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Friday, January 27, 2023

Mint Explainer: T+1 a milestone for the Indian stock market

Starting January 27, all shares in the Indian markets will switch from T+2 to a shorter T+1 settlement cycle, in which trades will settle just one day after they are made. Structurally, it will make India one of the most progressive and transparent stock markets in the world. It is the latest of India’s stock market reforms which began in 2001 with the ban on badla, the trade pass through mechanism on the BSE, after the Ketan Parekh scam. Badla gave way to equity derivatives, and index options are now the most popular futures and options (F&O) product on the NSE. It signals the maturity of investors and traders in India who understand the nuances of the stock market much better, preferring the less volatile index options over stock futures and riskier stock options.

How the transformation began

Following the Ketan Parekh scam, the Securities and Exchange Board of India (Sebi) initiated sweeping stock market reforms in 2001, in an effort to make the Indian stock markets more transparent and investor-friendly. . So, badla, a pass-through mechanism that encouraged excessive speculation and leverage in shares, gave way to shorter liquidation cycles. Instead of badla, a separate futures and options market was born. So, essentially, Sebi separated the cash and futures markets.

Since the T+3 settlement cycle, the Indian cash markets have gradually migrated to T+2 and are now moving to continuous T+1 settlements. It means that the shares are transferred to the buyer’s bank account and the money to the seller’s bank account one day after the execution of the operation (T+1), a complete transformation of the process in little more than two decades.

In 2001 both NSE and BSE had weekly settlement cycles. All transactions on the BSE were settled after the weekly trading cycle, Monday through Friday. On the NSE, the weekly settlement was after the Wednesday to Tuesday trading cycle.

The rise of index options

Badla was a mechanism to transfer trades from one weekly settlement cycle to another without the buyer receiving the shares. In line with global best practices, Sebi replaced badla with a separate, transparent and better regulated derivatives market. The futures and options market was initially settled in cash, but gradually migrated to physical delivery of shares at the end of the monthly trading cycle. Indexed contracts are settled in cash. The F&O market allows traders to hedge and speculate, with an evolved risk management framework. To reduce systemic risks, there are substantial margin requirements, from initial margins to market value.

In the early years, stock futures became popular among retail investors due to its resemblance to badla. In recent years, there has been an increase in retail participation in index options. This seems to indicate two things.

One, there is more responsible trading behavior among retail investors, who seem to have a better understanding of the nuances of the stock market. The market has come a long way from highly leveraged badla trading to more restricted speculation. Remember, index options are cash-settled and are less volatile than stocks and stock futures.

Two, Sebi has been trying for years to curb excessive speculation and promote stocks as a long-term investment. Shorter settlement cycles with cash and derivatives market segregation, and a gradual transition to the new order has worked well for Indian stock markets, seeding an equity culture in India.

In fact, the Indian stock market has skyrocketed after the reforms, with the Sensex jumping from around 3,000 levels to over 60,000 now. Makes 2001 the 1991 time for stocks.

The pivotal role of JR Varma

One man who played a major role in making Indian stock markets more evolved and transparent is JR Varma, a member of the RBI’s Monetary Policy Committee (MPC) and a professor at IIM Ahmedabad. He often makes headlines for breaking ranks with others in the MPC, and more recently voted against further rate hikes by the central bank.

Decades ago, Varma set the agenda at Sebi in various roles, helping to shape and reform the stock markets. While a panel led by Varma had initially suggested a handover in mobile liquidation, Varma later, as a Sebi board member, pushed for the dismantling of badla and the introduction of F&O in selected stocks. This is how the script subsequently developed.

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