MC Explains: What is instantaneous settlement and will it be challenging for FPIs?

What is settlement?

It is the closing of a trade; that is the buyer receives the securities which he/she has bought and the seller receives the payment for it in his/her bank account.

What is the settlement period now?

From January 27, 2023, the settlement period was reduced from T+2 to T+1. That is, if the trade is taken on day T, the settlement will be done within a day after (T+1) the trade was taken or within 24 hours of when the trade was taken. This transition was done in phases, starting from February 25, 2022—first by 100 stocks with the least market value, then 500 stocks in ascending order of market value were added every month, and with the blue chips stocks making the transition last.

In an interview given to Moneycontrol, Zerodha’s CEO and co-founder Nithin Kamath said that the change to this settlement cycle has helped “significantly”.

“The fact that India is T+1 (helps)… the fact that a customer if he/she buys a stock, it is settled in one day or if he/she sells a stock, he/she gets the money in one day. India is the only country outside of China (where this settlement regime is followed). Even in China, this isn’t followed across the market… It helps in building the India brand. It says that India is in the forefront of (innovation in the capital markets)… It attracts capital,” he said.

What will the new settlement period mean?

The Sebi chairperson was talking about settling the trades first within one hour of a trade being taken and then moving to a system where the trades will be settled instantaneously. That is, as soon as a buy order and sell order are matched, the transfer of securities and payment will be made immediately.

What will be the benefit from this?

“The immediate transfer of securities and funds between buyers and sellers reduces the counterparty and default risk in the market,” said Tejas Khoday, co-founder and CEO of FYERS.

It will improve liquidity and efficiency in the market, he added.

Who benefits and who’ll face challenges?

Sellers will be the immediate benefiaries because they can access their funds instantaneously, instead of having their funds locked up for T+1 days. Khoday added that such a settlement cycle will enhance “investor protection and confidence”.

Liquidity may also improve because of smaller margin requirement, which will come from lower counter party risk, according to other market insiders.

While these are the positives from the change, there will be operational challenges in the beginning. “We are still waiting for the operational details and hope that we will be given time to transition to this," said the senior executive of a brokerage, who did not want to be named.

How will FPIs be affected?

As of now, when FPIs want to buy a security, they send the funds in foreign currency to their custodian. The custodian then converts this forex into Indian rupee and transfers that into the cash account it holds for the FPI. With T+1 settlement, this whole process is completed within 24 hours so that the funds are available in time for the settlement. With instantaneous settlement, the funds will have to be made available immediately, which means that the custodian must receive the funds a day prior, especially in the case of investors belonging to western countries (because of the time difference), which means the FPI will need to estimate the purchase price even before the trade is executed.

“If the settlement has to instantaneous, they will have to pre-fund the transaction and transfer a buffer amount to accommodate any deviation in price of execution,” said a legal expert who advises FPIs.

Will that be a huge problem for FPIs? 

Not really, this isn’t bound to be a big problem in an environment with low volatility. That is, unless there is the possibility of the prices moving significantly, say by 10 percent, the buffer amount would not be significant. Heightened volatility may create problem and FPIs will need to have “adequate” buffer. Another limitation for some participants could be the inability to exploit any sudden market movements.