The next step: Rolling settlement

In recent weeks, SEBI has commenced on the last major challenge of secondary market reforms in India: the transition to rolling settlement. In the years to come, this will be written of as a historic turning point in the history of India's capital markets.

What is rolling settlement? Currently, the stock market operates with a netting period of one week (for NSE) or more (for exchanges which use badla). On NSE, it is possible to buy 100 shares of ITC on Wednesday morning, sell 100 shares of ITC on the coming Tuesday evening, and have no deliveries to the clearing corporation: the two transactions net out and only money changes hands (reflecting the change in price).

Rolling settlement involves shrinking the netting period to one day. This is part of the historical progression that we have followed in India's equity market. The length of the netting period has gone from an undisciplined fortnight to a disciplined week, and with rolling period it now goes to a day.

This means that trades net within the day. A person can buy 100 shares of ITC in the morning, sell 100 shares of ITC in the evening, and have to deliver no shares to the clearing corporation. However, if there is a net sell position of 100 shares at closing time, then shares have to be delivered a few days later.

In India, it makes sense to start with "T+5" rolling settlement, which means that settlement happens five working days after the trade date. Hence, the open position of Monday evening would get settled on the coming Monday; the open position of Tuesday evening would get settled on the coming Tuesday; etc.

If a person buys 100 shares on date 1 for Rs.100 and sells them off for Rs.101 on date 2, then he would have to bring in Rs.10,000 (and accept delivery of shares) on date 6, followed by making delivery of these shares on date 7 and accepting Rs.10,100. In this manner, overnight speculation remains possible under rolling settlement.

For intra-day traders, rolling settlement changes nothing. For institutional investors, who are forbidden to square off anyway, there would be no change. It is for retail investors who take leveraged positions across one night or more that rolling settlement has an impact.

Why rolling settlement?

How can the migration be achieved? The experience of depository adoption is the ideal success story from which we can draw lessons for the migration into rolling settlement. When the depository was born, depository trading was very illiquid, because nobody was using it. For each person, it was myopically efficient to ignore the depository until others adopted it. Hence, the decisive push given by SEBI in terms of making the use of the depository mandatory was critical in overcoming this hump. Here we see the vital role for the State in overcoming grid-locks that derive from the `network externality' character of market liquidity.

When the first N stocks moved into pure-depository settlement, each person had a choice: (A) to ignore the depository, and continue his life with other stocks, or (B) to open a depository account, learn the system, and engage in trading in these N stocks. For SEBI's fiat to be effective, the N stocks had to be large enough and important enough to encourage people to take alternative B.

This is the identical issue with rolling settlement. If the early batch of stocks picked for mandatory rolling settlement are obscure and unimportant, then people will choose the easiest path (that of ignoring rolling settlement and these N stocks). In this case, these N stocks will prove to be highly illiquid under rolling settlement, and it will be considered a failure.

The first batch of stocks for mandatory rolling settlement should be large enough and important enough that every person instead picks path B: that of learning rolling settlement, of rethinking strategies under rolling settlement, and using it. The best way to get this done is to pick the most liquid stocks. Hence, the first batch of stocks that are put into mandatory rolling settlement should be the fifty members of the NSE-50 index. In addition, a clear date should be set, a few weeks away, for the next 50 highly liquid stocks (the members of the Nifty Junior index) to come under mandatory rolling settlement. Under this environment, nobody will be able to ignore rolling settlement, and it will flourish.

In conclusion. India's equity spot market has come an enormous distance in the decade of the 1990s: open outcry and negotiated trades have substantially given way to the transparency of anonymous order matching; entry barriers into the brokerage business have greatly reduced with a resulting fall in brokerage fees; credit risk in the settlement system has been substantially diminished through the new institution of the clearing corporation (on NSE) and somewhat diminished leverage (on other exchanges); physical share certificates have substantially given way to dematerialised trading. In this picture, rolling settlement is the final missing element of the puzzle.

For the stocks in mandatory rolling settlement, some of the equity trading in India would conform to the highest international standards, with five key ingredients: (a) anonymous order matching, (b) high quality surveillance and punishment of manipulators, (c) novation at the clearing corporation, (d) rolling settlement, and (e) depository settlement. These changes add up to a revolution when compared with India's equity market as of 1993.

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