlement Mechanism
Market volatility
Even though the proposed mechanism contributes to instant access to funds and securities through a swift settlement cycle which enhances the market liquidity, this increase in liquidity may lead to market volatility and instability. The trades are settled quickly under this mechanism, as a result, traders are compelled to execute rapid decisions by leaving less time for market participants to analyze and react to uncertain market conditions. An unstable market affects the prudent decision-making of the participants and can also result in destabilizing of prices. Quicker price discovery does not lead to efficient price discovery and it can result in liquidity fragmentation and increase of impact cost.
Impact on market participants
Under the T+1 settlement cycle, the buyer can pay 20% of the price on the concurrent day and can cover the remaining margin the next day. However, under the new mechanism, the funds and securities should be made available upfront before placing the orders. This new settlement cycle impacts the market participants by increasing the cost of trading.
Divergence issues
Since the proposed T+0 and instant settlement mechanism are optional, the market participants may choose the best option that is beneficial to them. The existing T+1 mechanism is beneficial to the buyer since it provides him more time to settle the funds and the instant settlement mechanism is beneficial to the seller since it results in immediate settlement of funds. In the case of the buyer opting for T+1 mechanism and the seller opting for T+0 or instant settlement mechanism, this will result in divergence issues. The price of the same security in T+0 or instant settlement won't be similar to its price in T+1 settlement cycle.
Impact on brokers
The instantaneous settlement cycle will have a potential impact on the business of brokers. The proposed settlement cycle reduces the time of the float period. This reduction in the float period affects the brokers who depend on interest income from client funds. This implementation also forces the brokers to reassess their business models.
Apart from these potential concerns, the proposed mechanism also has an impact on clearing corporations, depositories and foreign institutional investors. It necessitates the clearing corporations and depositories to enhance their operational infrastructure and risk management functions. The instant settlement cycle can affect foreign institutional investors who operate in different time zones.
Solution for Potential Concerns
SEBI's pathbreaking initiative should be implemented prudently by eliminating the potential drawbacks resulting from it. SEBI in its consultation paper adds that the issue of liquidity fragmentation will be solved through participants who can access both T+0 (or instant mechanism) and T+1 markets and that can result in bridging of price and liquidities gaps. The divergence issues can be solved through possible arbitrage opportunities. The divergence in prices of the same security between the T+0 or instant settlement cycle and T+1 settlement cycle can be reduced through the arbitrage process. This leads to liquidity transfer and efficient price discovery. Apart from these issues, SEBI should consult with all the stakeholders of the market, including participants, brokers, and foreign investors, and pave the way for effective functioning of the proposed mechanism by mitigating the potential concerns.
Conclusion
India's digital infrastructure and real-time payment system have been facing a huge enhancement throughout the years, especially after the introduction of the UPI payment system. This contributes immensely to the efficient functioning of the newly proposed T+0 and instant settlement mechanism by resulting in faster settlement of funds and securities. By introducing this new settlement cycle, India sets a new benchmark by positioning itself at the forefront as a visionary and innovator. Since the proposed mechanism is the first of its kind in the global securities market, it is SEBI's utmost duty to exercise complete precision while implementing this settlement cycle. It is imperative for SEBI to coordinate with the market stakeholders to eliminate the potential drawbacks for a smooth functioning of the Indian securities market.