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Taking You Behind The Scenes

In this week's FinMail we will understand what happens at the backend when we place an order on the Stock Markets, in a simple manner. We also understand how T+1 settlement will change this and what benefits/limitations will it have.

The Story:

SEBI on the 7th of September came up with a circular saying that it is introducing a T+1 settlement cycle in the Indian Stock Markets to enhance the liquidity. This means that the buy/sell orders that you place on the stock market will be settled on the next working day itself. Currently, it takes two days (T+2) to settle the transactions.

For the uninitiated, consider this: Whenever you purchase a stock, it takes 2 days to transfer the stock in your Demat account and when you sell a stock, it takes 2 days to transfer the money to your Demat/Trading account.

Now what we don't know is that there's a complex process that goes behind which takes about 2 days and thus we can't actually withdraw money or transfer those shares until the process is completed. The process is called the settlement cycle which we are going to simplify in this FinMail. But T+1, T+2? What are we really talking about? Let's understand what it actually means:

T = Transaction day (the day you buy/sell a stock)

T+1 = Next working day

T+2 = Next to next working day (the day to receive stock/money to your Demat/Trading Account)

So T is nothing but the day you trade and +x is the number of days it takes to settle your trade order. But do you actually know what goes on behind after you place and order? Probably no, right? And so we will take you to the backstage of the show to help you really understand what happens after you place an order on the stock exchange. And then we will understand the new settlement cycle i.e. the T+1 Settlement cycle. So let's not waste much of your time and start right away. But before we do that, let us introduce you to the backstage characters i.e the participants who do the work for you after you place the order, buy or sell.

Stock Market Participants:

Buyer - Buyer of the Security - Receives the Security, Pays the Money

Seller - Seller of the Security - Gives the Security, Receives the Money

Stock Exchange: The Match Maker - The one that matches the buyer with the seller and vice versa. If the buyer places an order for XYZ Ltd at a particular price, the stock exchange will find a seller that is ready to sell that stock at that particular price and will match both the parties. Stock Exchange is the place where the buyer finds the seller and vice versa without knowing each other.

Trading Member - Stock Exchanges don't interact with the client directly i.e. A Client can't place an order directly at the stock exchange. They need a help of a trading member who is registered at the stock exchange to place the order. A Stock Broker is a Trading Member.

Now you might be thinking about who would be handling all the money and transfer of the shares if not the stock exchanges. Yes, to do that the stock exchanges have appointed various entities, let's take a look at them as well.

Depository - Depositories are entities that handle matters related to securities (Shares, MF units, etc.). Consider Depositary as a place/locker where all of the security holdings are stored in an electronic form. These holdings were stored physically in storerooms until the electronic form of shares was introduced which we now use i.e. De-materialised (Demat) form. Depositary holds the data about who owns what and how much when someone requires the data, the depository helps them with the same. NSDL and CDSL are the only recognised depositories in India.

Depository Participants - The Depository itself doesn't handle the client's security transactions. Remember, it is a watchman and hence the data of shareholding (earlier it was physical share copies) has to be transferred to them first. And the transfer is facilitated by the Depository Participants (DP). DP acts as an intermediary between the Depository and the client. The DP helps the client open an account with the depository which we commonly know as Demat Account. So your broker is an intermediary (DP) between you and your Demat Account (which is either with NSDL or CDSL).

Clearing House - It manages monetary matters on the behalf of stock exchanges. Clearing house sees to it that the buyer pays the required money for the order and the seller receives the exact amount that they are intended to receive. In short, Clearing House is a verifier that the transaction is correct and approves them. The clearing house also sees that the balance of the client is what it has to be and not more or less.

Clearing Member - Clearing member is the intermediary between the client and the clearing house that helps facilitate financial transactions. They settle the dues, make payments to the necessary entities and ensure proper transaction flow.

A Broker itself acts as a clearing member, depository participant and also fulfills the job of a Trading Member. And hence the client doesn't need to go for it somewhere else. If the broker doesn't do it by itself, they outsource the work to some other members so that the client doesn't need to go anywhere else.

Clearing Bank - Every clearing member has to open a bank account in the clearing bank affiliated with the clearing house. A clearing bank is just like a bank that helps facilitate the transactions. It is necessary for a clearing member to have a bank account with an affiliated bank because it can help in faster, safe, secured transactions.

These are the participants that play their part when a client places an order on the stock exchange. Now that we have understood their roles and responsibilities, let's take you backstage to show you what happens after you place an order on the stock exchange.

Understanding T+2 Settlement:

For starters, the buyer places a buy order on Upstox's Portal to buy 100 shares of Tata Motors @ ₹300/- on NSE. Now as this is a limit order, NSE's system will wait for seller/s that place the sell order for Tata Motors @ ₹300/-

On the other side, a seller places a sell order on Zerodha's portal to sell 100 shares of Tata Motors @ ₹300/- on NSE. As there's already a buyer that has placed the order with the same credentials, the exchange's system will match their orders and the orders would go through successfully.

Note that the quantity doesn't matter here for orders to match. If the quantity is less, the exchange will find another seller/s with the remaining quantities. If it's more, only a portion of the seller's order would be fulfilled till the exchange finds another buyer. But for simplifying the process, we have assumed that the seller also places the limit order for the same quantity and same price.

Before we go behind the scenes, let us divide the backstage process into two parts for better clarity - Money Transfer & Share Transfer. We have also attached a figure illustration of the process with this FinMail. Feel free to refer it back and forth while understanding the process. Let's begin!

Buyer's Broker - Upstox

Seller's Broker - Zerodha

Security Transferred - Tata Motors

Quantity - 100

Price - ₹300

Order Amount - ₹30,000 (no brokerage in example)

Money Transfer:

Entities Involved - Buyer, Seller, Stock Exchange, Broker, Clearing House & Clearing Bank

(2) Let's fast forward to the time till the order goes through successfully. Thus the order is now complete, the money would be deducted from the buyer's Trading Account and that's all the buyer & seller has to do from their end.

Behind The Scenes

(3) The Stock Exchange has now received the order and will now notify the clearing house as well the depository about the order. Let's keep it limited to the clearing house in the Money Transfer Part.

(4) The clearing house has received the intimation & details about the order and will send a request to Upstox (buyer's broker) for transferring the order's money on T+1 day. The clearing house will also notify the seller's broker i.e. Zerodha on the same day that it is going to receive the order money for the said transaction.

(5) When Upstox receives the request, it will transfer ₹30,000 (order money) to its Clearing Bank Account on the same T+1 itself, which it has deducted from the buyer's trading account on the T day itself. Upstox will then place a request to its Clearing Bank to transfer the said money to Zerodha's clearing Bank account.

(6) Upstox's Clearing Bank will transfer the full money for the order on the T+2 day.

(7) Zerodha will receive the notification that it has received the money for the order in its bank account and thus Zerodha will also transfer this money to the seller's trading account on the T+2 itself.

(8) The money transfer process completes with the seller receiving the order amount in their trading account.

Note:- The seller would be able to trade with the amount that they have received on the T day itself but will not be able to withdraw. For the seller to withdraw the full order amount, they will have to wait for T+2 day. And thus you might remember that you also can't withdraw the amount of the shares that you sold until 2 days.

Share Transfer

Entities Involved - Buyer, Seller, Stock Exchange, Broker, & Depository.

(1) Fast forward to the seller placing a sell order on Zerodha's portal for 100 shares of Tata Motors @ ₹300/- on NSE. The rest would be the same as the above buy process. The order would successfully go through once the buyer's order matches the seller's order.

The stock will be deducted from the seller's holding and the seller's trading account will reflect 80% of the trade amount but will have to wait for T+2 days for them to withdraw the money. They can trade but can't withdraw until the backend process gets completed.

(2) The buyer & seller has done their job and the rest will be taken care of by the participants.

Behind The Scenes

(3) The Stock Exchange has now received the order and will now notify the clearing house as well the depository about the order. We have already understood the Money Transfer part so let's understand the share transfer part.

(4) The Depository has received the intimation & the details about the order. The Depository will send a request to Zerodha (seller's broker) to transfer the seller's stock holdings to Zerodha's Pool Account with the Depository on T+1 Day.

(For the uninitiated, every depository participant i.e. brokers itself in most cases, have to open a pool account with the depository to enable faster, efficient, and secure transfer of securities)

On the other hand, the depository will also notify the buyer's broker i.e. Upstox that it will soon receive the buyer's security.

(5) Zerodha will transfer the seller's security to its depository pool account on T+1 day itself.

(6) Once the securities are received into Zerodha's Pool Account, it will be transferred to Upstox's Pool Account (buyer's broker's depository pool account) by T+2 day.

(7) Once Upstox has received the buyer's security in its pool account, it will transfer the security into the buyer's Demat account on the T+2 day itself.

(8) The security transfer will get completed once the buyer receives the security in their Demat account.

Note here that the buyer's trading account will reflect the fresh securities as 'T1 Holdings' until the backend process is completed i.e. the security is received in the buyer's demat account. The share transfer process is thus complete.

We have divided the whole process into two parts but a reminder that all of this happens in the span of T+2 days itself. With all the checks and verifications that are. And thus we can conclude that the process is complex enough that it is commendable that the process is completed within T+2 days.

How it is still fast?

Now you probably know what goes on behind the scenes when you place an order with your stock broker. There are a bunch of institutions working simultaneously to deliver the money & shares to your Trading/Demat account.

You might have found the process a bit complex, and it definitely is. Looking at the complexity, communications, dot connections, flow of shares & money, and everything in between, the time limit is still fast and at the industry's best standards.

SEBI implemented the T+2 settlement cycle from April 1, 2003. Prior to that, the settlement cycle was T+3. FYI, US markets adopted the T+2 settlement cycle only after March 22, 2017.

Currently, most major markets such as Singapore, Hong Kong, Australia, Japan and South Korea have the same settlement cycle which is T+2. Note here, Taiwan, which had switched to T+1 settlement, has moved back to the T+2 cycle.

Why SEBI has introduced T+1 settlement?

T+1 settlement cycle means faster completion of the transaction for the buyer/seller. Usually, in the T+2 settlement cycle, the seller of the security has to wait for two days to get the money of the sold shares. So SEBI, by introducing the faster settlement cycle, wants to make stock markets more liquid for the investors and the concerned stakeholders.

So if you sold the shares today, for example, you'll be getting the money the next day instead of the day after tomorrow. Isn't it a matter of joy for the investors!

How orders will be executed in T+1 settlement cycle?

In the current T+2 settlement cycle, there is a certain timeline which the concerned members have to follow and complete their end of process within the stipulated time. With the T+1 settlement introduced, the timeline is surely to get short and faster but we are still to hear the exactly timeline from SEBI.

What plan does SEBI have for implementing the T+1 Settlement cycle?

Shifting from T+2 to T+1 is not easy. It requires the system to be fast, the process to be precise while keeping all the security checks and verifications in place. And that is why SEBI has asked all the participants that function on the backend to deploy/upgrade their systems and make the system ready for T+1 settlement regardless of the implementation or not. SEBI has asked the entities to ready their systems by January 2022.

SEBI has also mentioned in the circular that the settlement rule is not mandatory for an exchange to follow. The exchange has to decide which settlement cycle to follow from the 2 available options. SEBI has also allowed partial settlement change i.e. the exchange can decide which security will be settled on T+1 basis and which on T+2 basis.

But does this mean that exchange can jump from T+2 and T+1 back and forth anytime?

Definitely not! (Pure Dhoni Feels) This would only create more confusion and SEBI clearly doesn't want this. SEBI to Retail Investor ki Maai Baap Hai. And thus SEBI has laid out some rules here as well.

SEBI has said that the exchange cannot change the settlement cycle frequently. Whenever an exchange wants to go from T+2 to T+1 settlement, they will have to send out a public notice - one month in advance. And once they shift to a new settlement cycle (let's say-T+2 to T+1 cycle) they can not shift back to the old settlement i.e. the T+2 cycle immediately. They'll have to wait for 6 months period till they can shift back. Consider this period as a lock-in period for any settlement cycle. The exchange will have to complete this period before it decides to go back and that too after a 1-month notice period. And so the lock-in period of 6 months and the advance notice period will be laid every time the exchange wants to shift back and forth.

Disadvantages of the move:

One of the disadvantages of this new settlement cycle is the choice that the exchange has about the settlement cycle. That is the exchange has to decide which settlement cycle to follow. There are 2 exchanges in India which the public at large use to trade - NSE & BSE. There's a chance that NSE decides to stay with the T+2 settlement while BSE shifts to T+1 settlement. This will lead to confusion. Also, the particular selection of securities is allowed for settlement. This means the exchange can decide which security will have T+2 and which will have T+1 cycle. What if stocks follow T+1 settlement cycle and ETFs follow T+2 cycle? What if Tata Motors settles on T+2 cycle and HDFC Bank settles on T+1?

So there's this grey area that SEBI needs to shed some light on for our clarity.

But while this problem can be tackled with, there's this another problem that has been making rounds since SEBI introduced the T+1 cycle which is the foreign whales (FPIs and FIIs) aren't really happy with SEBI with this move.

The settlement period is about to get short, isn't it good for all? While it is good news for domestic investors, but for FPIs & FIIs, not exactly. Here's why.

FPIs have been raising red flags over this move. They need to route their transactions through a global custodian which provides FPIs the time to pay the money on T+1 day in the current settlement cycle. But in the T+1 settlement cycle, the custodian needs to have the money with itself on the day of a transaction so that they can settle it on the next working day.

This will essentially force FPIs to 'prefund' their trades, i.e. pay for the shares even before getting delivery & also it will increase their trading costs. But it is unlikely that SEBI would budge just because someone has to pay their dues earlier. If it is seriously harmful, then SEBI will most likely consider not to implement, but with the greater good in the picture, it is most likely that FPIs and FIIs have to raise the white flag and not SEBI. Whatever happens, we'll have to wait and watch. And so that brings us to the end of this week's FinMail.

That is it for this week's FinMail. Keep Learning, Keep Calm & Trust SEBI. We will see you in the next week.


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