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

Beginning 27 January, all stocks in Indian markets will shift from T+2 to a shorter T+1 settlement cycle, where trades are settled just a day after they are done. Structurally, it will make India one of the most progressive and transparent equity markets in the world. It’s the latest in India’s equity market reforms that began in 2001 with the ban on badla – the carryforward mechanism for trades on the BSE – after the Ketan Parekh scam. Badla made way for equity derivatives, with index options now the most popular futures and options (F&O) product on the NSE. It signals the maturing of investors and traders in India who understand the nuances of the stock market much better, preferring the less volatile index options over the riskier stock futures and stock options.

How the transformation began

After the Ketan Parekh scam, the Securities and Exchange Board of India (Sebi) initiated sweeping stock market reforms in 2001, in an effort to make Indian stock markets more transparent and investor-friendly. So, badla, a carryforward mechanism that encouraged excessive speculation and leverage in stocks, made way for shorter settlement cycles. In place of badla, a separate futures and options markets was born. So, essentially, Sebi separated the cash and the futures markets.

From T+3 settlement cycle, Indian cash markets have gradually migrated to T+2, and is now moving to T+1 rolling settlements. It means shares are transferred to the buyer’s demat account and money to the seller’s bank account a day after the trade execution (T+1) — a complete transformation of the process in just over two decades.

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

The surge in index options

Badla was a mechanism to carry forward trades from one weekly settlement cycle to another without the buyer taking delivery of 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 cash-settled, but gradually migrated to physical delivery of shares at the end of monthly trading cycle. Index contracts are cash-settled. The F&O market allows traders to both hedge and speculate, with an evolved risk-management framework. To reduce systemic risks, there are substantial margin requirements, from initial margins to mark-to-market.

In the initial years, stock futures became popular with retail investors because of their resemblance to badla.In recent years, there has been a surge in retail participation in index options. This seems to indicate two things.

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

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

Indeed, Indian stock market has soared after the reforms, with the Sensex vaulting from about 3,000 levels to over 60,000 now. It makes 2001 the 1991 moment for equities.

J.R. Varma’s pivotal role

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

Decades ago, Varma set the agenda at Sebi in various capacities, helping shape and reform the stock markets. While a panel under Varma had initially suggested a carryforward in rolling settlement, Varma later, as Sebi board member, pushed for dismantling badla and the introduction of F&O in select stocks. That’s how the script played out subsequently.

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