What next on the equity market?
The recent crisis on the equity market has helped policy-making break out of the deadlock of recent years. We are now on the verge of important changes. What will these changes be like? How will they impact on the equity market? How should investors, issuers and intermediaries plan for this new world?
We will now have onset of a genuine spot market for equities. This will be based on rolling settlement. T+5 rolling settlement will operate as follows: trades of Monday will be netted, and the net open position as of Monday evening will be settled in full on the coming Monday. Similarly, trades of Tuesday will be netted, and the net open position as of Tuesday evening will be settled in full on the coming Tuesday. The present practice of trading for one week and then doing one settlement will cease.
For the first time, in recent weeks, we have seen SEBI embarking on the idea of having a market with rolling settlement without badla. This is an extremely important and positive development, and we must commend SEBI for this sensible course. The whole point of rolling settlement is for outstanding positions and leverage to be closed off at the end of each day. To reinject badla into rolling settlement would have been missing the point.
For "day scalpers" or day traders, who do intra-day position taking while avoiding carrying overnight positions, rolling settlement would be an environment they would be quite comfortable with. Intra-day, rolling settlement would continue to offer leverage and squaring off. A trader would be able to buy 1000 shares of Infosys, hold on for a few minutes, and sell them off. However, the trader would have to plan for the eventuality that if the position is held till the evening, it would require settlement in full.
For institutional investors, rolling settlement will be a boon. They will be able to fluently buy on day 1 and sell on day 2, without running afoul of the regulation which forbids squaring off. Suppose the institution buys on 17 April (Tuesday) and sells on 18 April (Wednesday). Under T+5 rolling settlement, the buy of 17th would be settled in full on 24 April (Tuesday) and the sell would be settled in full on 25th April (Wednesday).
Continuous Net Settlement (CNS) is a convenience associated with rolling settlement that was created by NSCC's counterpart in the US. It allows for the possibility that a clearing member may be short of securities on the settlement day, and has a two-step fallback procedure which makes this more convenient. However, the popular notion in India that CNS "is like badla" is simply incorrect. The essence of badla was that the long and short positions on the market are brought into a separate market (the badla market) where they are netted against each other. That is simply not the case with CNS. CNS is unforgiving to buyers: they have to bring in funds in full. CNS is a convenience designed for sellers since shares are not fungible and clients may be sloppy in supplying instructions in time to the brokerage firm.
The migration of the spot market into a genuine spot market will bring derivatives into the limelight. The index futures and index options markets will be the centrepiece of leveraged trading in the economy. It is remarkable to observe that while the spot market volumes have fallen by a factor of four ever since SEBI's misguided ban on short selling, the trading volume on the index futures has only dropped by 25% or so. The index futures market is the place in India today where convenient leveraged trading is found, and this is the way things should be.
Looking forward, the most important fronter lies in improved process design and IT integration between brokerage firms, banks and the depository:
- Growth of the derivatives market will make it essential for brokers to have IT hookups with banks to effect daily fund flows for the mark-to-market margin which involves funds movement every day.
- Margin trading will become very important on the spot market. This is a means for investors to obtain a modest degree of leverage for either long or short positions, where money or shares is borrowed in order to fund settlement. Unlike badla, the long buyer genuinely borrows money and the short seller genuinely borrows shares. Margin trading will require exquisite IT integration between banks and brokerage firms to give investors a smooth and convenient experience.
- The badla financing community will move into index arbitrage. Both funds and shares will be lent into the stock market, however these transactions will take place at new heights of safety and transparency when compared with the old world of badla financing.
The central goal of brokerage firms should be to make the above three activities seamless and convenient for investors.
A lot has been said about how India's banking system is incapable of moving funds efficiently, and why this makes T+5 rolling settlement difficult. I have a somewhat different perspective on this problem. For all practical purposes, there are ten banks in India with good IT systems which account for 95% of the capital market activities. All these banks have the ability to move funds between any two locations in India with a delay measured in seconds.
We should exploit the strengths of these ten banks for building a sound capital market, instead of being hobbled by the inefficiencies of the core payments system operated by RBI. The capital markets should make aggressive demands requiring high quality banks with speed and reliability. This will spontaneously push brokers and investors to migrate their business to the banks with good IT systems. However, we do not need to hobble capital markets policies by trying to accomodate RBI's payments system and the weakest banks.
Once we think in this fashion, it is not hard to imagine that we can be at T+5 rolling settlement in July and move on to T+3 rolling settlement by December. We may recall that in 1989, the Group of 30 had recommended T+3 rolling settlement as the minimum international standard, it would be nice for us to achieve this, even if we are 12 years late.
In summary, I believe that India was in an excellent position in terms of capital markets reforms in the mid-1990s with the onset of electronic trading, novation at the clearing corporation, and demat settlement at the depository. We lost our way after that. We could have and should have moved on into rolling settlement and derivatives in 1996. We have lost five years owing to these failures of vision and political economy. Scam '01 is the best thing that could have happened insofar as it has broken the deadlock and brought reforms back on the table. These reforms will produce important changes for brokers, mutual funds, banks and investors. We need to understand this new world, and gear up for it.
Back up to Ajay Shah's BS column