Foreign funds oppose Sebi’s instant settlement plan

Sebi plans to implement the new settlement in two phases.

Foreign Portfolio Investors (FPIs) have expressed concerns about market regulator Securities and Exchange Board of India’s (Sebi) plan to introduce instant trade settlement in the equity markets.

In a January 12 letter to Sebi, the Hong Kong-based Asia Securities Industry and Financial Markets Association (ASIFMA), which represents many leading offshore funds, has cautioned that while the intent behind this is commendable, it may fragment market volumes due to the existence of two settlement cycles.

“While India should be commended for being one of the first movers in the accelerated settlement, which we note is a global trend, we urge caution if India moves too fast ahead of the rest of the major markets, which are also competing for foreign investments,” ASIFMA said in the 20-page letter, which was reviewed by Moneycontrol.

An email sent to a Sebi spokesperson remained unanswered.

Market fragmentation

In December 2023, Sebi floated a discussion paper proposing an instant settlement of trades, along with the existing T+1 settlement cycle.

Sebi’s proposal is unique globally. Experts believe that the move will boost liquidity for domestic retail investors since they would be able to receive the proceeds of the trade immediately as compared to the current T+1 settlement, under which stocks and funds are deposited in a trader’s account with a day’s lag.

Market participants say while most of the retail investors and domestic funds will opt for the instant settlement since it offers better efficiency and liquidity, foreign funds and select AIFs (alternative investment funds) may stick to the existing T+1 cycle.

ASIFMA has argued that this could impact market liquidity and also lead to higher trading costs. One of its key concerns is that shares of the same company may trade at two different prices in the instant and T+1 settlement cycles.

“Market fragmentation clearly gives rise to liquidity risk, which is not good for any market. Most investors, as well as regulators, want to see a liquid market, which, among other things, comes with a diversity of investors and market participants,” ASIFMA said.

In the consultation paper, Sebi acknowledged these concerns but has taken the view that there will always be arbitrage traders who will step in to ensure price consistency. However, FPIs do not agree with this view.

“The proposed bifurcated settlement model also seems to rely on only a subset of the arbitrage community to re-distribute liquidity between the two settlement segments. It is unusual for a major market to rely on open market arbitrage for such an important task, especially when there are other potential options to allow T+0 and T+1 settlement to co-exist,” ASIFMA said.

“The consultation paper seems to assume ready availability of inventory from arbitrageurs to offer stock in the T+0 segment and purchase in T+1,” it said.

Pre-funding of trades

Another key challenge for foreign funds pertains to the pre-funding of trades. Domestic investors buy shares directly and pay for them through their bank accounts. However, foreign funds first need to convert their money from dollars into rupees before paying for a trade.

Indian forex markets don’t operate round the clock, and cross-currency trading closes by 7:30 PM. This poses a major problem for funds that are based in the US, Europe and Canada, which have 10-12 hour differences in terms of time zones.

“Instant settlement will definitely mean pre-funding for FPIs as they will need to exchange in advance their home currency for Indian rupees (INR) when the settlement amount for an India equities transaction has not even been determined,” it said.

“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 the time zone differences and the need to go through multiple parties, such as brokers, global custodians, local custodians and foreign exchange banks,” ASIFMA said.

To be sure, two years ago, when Sebi wanted to shift from the T+2 settlement system to T+1, FPIs had expressed similar concerns. However, eventually, FPIs adjusted their internal systems to align themselves with the new timelines.

What is Sebi’s instant settlement plan?

Faster settlement is proposed to be optional, and the existing T+1 settlement will continue to be available for market participants. Sebi plans to implement the new settlement in two phases. In the first phase, Sebi will introduce an optional T+0 settlement, which implies traders will receive proceeds by 4:30 PM on the same day. This will be an intermediate step to help market institutions align with the shorter settlement cycle.

Then, the market will transition to instant settlement, where traders will receive proceeds on a trade-to-trade basis instantly within an hour of the trade. Once phase two is implemented, the intermediate phase, i.e. T+0 settlement, will be discontinued. While Sebi is still in the process of collecting market inputs on the same, market participants expect phase one to be started this year, while phase two is likely to be implemented by next year.