The concerns flagged by market experts and participants on the recent plan of the Securities Exchange Board of India (SEBI) to transition the stock market to an instant settlement system from T+1, deserve serious attention. In its recent consultation paper, SEBI has made a case for instant settlement on the premise that it will lower settlement risks and enable more efficient use of capital for retail investors. But the challenges that this will create for institutional investors and the risk of fragmented market liquidity, make a case for treading cautiously. Most global stock markets except for China, are yet to implement even the T+1 settlement system which India adopted in January 2023.

An instant settlement system, in which a trade is followed by an immediate credit of shares or cash into the investor’s account, is beneficial for retail investors doing delivery-based trades. These investors usually pre-fund their accounts with cash; immediate credit of shares can significantly lower their counter-party risk and minimise balances or shares lying with the broker. Cash realised from sales can also help them redeploy capital quickly. But while this system may be capital-efficient for retail investors, it may prove to be quite the opposite for institutions. They will now have to incur the opportunity cost of pre-funding their large positions and idling funds if they can’t immediately deploy it. Foreign institutions may face the additional challenge of working with overseas custodians who have longer timelines and taking on foreign exchange risk in their India accounts.

These constraints seem to have prompted SEBI to suggest an optional instant settlement system, where every investor can either choose the T+1 system or instant settlement for each trade. The exchanges will create a new group/series to distinguish shares trading on the instant versus T+1 segments of the market. But the availability of the same scrip both in the T+1 and instant settlement windows, apart from causing confusion to retail investors, may also fragment market liquidity and depth. With retail investors likely to take to instant settlement while institutions stick with T+1, significant divergence could crop up in the price of the same share between the two windows. SEBI is hoping to bridge the gap through mandatory price bands, but liquidity will remain an issue. To help markets adjust, SEBI proposes to implement the shift in two phases. Phase 1 will see same-day settlement of trades with institutional investors kept out, while Phase 2 will see instant settlement with institutional investors also participating. To begin with, instant settlement will also be tried out only in the top 500 stocks. All these promises may only add to the complexity.

The dual system can put significant pressure on clearing corporations and depositories. SEBI needs to weigh if these costs are worthwhile, simply to allow retail investors intra-day access to their capital.