Accelerating the settlement cycle & challenges facing FPIS
About two decades back, one would have had to walk to the nearest taxi point to get a taxi to travel to a chosen destination. Today, an app brings the taxi to the customer’s location.
Technology has made this possible. Also, about two decades back, G N Bajpai, then chairman of the Securities and Exchange Board of India (Sebi), had expressed a desire to implement the T+1 settlement cycle by April 2004. This was after India had gone live with T+3 effective April 2002. The regulators did move this further to T+2 effective April 2003, but the move to T+1 has unfortunately remained pending. Can technology help address the perceived challenges and make T+1 possible, too?
On September 7, Sebi issued an interesting circular that lets the exchanges and investors decide whether they want to move to the T+1 model effective January 2022. Almost everyone agrees that an accelerated settlement cycle is a progressive step, will help reduce settlement risk and free up capital, effectively leading to higher volumes. Incidentally, the United States is also exploring a shift to the T+1 model.
In the proposed model of Sebi, a stock exchange can offer a T+1 settlement cycle on any scrip, which then needs to be followed uniformly for all transactions, including block deals in that scrip. Domestic investors, including the retail segment, platform providers and tech-savvy brokers, seem quite delighted, as their capital can be deployed more effectively. Also, this can help prevent misuse by the broker of the securities received in payout apart from reducing margin requirements. By crunching the time between trade execution and settlement, the risk of a counterparty failing during this time comes down, too. However, foreign portfolio investors (FPIS) don’t seem to be happy.
With a return of over 50 per cent in the past 12 months, India has been a top performing market. No wonder then that the equity assets of FPIS have touched a record $651 billion at the end of August 2021, which is almost one-fifth of India’s market capitalisation of about $3.5 trillion. It is, therefore, important to ensure that any such transition to the T+1 model doesn’t end up disturbing the FPIS.
The first challenge here stems from the fact that currently, FPIS send out the details of the trade done on T day to their global custodian (GC) after India trading hours, which the GC relays to the India custodian during the night. Postreconciliation with the broker contract note, the India custodian confirms these trades with the Clearing Corporation by 1 pm on T+1 day. In the T+1 model, such confirmation would perhaps need to be completed on T day itself, within a few hours of the close of market hours, which can be challenging. In case of a mismatch, the India custodian may not be able to confirm the trade, and the resultant hand delivery can put pressure on the broker who needs to arrange for funds overnight to complete the pay-in process the next morning. During certain times of the year, e.g. MSCI rebalancing, trade volumes tend to shoot up sharply, and so could such mismatches.
The second challenge is that FPIS have to pre-fund in the T+1 model. In the current T+2 structure, on the morning of T+1 day, when FX markets are active, the FPIS book FX deals to buy the Indian rupee (INR) to fund the trades of T day by selling foreign currency. The exact value of US dollar (USD) is then remitted by the FPIS via their global custodian. This helps reconcile the value of the trade with the FX booked for the same on an end-to-end basis. In the T+1 format, the FPIS would have to pre-fund on an approximate basis, or alternatively keep INR in their account with the Indian custodian on T day itself. FPIS could lose out on ease of reconciliation and on best time to book FX deals.
Thirdly, the T+1 model could disrupt the Securities Lending and Borrowing (SLB) segment, and unless trading hours are extended by a few more hours, that product would become irrelevant.
Fourthly, as India looks to increase its weightage in the global indices, global funds tracking such indices and ETFS, for example, could face challenges in the absence of adequate liquidity.
The concern is that should, for example, one exchange turn into a T+1 exchange, we could see a fragmentation of the order book and the liquidity, should domestic volumes move to such T+1 exchange.
It would be interesting to see how the key exchanges in India react to this circular, as that could decide the future of liquidity. Domestic investors could jump at this while FPIS might perhaps wait and watch. Technology can certainly solve the challenges outlined above, and it is a great opportunity for the market intermediaries to chip in here.
Congratulations are due to the regulators though, who have avoided the temptation to get prescriptive here and instead chosen to let the market decide the way forward. Let the action begin.
The concern is that should, for example, one exchange turn into a T+1 exchange, we could see a fragmentation of the order book and the liquidity, should domestic volumes move to such T+1 exchange