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What Does Settlement Cycle Mean 

19 Jul 2023

Introduction

In the stock markets, the settlement cycle plays a crucial role in determining the timeframe between executing a trade and exchanging cash for securities. Initially, the settlement cycle stood at T+3 until 2003. 

However, it was later reduced to T+2, implying that shares would be transferred to investors’ demat accounts within two days. To further expedite the process, SEBI proposed a new cycle of T+1. 

Exchanges have the flexibility to adapt T+1 from 2022, depending on their preparedness, or opt for a temporary T+2 cycle with a one-month notice. These changes promise faster share transfers and fund settlements for investors. 

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What does the settlement cycle mean?

The settlement cycle refers to the time required for a trade to be settled. Within Indian exchanges, the customary settlement cycle for all traded instruments is T+1 day, wherein T signifies the trading day. 

Let’s take a look at an example in the equity segment. When shares are bought on Monday (T day), they are credited to the DEMAT account on the following day, Tuesday (T+1 day). Similarly, when shares are sold on Monday (T day), the funds from the sale are credited to the trading account on Tuesday (T+1 day). However, these funds can only be withdrawn from the training account after Tuesday evening. 

In the F&O segment, if a long or short futures position is initiated on Monday (T day), any type of financial responsibility involving borrowed funds, such as Mark to Market (MTM) or premium, is resolved and recorded in the trading account on Tuesday (T+1 day). Again, these funds can only be withdrawn from the trading account after Tuesday evening. Any outstanding payment obligations are resolved on the same trading day, referred to as T day, directly from the trading account. 

The T+1 settlement cycle ensures the timely transfer of shares and funds, providing investors with efficient and transparent trade settlements. 

What are the benefits of the settlement cycle?

The introduction of the T+1 settlement cycle aims to enhance efficiency and speed in stock market trading. When the settlement period is reduced from 2 days to 1 day, both buyers and sellers can save time and boost trading volume. Furthermore, traders will benefit from reduced capital requirements as margins will be released on T+1 day, and funds from share sales will be received within 24 hours.

This streamlined process makes it easier to roll funds and stocks into the market, providing convenience and flexibility to market participants. In a nutshell, the T+1 settlement cycle brings improved efficiency and convenience to the stock market ecosystem.

What difference does the settlement cycle make in a volatile market?

The reduction of the settlement cycle will bring increased market volatility, demanding vigilant monitoring of new investments by investors. While developed countries like the USA, UK, and Japan currently follow a T+2 trade settlement cycle, implementing a shorter cycle entails certain complexities.

However, the benefits of enhanced operational efficiencies and significantly reduced capital requirements make it worth considering. It is advisable to conduct a two-day pilot testing phase to assess its effectiveness, followed by a potential extension of one week.

If the testing proves successful, the shorter settlement cycle can be implemented permanently, bringing greater efficiency and effectiveness to the market.

Is the settlement cycle safe?

SEBI has highlighted the safety benefits of the new T+1 settlement cycle in the Indian stock market. According to the regulator's report, the shortened cycle not only saves time but also increases the flow and reduces the capital required to manage risk.

Reducing the number of unsettled trades decreased the Clearing Corporation’s exposure by 50%. This shorter settlement cycle minimises the impact of counterparty bankruptcy on the trade cycle, enhancing overall safety measures in the market.

Conclusion

The settlement cycle offers several advantages, like increased liquidity and trade volume, but it is not without drawbacks. Potential challenges arise from unforeseen disruptions in banks, particularly larger institutions, which can impact the system. So, think carefully before trading in settlement cash. 

 

Related Articles: Using futures as a form of Margin Trading in Stocks | What is Mark to Market Margin in Futures and Options and when is it Applicable? | The importance of operating margins for a company

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