Indian Securities Market Settlement Process: Comprehensive Study Notes (Part 1)

1. Overview of the Securities Settlement Cycle

In the Indian equities market, all trades executed on a recognized stock exchange follow a standardized T+2 settlement cycle.

• Definition: Under this framework, a transaction entered on Day 0 (the Trade Day) must be fully settled on the day T+2 working days.
• Key Event: On the T+2 day, the final funds pay-in or securities pay-out takes place.
• Working Days: "T+2" refers specifically to the trade day plus two working days, excluding exchange holidays and weekends.

2. Determination of Settlement Obligations (Equity Segment)

To complete the transaction lifecycle, the clearing system determines what each member owes or is owed. In the equity segment, obligations are computed using two primary methods depending on the category of the security:

A. Netted Obligations

• Netting Principle: Under this method, all purchase and sell transactions executed by a member in the same security are offset (netted) against each other.
• Delivery Obligation: A clearing member has an obligation to deliver a security in a settlement only if their total sell quantity exceeds their total buy quantity.
• Receipt Obligation: Conversely, a member receives securities only if their total buy quantity exceeds their total sell quantity.

B. Trade-to-Trade or Gross Obligations

• Gross Settlement Principle: Under this method, transactions are settled on a gross trade-for-trade basis without any netting.
• Securities Obligation: A member's security pay-in obligation is equivalent to their cumulative sell quantity, and their security pay-out is equivalent to their cumulative buy quantity.
• Funds Obligation: Funds pay-in is equivalent to the cumulative value of all buy transactions, and funds pay-out is equivalent to the cumulative sell value.

Obligation Type Comparison Table

3. Clearing & Settlement of Derivatives (Futures & Options)

The clearing and settlement mechanism for derivatives involves working out open positions and financial obligations, which are settled in cash.

Daily Mark-to-Market (MTM) Settlement (Futures)

• Daily Settlement Prices: Daily settlement prices are computed for futures contracts at the end of each trading session based on a specified methodology.
• MTM Process: All open positions of a member are marked to market against these daily settlement prices to determine the daily cash gain or loss.
• Cash Settlement: These mark-to-market obligations must be settled in cash on a daily basis.

Final Settlement (Futures)

• Index Futures / Cash-Settled Contracts: For futures contracts that are cash-settled (such as equity Index Futures), the final settlement occurs on the last trading day.
• Scope of Positions: All positions—including brought forward positions, positions created during the day, and positions closed out during the day—are evaluated at the close of trading hours.
• Final Marking: The positions of a clearing member are marked to market at the final settlement price on the last trading day and settled in cash.

Premium Settlement (Option Contracts)

• Cash Settlement: Premium payment and receipt for option transactions are cash-settled.
• Mechanism: Settlement occurs through direct debit or credit to the clearing bank accounts of clearing members.
• Netting of Premiums: The net premium payable or receivable value is calculated after netting the premium payable and receivable positions across the member's trades.

Exercise Settlement (Options)

• Assignment Process: Long positions in in-the-money (ITM) option contracts are assigned to short positions in options of the same series on a random basis.
• Settlement Execution: For cash-settled option contracts, the exercise settlement value is debited or credited to the clearing accounts of the respective clearing members with their clearing banks.

4. Settlement of Funds

Mode of Payment and Delivery from Clients

• Mandatory Channels: All payments must be received or made by brokers strictly through secure financial channels:
  • Account payee crossed cheques
  • Demand drafts
  • Direct credit into bank accounts through Electronic Funds Transfer (EFT) or other modes approved by the RBI.
• Client Account Restriction: Brokers are strictly required to accept cheques drawn only by the clients and must issue cheques in favor of the clients only. Third-party payments are prohibited.

Margin Payment

• Upfront Requirement: Both initial margins and exposure margins are payable upfront by clearing members.
• Acceptable Collateral Forms: Initial margins can be paid using:
  • Cash
  • Bank Guarantees
  • Fixed Deposit Receipts (FDRs)
  • Approved Securities.
• Collateral Limits: Clearing members who clear trades for other trading members have the authority to set maximum collateral limits towards initial margins for each trading member and custodial participant clearing through them.

Settlement Dues Flow

1. Member/Custodian Obligations: Clearing members and custodians must pay the clearing agency all outstanding financial dues arising from their cleared positions.
2. Clearing Agency Payments: In turn, the clearing agency pays out the moneys due to the clearing members and custodians.
3. Information Source: All payments are based on trading data provided by the Exchange or the Clearing Agency.

5. Settlement of Securities

Securities Delivery Mechanics

• Standing Instructions: A buyer of securities can establish a one-time standing instruction with their Depository Participant (DP) to automatically receive securities into their demat account.
• Delivery Flow:
  1. The Clearing Corporation or Clearing House delivers the purchased securities to the broker's demat account.
  2. The broker subsequently transfers the securities into the client's demat account.
  3. Alternative Route: The broker can request the Clearing Corporation or Clearing House to deliver the securities directly to the purchaser’s demat account.

Depository Clearing System

• Simultaneous Timing: The securities pay-out takes place on the same date as the securities pay-in date (T+2 working days).
• Multi-Depository Execution: Securities pay-out is executed simultaneously across both national depositories (NSDL and CDSL).
• Cut-off Time: The securities settlement process is typically completed by 1:30 PM on the T+2 settlement day.

Key Terms to Remember

• T+2 Cycle: The trade settlement timeline requiring final settlement on the Trade Day + 2 working days.
• Multilateral Netting: The process performed by the clearing agency to net all buy and sell obligations of clearing members.
• Mark-to-Market (MTM): The daily cash settlement of gains or losses on outstanding futures contracts based on daily closing prices.
• Pay-In / Pay-Out: Pay-in refers to the delivery of funds/securities due from a member to the exchange; pay-out is the distribution of funds/securities from the exchange to members.