Making sense of Uniform Settlement

An idea now making the rounds is the notion that if all stock markets in the country use "uniform settlement", i.e. the identical trading and settlement calendar, then the quality of the equity market will be greatly enhanced. In order to make sense of this question, we need to look deeper at the dynamics of trading with multiple exchanges, with and without uniform settlement. The arguments in this article suggest that there is little reason to expect improvements by moving to uniform weekly settlement -- the real gains are connected with a (uniform) transition to rolling settlement.

Consider the situation with NSE and BSE, which trade with different cycles. These markets operate as futures markets. NSE trades from Wednesday to Tuesday (the expiration date). BSE trades for a week till Friday, the expiration date.

On any given day, the price of a share on either exchange pertains to a different settlement date. For example, on Friday, the BSE is trading on a seven--day forward basis while NSE is trading on a 10--day forward basis. This will inevitably generate a pricing difference corresponding to the interest cost for three days. (Fund managers who "buy at NSE if it's cheaper there but buy at BSE if it's cheaper there" should take note. Stock prices at NSE will always be higher on Wed/Thu/Fri and lower on Mon/Tue; these differences merely reflect the cost of carry and are unimportant. The real issue that fund managers should care about is liquidity, i.e. the impact cost).

Many people think that "this pricing difference generates arbitrage opportunities". This is simply incorrect. An arbitrageur has to carefully calculate out a set of profitable trades. If the cost of funds is 0.06% per day, and if a stock is 0.2% higher on NSE on a Friday, then there is no arbitrage opportunity! The fact of different expiration dates does not, in itself, generate arbitrage opportunities.

It is only when a stock is not 0.2% higher on NSE on a Friday that there may be arbitrage opportunities. Such pricing differences can equally well crop up with uniform settlement! (With uniform settlement, the number 0.2% changes to 0.0%, everything else is intact.) Uniform settlement does not ensure that all stocks trade at the same price. Fluctuations in prices between exchanges will continue to take place, and arbitrageuers will continue to eliminate pricing differences. Hence my forecast is: there will be no decline in arbitrage volumes if uniform settlement comes about.

Arbitrage is considered intrinsically unhealthy by some, which leads to this idea that if uniform settlement can diminish the extent of arbitrage--related volumes, then it is desirable. Economists have no such qualms when thinking about arbitrageurs, who play a vital role in producing efficient markets by eliminating mispricings. However, even if diminished arbitrage volumes were an objective, there is no link between uniform settlement and arbitrage volumes.

The existence of non-uniform settlement cycles is criticised on the grounds that it enables the perpetuation of leveraged positions by investors who move them from one market to another, dodging settlement on each of them. This violates the basic ethic of the spot market, and it is indeed a problem. However, as long as badla exists in the country, this problem is more strongly present through badla, which precisely enables such prolonged leveraged positions which have no place on a spot market. Badla offers a cheaper method for people to carry positions forward as compared with cycling them through other exchanges. Hence, it is not intellectually consistent to tolerate badla while criticising the movement of positions across non--uniform settlements. If anything, cycling positions across markets is intrinsically safer than badla because financial closure takes place on each market, and speculative bubbles with large open interest are harder to build up.

From a BSE perspective, there is a hope that uniform settlement could help the BSE to gain market share: this is based on the idea that once uniform settlement comes about, BSE and NSE would be identical except that badla would be absent on NSE, so more users would come to BSE. This intuition is suspect -- it is likely that NSE will actually gain market share with uniform settlement. Uniform settlement would focus the attention of users of the market upon liquidity and market impact cost, with reduced confusion from different prices. Anything which makes it easier for investors to focus on market impact cost is not in the interest of BSE, where impact cost is higher.

In general, the tone of competition between exchanges worldwide is that small markets try to differentiate themselves from major markets. In this sense, non-uniform settlement is in the interests of BSE (the smaller market) which should be trying to be as different from NSE (the main market) as possible in terms of trading mechanisms, etc.

In summary, a variety of ideas underlie the drive towards rolling settlement -- notions such as "arbitrage volumes are unhealthy", "arbitrage volumes will shrink with uniform settlement", "cycling positions is bad but badla should be tolerated", "BSE will gain market share with uniform settlement", and "uniform settlement will reduce price volatility" (it will not). These notions do not hold up to close scrutiny.

There is a fundamental flaw in the operation of India's equity market, and that is the use of weekly settlement itself. The international standard that is followed by all major markets is the use of rolling settlement. Rolling settlement will (a) greatly diminish the leverage that is present with "cash market" for equity in India, (b) eliminate the abnormal price fluctuations which take place on NSE each Tuesday and Wednesday, and (c) narrow the gap between India and the best financial markets in the world.

Rolling settlement was, for years, considered an abstract ideal which was unattainable in India. In 1998, we are now at a historic moment where, for the first time, rolling settlement is on the verge of becoming a highly practical alternative. The three inputs that make rolling settlement work are depository, stocklending and index derivatives. NSDL already accounts for over 82% of the settlement volume for the NSE-50 stocks, stocklending has begun in a small way, and index derivatives can be started in a few weeks if the amendment to SCRA is passed in early December. Hence, for the first time, we can now seriously chart course in terms of a complete transition to rolling settlement.

It is incorrect to diagnose the problems of our equity market as being caused by non--uniform settlement; they are caused by weekly settlement itself. The important issue in market development on India's equity market is the move to rolling settlement, not the move to uniform settlement. Policy--makers should avoid expending scarce ammunition on obtaining uniform (weekly) settlement; they should instead allocate their energies for obtaining (uniform) T+5 rolling settlement.

Markets internationally have thriving index futures markets, and are plotting the transition from T+5 to T+3 to T+1 to T+0. It is a comment on the understanding of markets in India that we have badla, have spent three years in delays to index derivatives, and are expending energies on debating uniform settlement.

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