Settlement process

What is the Settlement Process in stock markets in India?

The Settlement process refers to the back-end activity of completion of a financial transaction when all the pending obligations have been fulfilled. The Settlement happens, depending on the obligations that were notified to the parties after the Clearing Process.

Settlement is a broad term and it could be used in different contexts in different industries.

Example: In Banking industry, settlement of a Cheque happens when money is transferred from the payer to payee.

In capital markets, the term is used for delivery of securities to the buyer and simultaneous delivery of money to the seller.

This page will focus on Settlement of trade, in case of buying/selling of stocks through the Stock Exchange.

Settlement in Stock Markets

When buying through exchanges, the term ‘Settlement’ refers to the conclusion of the trade, after securities have been credited to the Demat Account of the buyer. And at the same time, the consideration amount is credited to the seller.

Many investors believe that their trade gets completed as soon as the order is executed on the exchange. However, a trade is not completed until the following three steps are successfully done:

(Some investors, Brokers and news sources consider the Clearing process to be a part of the Settlement process and use the term ‘Settlement Cycle‘ for the entire back-office process after execution of the order.)

There are 2 ways to give delivery of securities to settle the transaction (as detailed below). The new settlement option was introduced in May/June 2021 and the Brokers can choose to switch to this process.

How does the Settlement process work?

On a high level, the Settlement process in share market involves these steps:

Step 0: A trade happens on the Stock Exchange
Step 1: A list of all executed trades is forwarded to the Clearing House by the exchange
Step 2: Clearing House conducts the Clearing Process and notifies the members about their obligations

Step 3:

Option 1: Pool account or Early Payin account
The Clearing Members who have an obligation to send securities, need to make the securities available in the securities Pool account or the Early Payin (EPI) account.
(All members have to create a pool account with both Depositories. This account is created in the name of the member and contains the securities to be transferred from their clients. This account is also used to receive the securities for Settlement)
(Early Payin account is used to store securities that have been delivered before time by the seller.)
Option 2: Earmarking of securities
The Clearing Members who have an obligation to send securities, can earmark the securities (for delivery) in the Demat Accounts of their clients. This is a way to let the Clearing Corporation know that the securities will be debited directly from the Demat Account of the investor.
In this case, the Clearing Member does not have to transfer the securities from the Demat Account of their client to the pool account. This is beneficial in BTST trades as the client gets ownership of the securities for one day.

Step 4: The Clearing Members who have an obligation to send money, need to make the funds available in their Clearing Account with the bank.
(All members have to create at least one bank account, dedicated for Clearing operations. This account is created in the name of the member and is used for maintaining cash margins, for sending/receiving payments for settlement etc.)
Step 5: The members submit their special instructions to the Clearing House for any preferences they might have.
Example: By default, securities are transferred from the pool account of one member to the pool account of the other member. But if the member wants the securities to be directly delivered/credited to the client’s account, then they can send the client’s BO ID to the Clearing House.
Step 6: Based on the securities that have been deposited in the pool account and the earmarked securities, the Clearing House can determine a list of securities that will be Short Delivered. An amount equal to the value of securities which are not delivered, is blocked in the Clearing Account of the member, held with the bank.
Step 7: Clearing House releases the Pay-out instructions to the Depositories and Banks, to release the funds and securities to the beneficiaries.
Step 8: A post-settlement Auction then takes place for the securities that were Short Delivered. If the amount blocked in Step 6 is not enough, the member has to pay the excess amount.

The process is now largely automated and happens fairly quickly. However, some transactions like those involving physical share certificates, still take long time for clearing and settlement.

Note: For purchase and sale of Mutual Funds, the money is directly transferred between the bank account of the investor and the account of the Clearing House. So, the money is not transferred through a pool account of any intermediary.

Types of Settlement process

In the stock market, the following types of Settlement mechanism are currently offered by the Clearing house:

  • Normal segment
    Settlement of securities like Stocks, Derivatives, ReiTS, InvITs etc. which are bought normally on the Stock Exchange.
  • Trade for Trade segment
    Refers to the settlement of securities which have to be compulsorily delivered and should be owned by the investor. There is no chance of Short Delivery of these securities, as investors need to have the securities in their Demat Account on the day on which the sell order is placed.
  • Retail Debt segment
    Refers to the Settlement of debt securities that are tradeable by retail investors on the Stock Exchange.
  • Auction Market
    This refers to the settlement of securities that have been bought in the Auction Market due to Short Delivery.
  • Non-cleared Trade for Trade segment
    This refers to the settlement directly between the Buyer and Seller. The securities are transferred in a way which is agreed by both parties. Most of such trades either use Delivery Instruction Slips (DIS) or online transfer of securities. (Refer: Step by step guide for off-market sale of shares using CDSL)
  • Physical segment
    This segment refers to the trading in physical shares. This option has been kept to provide an exit option for retail investors who currently hold physical shares. There is very limited activity in this segment as trading of physical shares is now banned.

Modes of settlement

  • Dematerialized format
    With advancement in technology, most of the Settlement now happens in electronic format. All ‘Types of settlement process’ mentioned above (except ‘Physical segment’) are now settled in this format. ‘Non-cleared Trade for Trade segment’ can be settled in either physical or dematerialized format.
    The Clearing Houses currently follow a Rolling Settlement cycle for settling in Dematerialized format.
  • Physical format
    The trades done under physical segment are settled in physical format. Trading of physical shares has now been banned and therefore this format has very limited activity.

Disclaimer

  • This page is for education purpose only
  • Some information could be outdated / inaccurate
  • Investors should always consult with certified advisors and experts before taking final decision
  • Some images and screenshots on this page might not be owned by FinLib

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