Moving to Rolling Settlement

Rolling settlement on India's equity market was first introduced by OTCEI. When demat trading began at NSE on 9 July 1997, it used rolling settlement. SEBI recently made it mandatory that all demat trading should use rolling settlement. Why is rolling settlement important, and how can a liquid market be created using rolling settlement?

What is rolling settlement? Under 'T+5' rolling settlement, all open positions at the end of a date 'T' turn into delivery and payment five working days later. For example, trading commences on thursday morning from a clean slate, and trades take place all through the day with "squaring off". The open positions present at the close of trading mandatorily result in delivery and payment on the coming thursday.

This is in contrast with physical trading in India, which takes place through "futures--style settlement". Most markets in India today use a week--long trading period, following which delivery and payment takes place roughly a week later. We can think of rolling settlement as compressing the week--long cycle into a day. In addition, there is no `carryforward' with rolling settlement.

Suppose a person wants to buy on Monday and sell on Tuesday. Using futures--style settlement, he would only earn the profit (or pay the loss), he would not need to have funds equal to the position adopted. Using rolling settlement, his buy on Monday would need to be backed by full funds on the coming Monday. His sell on Tuesday would imply making delivery of shares on the coming Tuesday. This intrinsically involves less leverage than is seen on the existing cash market in India.

Why is it useful? From an investors perspective, rolling settlement reduces delays. Shares sold on Monday result in money obtained the coming Monday. In the future, we will even see shares sold on Monday resulting in funds paid out on Tuesday. Securities and money become more easily interconvertible -- indeed, securities become more like money.

From an economic perspective, rolling settlement eliminates the pricing glitches that take place on the expiration date of the existing futures--style trading (i.e., Tuesdays on NSE and Fridays on BSE).

The regulatory problems that we face on the cash market in India today, with futures--style settlement, belong on derivatives markets, not on the cash market. A transition to rolling settlement would help sidestep the contentious issues about how leveraged trading on the cash market should take place.

What is the international practice on the equity market? India and France are two major markets which use futures--style settlement. Apart from these, major markets in the world use T+3 rolling settlement, and are in the process of moving to T+2 or T+1 or T+0.

Access to swift rolling settlement is truly a new phase for investors in India, who are used to long delays in buying or selling shares. T+1 settlement would mean that shares sold today yield funds tomorrow. This would be unprecedentedly convenient.

Can rolling settlement be done with physical certificates? While it is technically feasible, rolling settlement becomes much more expensive if applied with physical certificates. Hence, the rise of the depository is a vital factor which has made rolling settlement possible.

Why is rolling settlement in India afflicted by poor liquidity? So far, we have two experiences in India with rolling settlement: very small stocks on OTCEI, and the recent weeks on NSE and BSE (with stocks where dematerialisation is not yet pervasive). It is fair to say that if 100% of the shares of (say) Reliance were dematerialised, and if trading took place with rolling settlement, then the liquidity that we observe would be much better than what we are seeing today with Reliance trading under rolling settlement.

Even if this were the case, rolling settlement intrinsically attracts reduced speculative trading, given the lack of leverage. The appeal of rolling settlement, in terms of reduced problems with regulation of highly leveraged trading, goes along with diminished trading intensity and liquidity.

There are three factors which will improve liquidity under rolling settlement: (a) complete adoption of depository, (b) onset of derivatives trading and (c) `margin trading' facilities for borrowing of money or shares.

The first is obvious; the liquidity that we see with demat trading for Reliance reflects the outcome of around a fifth of Reliance being dematerialised -- the liquidity would improve by more than five times when 100% of Reliance is dematerialised.

Derivatives trading would stimulate liquidity on the cash market in direct and indirect ways. The most direct link is through arbitrage. Small mispricings on an index futures market would be eliminated by arbitrageurs. This would stimulate liquidity on the cash market. At a more subtle level, informed traders would generally favour trading on the derivatives market, thus reducing the risk of losses on the part of traders who use the cash market. This would result in reduced bid--ask spreads on the cash market.

Leveraged speculative trading on the cash market, under rolling settlement, is implemented by borrowed shares or borrowed funds. A long position is implemented by borrowing money, buying shares, and pledging them. The initial margin which the buyer would have to put up is typically around 40%. Hence, while this is access to leveraged trading, the degree of leverage is greatly reduced as compared with what is currently prevalent in India -- where NSE requires 15% initial (upfront) margin and other exchanges require less.

Margin trading has a major appeal from a regulatory and policy perspective: the cash market remains a pure cash market, since all open positions turn into delivery or payment. Similarly, borrowed shares would enable short positions.

Access to borrowed shares and funds would enable leveraged trading on a cash market with rolling settlement, and hence stimulate liquidity with rolling settlement.

What is the sequencing leading towards rolling settlement? The path to rolling settlement is hence paved with (a) complete adoption of the depository, (b) `margin trading' facilities and (c) active derivatives markets. Once these three market institutions are well developed, rolling settlement would work much better.

As of today, each of these components is not in place. This ensures that trading with rolling settlement is afflicted with poor liquidity. To some extent, this poor liquidity is serving to slow down the adoption of the depository. It may be easier to stay with weekly settlement until these three components are in place, and then move on to rolling settlement.

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