Equity Research(Part 3): Understanding Equity Clearing and Settlement

Welcome back to our series on navigating the complexities of the financial markets! In our previous discussions, we explored the foundational aspects of equities trading, from understanding different types of securities to how trades are executed on exchanges. If Part 1 laid the groundwork for what equities are and Part 2 perhaps delved into the mechanics of placing trades then in Part 3, we delve into the crucial back end processes that ensure every trade reaches its rightful conclusion: Equity Clearing and Settlement.

This process is more than just paperwork; it’s the bedrock of market integrity and risk management, ensuring that once a trade is agreed upon, the exchange of funds and securities happens smoothly and securely. Without an efficient clearing and settlement system, unexpected losses and problems would proliferate, undermining confidence in the market. Let’s break down how this vital system works with a focus on the Indian settlement system.

The Heartbeat of the Market: The Settlement Cycle

The settlement cycle, also known as the settlement period, refers to the time from the day shares are bought or sold until the obligation of each client is settled by the exchange. This period ensures that both the buyer receives the securities and the seller receives the funds.

In India, both the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) currently operate on a T+2 rolling settlement system. The ‘T’ stands for the trade day. So, T+2 means that the final settlement, involving the exchange of funds and securities occurs on the second business day (excluding holidays) after the trade day. For example, trades executed on a Monday are settled on Wednesday, and Tuesday’s trades are settled on Thursday.

This wasn’t always the case. Historically, the cycle was much longer, comprising T+7 days. With the advent of dematerialization (demat) in 1996, the system transitioned to a rolling settlement, initially T+5, then T+3 and finally settling at the current T+2.

Key Terms in the Settlement Process:

To fully grasp settlement, it’s important to understand these specific terms:

• Settlement Number: This is a unique number assigned by the exchange for trades settled on a particular day.
• Pay in Day: This is the day when brokers are obligated to transfer payments to the exchange’s clearinghouse for all purchases made in the preceding settlement period. On this day, they also need to deliver security certificates and transfer deeds for all sales.
• Payout Day: Conversely, this is the day when brokers receive payments from the clearinghouse for all sales they facilitated in the preceding settlement period. They also receive security certificates and transfer deeds for all purchases.

Dematerialization and Rematerialization

One of the most significant advancements in modern equity markets is dematerialization often shortened to demat. This is the process of converting physical share certificates into electronic form. When records of securities are maintained electronically with a depository, they are considered dematerialized.

The Role of Depositories and Depository Participants

Think of a depository as a bank for securities. In India, there are two primary depositories: NSDL (National Securities Depository Limited) and CDSL (Central Depository Services Limited). They handle securities in the same way banks handle funds.

To access the services of a depository, an investor must open an account through a Depository Participant (DP). DPs are market intermediaries — entities like banks, brokers, custodians and financial institutions that are regulated by SEBI to provide depository services. Prominent DPs in India include Karvy, Kotak Securities, HDFC Securities and ICICI Bank.

Why Demat? Addressing the Problems of Physical Certificates

The transition to dematerialized securities was driven by numerous issues inherent with physical share certificates. These problems included:

• Risk of Mutilation, Loss or Theft: Physical certificates kept in personal custody are vulnerable.
• Loss in Transit: Securities could easily get lost when transferred from seller to buyer.
• Delays and Costs: The physical movement of certificates caused inefficiencies and imposed costs on both parties.
• Incorrect Deliveries: Errors in addresses could lead to shares being delivered incorrectly.
• Prevalence of Fake Certificates: The market faced issues with counterfeit certificates.

The Advantages of Dematerialization

Dematerialization offers a multitude of benefits, making the trading process safer, faster and more cost effective:

• Elimination of Bad Deliveries: The risk of receiving defective or fake certificates is gone.
• No Loss in Transit: Securities are transferred electronically, removing the risk of physical loss.
• Cost Savings: Expenses like courier fees and notarization are saved.
• Stamp Duty Savings: A significant 0.5% stamp duty on the transfer of electronic shares is saved.
• Reduced Brokerage: Trading in dematerialized shares often incurs lower brokerage fees.
• Increased Liquidity: Immediate transfer and registration enhance the liquidity of securities.
• Protection Against Loss: No need to worry about obtaining duplicate certificates if originals are mutilated or misplaced.
• Direct Credit for Corporate Actions: Bonuses and rights issues are directly credited to the depository account, saving time and reducing risk.
• Lower Loan Interest: Loans taken against demat shares generally have lower interest rates compared to physical shares.

Rematerialization: The Reverse Process

Just as physical shares can be converted to electronic form, securities in electronic form can be converted back into physical form a process known as rematerialization. To do this, an investor submits a Remat Request Form (RRF) to their DP, who then forwards it to the depository. The depository in turn informs the Registrar and Transfer Agent (RTA)/Company, which then prints and dispatches the physical certificate to the investor.

The T+2 Timeline: Funds and Securities Pay-in/Payout

The SEBI prescribed time schedule for T+2 rolling settlements is highly structured to ensure timely completion:

• T (Trade Day): The day the transaction occurs.
• T+1 (By 11:00 a.m.): All trades are confirmed.
• T+1 (By 1:30 p.m.): Processing and downloading of files to brokers/custodians takes place.
• T+2 (By 11:00 a.m.): This is the pay-in time for both securities and funds.
• T+2 (By 1:30 p.m.): This is the pay-out time for both securities and funds.

Funds Pay-in and Payout

• Funds Pay-in: Funds move from the client’s bank account to the broker’s bank account, and then all funds are transferred to the clearing corporation (like NSCCL or CDSL) to meet settlement obligations. Clearing banks directly debit the accounts of members for their settlement obligations through computerized postings.
• Funds Payout: Funds are transferred from the clearing corporation to the broker’s bank account, and subsequently to the client’s bank account.

Securities Pay-in and Payout in Demat Form

• Securities Pay-in: Securities are credited from the client’s beneficiary accounts to the broker’s pool accounts, from where they are transferred to the clearinghouse.
• Securities Payout: The Clearing House credits securities to the member-brokers’ pool accounts. From there, they are transferred to the client’s beneficiary account (maintained with depositories). There is also a facility for the Exchange to directly transfer pay-out securities to clients’ beneficiary accounts, bypassing the broker’s pool account, if the broker uploads a client-wise breakup file. The Clearing House then instructs depositories (CDSL & NSDL) to credit the securities to the clients’ Beneficiary Owners (BO) Accounts.

While dematerialized settlement is the norm, physical settlement still exists. For physical securities pay-in, brokers deliver certificates and transfer deeds to the Clearing House with relevant details on a floppy disk, which are matched against master file data. For physical payout, receiving brokers collect the securities from the Clearing House on the payout day.

The Custodian’s Crucial Role

A Custodian is a financial institution with the legal responsibility for a customer’s securities, encompassing both management and safekeeping. Custodians often take membership of the Clearing Corporation as “Professional Clearing Members”. They play a significant role in institutional trades.

Functions of a Custodian:

1. Clearing Function: The custodian receives trade information from clients, typically via SWIFT (Society For Worldwide Interbank Financial Telecommunication) or internal communication. These trades are then matched with information received from the exchange. Matched trades are confirmed for the clearing process. Unmatched trades are referred back to the client for rectification or are converted into Delivery versus Payment (DvP) trades with the broker.
2. Settlement Function: Based on the Settlement Obligation statement provided by the Clearing Corporation at the end of the trading day, the custodian makes the required pay-in of securities and funds to and receives the payout of funds and securities from the Clearing Corporation.
3. Post-Settlement Function: After settlement, the custodian ensures that the pay-in and pay-out of securities and funds were properly performed. They are also responsible for reporting this information to clients, enabling them to reconcile their records and make informed investment decisions.

Important reports prepared by custodians include:

• Execution Confirmation: Brokers report executed transactions to Foreign Institutional Investors (FIIs) by fax immediately after trading hours.
• Contract Notes: Original contract notes for FIIs are forwarded to their custodians after market close.
• Settlement Confirmation: The custodian sends a confirmation to their FII client and broker via SWIFT, fax, or telex. SWIFT is a global cooperative providing secure messaging services for financial institutions, facilitating cross-border electronic messages.
• Account Settlement: Brokers and custodians mail or courier account statements to their FII clients on a fortnightly or monthly basis.

Delivery versus Payment (DvP) Explained

Delivery versus Payment (DvP) is a critical mechanism. If a custodian cannot match a trade received from a client with that from the exchange, they cannot undertake the settlement obligation themselves. In such cases, the trade is converted into a DvP trade, meaning the obligation to settle the trade remains with the broker.

• For a sell trade, the Custodian delivers securities to the selling broker upon receiving funds from the broker.
• For a buy trade, the Custodian provides funds to the broker upon receiving securities.

Tackling Settlement Troubles

Despite robust systems, issues can arise. Common settlement troubles include:

1. Short Delivery: This occurs when a custodian or the clearinghouse delivers fewer securities than agreed upon. Short deliveries between the clearinghouse and brokers are handled by ‘Buy-in’ procedures, where the exchange conducts an open market purchase to fulfill the obligation.
2. Bad Delivery (in case of physical delivery): This refers to the delivery of share certificates and accompanying transfer deeds that have an obvious defect such as a missing broker’s stamp, which would prevent the transfer of ownership.
3. Securities Default: A securities default occurs if a pay-in member fails to transfer securities to the Clearing Corporation before settlement. Methods to handle this include:

• Securities Lending and Borrowing: The defaulting broker can borrow securities to fulfill their obligation, returning them later with interest.
• Auction Window: If no lending mechanism exists, an auction is held the day after settlement, where shares are bought at a higher price, debiting the defaulting member for the difference and a penalty.
• Close Out: If shares cannot be obtained in the auction, the position is closed out at an even higher price, and the receiving members receive the close-out price instead of securities.

4. Funds Default: This happens if a pay-in member fails to transfer funds to the Clearing Corporation before settlement. The Clearing Corporation typically handles this using Line of Credit (LoC) or Overdraft facilities from Settlement Banks recovering the charges from the defaulting member.

Conclusion

The equity clearing and settlement process, particularly the modern T+2 rolling settlement system coupled with dematerialization, forms the invisible backbone of trust and efficiency in our financial markets. From defining the settlement cycle and key terms like pay-in and payout days, to understanding the digital transformation brought by demat and the crucial role of custodians, we’ve seen how intricate and vital this entire ecosystem is. It ensures that every trade, whether a small retail purchase or a large institutional transaction is completed securely and reliably, mitigating risks and fostering market confidence.

In our next installment, we will dive into algorithmic trading, its components and trading strategies . Stay tuned to continue your journey into understanding the fascinating world of equities!

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