Settlement test

Phased, optional transition to T+1 is a pragmatic decision

The Securities and Exchange Board of India (Sebi) is moving ahead with its plans of tightening settlement timetables to “T+1”, which is the settlement and transfer of funds and securities within one working day of a given trade, from the current cycle of T+2 (two days). However, the new cycle will be introduced from January 1, 2022, and will be optional. Exchanges can decide which scrips, if any, they would move to T+1, and will give a month’s notice before switching the settlement period in a scrip. Once there is a switch, the scrip will remain on T+1 for a minimum trial period of six months. It can be switched back to T+2 subsequently, again with a month’s notice. There cannot be a netting off if the scrip is available on both T+2 and T+1, on different exchanges. The advantages to this shorter cycle should be quicker cash flows and faster security transfers. This reduces the chances of default and can lead to gains in trading volumes by freeing up margin capital and securities faster. The price-risks will also be reduced in the case of highly volatile scrips, where prices may move considerably away from the transaction price in T+2. In turbulent periods when markets experience high stress and volatility, this can be a considerable benefit.
 

The problem is, investors based overseas in different time-zones will face serious difficulties in managing trade reconciliation and settlement in this shorter cycle. The working day ends several hours earlier than in Mumbai for foreign portfolio investors (FPIs) based in Tokyo or Singapore. It starts several hours later for FPIs based in New York or London. In addition, overseas investors can face delays in cross-border transfers and reconciliations due to differences in working hours for different banking systems and depositories. Plus, there can be issues related to differences in mandated holidays. Hence, overseas investors could end up in technical default, or their counterparties may end up in technical default, in coping with a T+1 cycle. A full-scale transition to T+1 will require coordinated, expensive, and complex structural changes to settlement processes, which may be unrealistic in the timeframe of January 2022. These time-zone differences are a primary reason why major financial exchanges have tended to retain T+2 cycles, despite the theoretical advantages of T+1. In the US, for instance, (there are multiple time zones in the US), equity is traded on T+2 while the money market is settled at T+1. Taiwan tried T+1 and reverted to T+2, due to such difficulties.

However, automated systems for reconciliation have improved a great deal in the recent past. Delays in cross-border transactions have also reduced. Sebi has stayed with the T+2 cycle since 2003, and while it works well enough, T+1 could lead to significant reductions in friction for traders. Offering a phased optional transition is a pragmatic decision. The stock exchanges can pick a basket of scrips for T+1 and see how the new system works in practice. Most likely, exchanges will start “test runs” by picking stocks, which don’t have a large FPI presence and, thus, gauge the impact of the new settlement. There would obviously be teething problems, corrective action can be taken without freezing the entire market. If the anticipated benefits of higher liquidity and lower risk are outweighed by the time-zone mismatches, the regulator can always revert to the earlier plan.