A shorter settlement cycle will make Indian stock markets even better than the rest




India is prepared to move to the T+1 settlement cycle as the country’s banks now offer online settlement for funds. It will substantially improve liquidity and remove the need for transactions like “Buy Today, Sell Tomorrow”

The stock market in India is one of the best in the world. This may come as a surprise to many. The reasons are obvious. India has rarely contributed to financial innovations in recent times. Also traditionally India has been one of the late starters in stock market and stock market continued to follow primitive practices till the time two major changes happened, which are: 1) starting of screen-based trading, and 2) dematerialization of securities.

We have often been accused of aping practices of the US and European securities market. Whatever be the fact, today India seems to have left behind some of the advanced economies in managing settlement cycle. If you do not believe it, you just need to look at the table below:

Source: CISI, London (India also has T+1 and T+0 settlement cycle for debt and Germany has T+ 2 for equity if both parties are German)

The table clearly shows that countries like USA, Australia, France  and UK still continue to follow T+3 settlement cycle in stocks. These so-called advanced countries have not been able to move to T+2 settlement cycle as yet while a country like India with relatively less advanced banking system managed to move to T+2 settlement cycle in 2003. Benefits of shorter settlement cycle (SSC) have already been reaped by investors in India.

Longer settlement cycles have several negative aspects like higher capital required, increases in operational risks and liquidity issues, while it has some limited benefits as well. In order to overcome shortcoming of T+3 settlement cycles, The Depository Trust and Clearing Corporation (DTCC),USA, appointed Boston Consultancy Group (BCG) to study the cost benefit analysis of shortening of settlement cycle. BCG has submitted its report earlier this month to DTCC on the subject ( http://www.dtcc.com/downloads/leadership/whitepapers/BCG_2012.pdf). While India is already operating in T+2 settlement cycle, there are some interesting aspects in the study which can be used in India as well.  Let us look at some of the interesting findings from the reports, which are as follows:

Shorter the settlement cycle, more the cost benefits 

Analysis done by BCG shows that shorter the settlement cycle, more is the benefit in terms of costs and risk reduction. The summary of cost benefit analysis is as follows:


Source: dtcc.com

The data above shows that initial investments of $550 million will have to be done for moving to the T+2 settlement cycle, while $1770 million will be required to move to the T+1 settlement cycle. The costs are high but there is a substantial saving in annual recurring cost which can very well compensate the costs. The BCG study says, “T+2 would result in $170 million in annual operational savings and $25 million in annual return on reinvested capital from Clearing Fund reductions, whereas T+1 would result in $175 million in operational savings and $35 million in return on reinvested capital. The assumed cost of capital in the above numbers is 3.5% and assumes firms are investing the proceeds in Fed Funds. 3.5% was the average Fed Fund rate for the 10-year period prior to the 2008 financial crises. If these funds were invested in alternative ways to Fed Funds, that yielded a 5% or 10% return, annual returns would be $30 million and $60million for T+2, and $50 million and $100 million for T+1, respectively.” The study also shows that there is a substantial reduction in risk exposure on unguaranteed buy-side trades which is $200 million and $410 million. Since this is unique to US market, drawing a parallel in India won’t be fair.

The study has also calculated payback period of the investments. On payback period the report says, “The payback period range is still quite favorable for most segments, considering only operations cost savings for the T+2 model. The longest payback period is 5.2 years for the buy side and other constituent groups have comparatively short payback periods ranging from 2.1 to 2.6 years. The segment-level payback periods for the T+1 operating model have a somewhat higher range. Excluding the buy side, these payback periods range from three to 3.7 years, assuming adherence to a “trade date” environment. The buy side payback period is 10.9 years, but this is based on relatively low operations savings only and does not take into account the significant additional upside due to risk reduction, which would shorten the payback period for the buy side to less than one year for either operating model.”

Challenges in moving to shorter settlement cycle (SSC)

A shorter settlement cycle has its own challenges. BCG has identified some of such challenges in the US context and has list the following as main challenges:

  • • Handling of retail client cheques and payments
  • • Systems modifications and increased automation
  • • Infrastructure to support near real time settlement
  • • Investments to standardize communications of institutional trade

These challenges are more or less the same in India. However, like in the past we should be able to smoothly overcome these challenges.

Lessons for India

The study has brought out the details of cost benefit analysis of a shorter settlement cycle in USA. Is there any lesson for India in this? Can we move to the T+1 settlement cycle now?  India moved to T+2 settlement cycle in 2003. At that time it was thought that since banking system does not have RTGS (Real Time Gross Settlement) it would have been challenging to move to settlement cycle of T+1. But now things have changed significantly. Today banks have online settlement systems for funds. Money movement is very smooth and RTGS is working fine.

Moving to T+1 settlement will have many benefits for stock exchanges. It will substantially improve liquidity and remove the need for transactions like BTST (Buy today, sell tomorrow). Also mark to market margin requirement will get reduced. More than anything else, it will help bring more funds from outside to India. It is high to analyse cost benefit of moving to T+1 settlement cycle in India.
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Credit :  Vivek Sharma for http://www.moneylife.in/