Rolling In A New Settlement

The V. Raghunathan Column
Rolling In A New Settlement

By V. Raghunathan

August, 1999, was an eventful month for the stockmarkets, not only because of the phenomenal rally by the BSE Sensex, but by the BSE's decision to introduce a Rolling Settlement System which is, by far, the most significant development on the bourses. This move can be seen as a hat-trick in a series of measures by the Union Ministry of Finance and the Securities & Exchange Board of India (SEBI) aimed at transforming the face of the Indian equity trading system in recent years.

The graduation of our stockmarkets from an open cry-based trading ring to the electronic trading system; from a physical delivery to a national electronic depository system; and now, from a fortnightly settlement to a daily settlement--or, the rolling system--in a relatively short time has been steady, smooth, and impressive. The new T+5 Rolling Settlement System will settle the intra-day net position at the end of a given day on the following fifth working day. Thus, the net effect of the trades done on any day of the week, say, Wednesday, will be settled on the same day of the following week, assuming that there is no non-working day in-between except Saturday and Sunday.

For instance, assume that an investor buys 100 Infosys Technologies shares at Rs 5,000 per share on the Tuesday of Week 1, and sells 30 shares of the scrip later the same day at Rs 5,100 per share. Then, on Thursday, Week 1, she sells another 30 shares at Rs 5,200 per share. Under the T+5 system, on Tuesday, Week 2, the investor will have to take delivery of 70 Infosys shares and pay a net amount of Rs 3,47,000 (Rs 5,00,000 - Rs 1,53,000). On Thursday, Week 2, she will have to deliver 30 Infosys shares and will receive Rs 1,56,000 (Rs 5,200 × 30).

Although most regulators have welcomed the Rolling Settlement System, some have voiced concern about introducing the system before derivatives trading is allowed. They fear that the bourses will find it difficult to cope with the system unless they first develop settlement systems for derivatives, as the system required under the rolling scheme will be more demanding than that required for trading derivatives. That, however, is a mistaken notion. Derivatives are more complicated instruments, and waiting for their introduction would have needlessly postponed the introduction of rolling settlements. Our depositories today are fully equipped to handle the traffic arising from the Rolling Settlement System; so, the decision taken to allow it ahead of derivatives is welcome.

Another issue is the choice of scrips for trading in the Rolling Settlement System. The media has widely speculated that 10 liquid, non-carry-forward scrips will be chosen. While a non-carry-forward but liquid scrip may not altogether be an oxymoron, those deciding on the scrips may have been constrained by the fact that--for various reasons--SEBI may not be ready to drop the carry-forward system altogether.

Obviously, we cannot have both carry-forward trading and rolling settlement simultaneously for the same scrip. But the committee could certainly look at a larger population of non-carry-forward scrips to start with--say, 25-30 scrips--to broadbase the depth in the market. The decision on whether to allow only the national bourses to introduce rolling settlements must be based on whether or not an exchange is linked to an appropriately-equipped depository and has a compatible electronic trading and settlement system.

The T+5 system will go a long way in reducing transaction costs in the market, including narrowing the bid-ask spreads. It will also reduce the settlement risks in the market and provide a platform for disciplined trading. And, finally, the system will eliminate the need to synchronise the settlement dates on the National Stock Exchange and the Bombay Stock Exchange, and ensure that the prices of the scrips are not contaminated with some time value of money as in the current weekly-settlement system.

Of course, the logical extension of the Rolling Settlement System is the Continuous Net Settlement (CNS), which is being considered by the government. The difference between the two is that while the former only nets out intra-day transactions, the CNS will net out inter-day transactions on a rolling basis. For instance, as per our earlier assumption, the payments and deliveries under the CNS--on T+5 settlement cycle--will be different. On Tuesday, Week 2, all the transactions between the Tuesday of Week 1 and Monday of Week 2 will be netted out.

Thus, on the Tuesday of Week 2, the investor will take delivery of 40 Infosys shares and pay Rs 1,91,000--the value of the purchases, minus the value of sales within the T+5 settlement cycle. As such, under the cns, the net deliveries and payments will be smaller, resulting in greater liquidity as compared to the Rolling Settlement System. And, of course, T+5 settlement may, in time, give way to T+3, T+2, and, finally, T+1 settlement, once the necessary software is in place--SEBI and a stable government willing.

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