BY PARV JAIN, A THIRD-YEAR STUDENT AT INSTITUTE OF LAW, NIRMA UNIVERSITY, GUJARAT
Introduction
According to SEBI’s annual report, the year 2022–23 faced a foreign portfolio investors (“FPIs”) outflow of Rs 40,936 crore. This was the third highest sell-off by FPIs during a financial year. This FPI pull-out could be driven by the opening of China post-lockdown, the Russia-Ukraine crisis, and a series of rate hikes due to inflationary pressures. But now, it is the need of the hour to ensure not to give offshore investors any reason to pull out of India, given the huge contemporary capital requirements.
In September 2023, Securities and Exchange Board of India (“SEBI”) announced the plan for the implementation of instantaneous trade settlements, which has caused a plethora of debate regarding the future implications of such a move. SEBI Chairperson Madhabi Buch had expressed her enthusiasm for instant trade settlement, which will become a game-changer for the Indian stock market and will benefit investors greatly by making trading faster, safer, and cheaper. According to her, it will also enhance India’s position as a leading financial market in the world. This implies that the instant trade settlement plan might roll out very soon, but it is still unclear whether the regulator would resolve the potential challenges for foreign investors from such a change beforehand or not. SEBI now aims to achieve a same-day i.e. T+0 settlement system by March 2024, and then aspires to move towards a method of instantaneous settlement of trades.
As the discussions increase, people are anticipating a withdrawal of offshore investors from the market, who fear that the settlement of equity market trade on the same day will eventually fragment the liquidity of the market. In this regard, I discuss how the instant trade settlement affects foreign investors. I argue that the demerits of such a change could outweigh its merits. Lastly, I propose certain additions and changes in the framework to ensure the inflow of foreign investment.
Addressing the Lacunae
From a practical standpoint, achieving instant trade settlement might be impossible within the current financial framework. In 2020, the Asia Securities Industry and Financial Markets Association (ASIFMA) also highlighted the difficulties for foreign investors if the settlement cycle is reduced, as this may result in inefficiencies for trade matching and end of day reconciliations. This is because the settlement of securities transactions requires a multi-faceted procedure, demanding seamless coordination and communication among a diverse array of stakeholders. Adequate time must be allocated post agreement on a trade for the underlying securities to undergo the necessary transfers and for the corresponding funds to be transferred. At the core of the settlement process, time must be allowed to guarantee legitimacy, accuracy, and adherence to regulatory standards.
These conceptual issues might be solved through technological alterations and mutual agreements, but the core issue would lie in the fact that such a move would require an alteration of the whole financial system. This includes the configuration of the Indian payment system as well as the framework governing pivotal banking functions, such as the facilitation of deposit accounts and the extension of credit. To achieve instant trade settlement, a substantial restructuring of the current clearing, payment, and settlement infrastructure within the Indian market would be required.
Demystifying the Implications on Foreign Investors
Currently, there is a set procedure followed by foreign investors to deal in the Indian stock market. For instance, if a Germany-based foreign investor wants to buy shares in India, he has to first send euros to the custodians, who will then book the forex, convert the euros into Indian rupees, and deposit the funds into the FPI’s cash account in India. By the time settlement occurs, the funds are deposited with the custodians. Currently, there is a set window of time for transferring the funds and converting them to Indian rupees, subject to market fluctuations which almost occur within a day. But the instantaneous trade settlement will reduce this time, which means foreign exchange transactions will have to be expedited as well to fast track the conversion of currency into Indian rupees. The foreign investors will have to face a lot of challenges, and this might cause a lot of unexplored issues.
The core issue with instantaneous trade settlement arises from the time difference between Indian and foreign jurisdictions. As a result, foreign investors would need to predict the entry price of a stock in advance, and the price may also fluctuate before they make a purchase. To mitigate this, offshore investors would be compelled to prefund the transaction. Consequently, in the case of SEBI’s instant settlement plan, the law of diminishing returns applies, as the shortened time frame introduces more risk without generating additional benefits for widespread adoption across the market. This could potentially lead to a situation where capital is underinvested, making the delivery of securities more complex, fraught with increased risk and escalation of costs. Thus, the implementation of this measure could make the Indian financial markets less appealing to global investors.
The Way Ahead
Ms. Madhabi Buch has said that FPI would not face any problems as they would be given the choice to opt out of instantaneous settlement if they prefer not to use it. She ensured that SEBI had ascertained the data that shows which trades are matched with each other. Based on this data, they believe that choosing not to opt for instantaneous settlement will not create any issues or problems for anyone involved. In essence, they are reassuring that the traditional settlement process will still be accommodated and will not cause any difficulties for those who prefer it. However, this optimistic model would fail when the foreign investors would be left with no option but to opt for instant trade settlement if a large share of retail volume does so. This is because, with two distinct trade settlement cycles, the liquidity could be divided in the two-way transaction. Most of the domestic investors are likely to prefer instant trade settlement creating a risk of fragmentation of liquidity and an increased likelihood of failed trades. To prevent this, SEBI should take certain measure like trade limit for a specific settlement cycle to ensure that the liquidity is sufficient, if not equal in both the trade settlement cycles.
To bypass this hurdle, SEBI will have to formulate a mechanism similar to the one implemented in China. China, at the time of introduction of the T+0 settlement cycle for Stock Connect, was facing several challenges as it increased the operational burden for foreign investors and market participants to complete the settlement obligations. Also, when China A-shares got listed on global indexes such as Morgan Stanley Capital International and Financial Times Stock Exchange, foreign interest in the Chinese onshore equity market skyrocketed. It became very crucial to make an A-share investment channel to entice foreign investment. Thus, in partnership with Depository Trust and Clearing Corporation, Hong Kong Exchanges and Clearing Limited (“HKEX”) launched HKEX Synapse, a revolutionary settlement platform specialized to Northbound Stock Connect.
Synapse works as a standardized and centralized platform that efficiently transmits settlement instructions to all relevant parties concurrently. This simultaneous processing ensures full transparency in the trade processing status. After obtaining consensus and approvals, Synapse transmits settlement instructions to the Central Clearing and Settlement System (“CCASS”) for final settlement. Real-time integration with CCASS allows Synapse to provide prompt status updates to all involved parties after a matching or settlement batch run. This results in comprehensive transparency, improved control, and increased efficiency for investors and their counterparts throughout the settlement process.
In India, if instant trade settlement has to be introduced despite having several loopholes, a platform similar to HKEX Synapse is necessary to ensure that international investors gain immediate access to the real-time status of their trade settlements. This would provide a measure of relief from the constraints imposed by the narrow settlement window. Also, this will standardize and simplify post-trade procedures and empower investors to optimize connectivity and operational efficiencies within a framework that is both transparent and secure. Custodians will be equipped with comprehensive insights regarding the parties that have endorsed and sanctioned specific trades, thereby furnishing them with the essential data needed to promptly address and rectify any trade anomalies prior to the designated cut-off time.
Apart from this, SEBI can also give brokers the responsibility of guaranteeing payments on behalf of foreign investors, effectively extending them credit for the interim two-day period until the transactions are duly finalized. For instance, Indian stockbrokers can vouch for foreign investors and settle their trades in instant trade settlement, and later, these investors can repay money to the brokers within two days. While the brokers would take some risks, in the long term they would benefit from the new inflows.
Concluding Remarks
India has at various instances, taken the lead in terms of technological innovation by changing the digital infrastructure with platforms like CoWIN and Unified Payments Interface. Instant trade settlement might put India at the forefront of the globe in terms of trade settlement if it is proven to be the fastest and most efficient in the world.
However, it is crucial to recognize the complexities and potential disruptions it may introduce to the existing financial framework. Foreign investors, in particular, will face significant hurdles with the proposed instantaneous settlement. This may necessitate prefunding transactions, introducing added complexity and risk to the process. Additionally, the implementation of this measure may lead to increased operational costs for foreign investors, potentially making the Indian financial markets less attractive on a global scale. SEBI’s assurance that traditional settlement processes will still be accommodated is a positive step, but it may not entirely alleviate concerns, especially if a significant portion of retail volume opts for instantaneous trade settlement.
Therefore, careful consideration and strategic measures are essential to mitigate potential risks and ensure a seamless transition. By adopting proven mechanisms and addressing the concerns of foreign investors, India can pave the way for a more dynamic and resilient financial ecosystem in the years ahead.
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