Carry-forward system in rolling settlement

Sanjiv Shankaran

A FEW years ago, speculation was considered a dirty word in the Indian capital market. Anyone who wanted to borrow money to back a forecast was considered a dangerous element.

It is a sign of how views have changed when the regulator, Securities and Exchange Board of India (SEBI), approves a badla system for its pet project, the rolling settlement system. To understand the significance of the move, it may be worthwhile to take a closer look at the settlement system in the Indian equity market.

The account period settlement system

Traditionally, the Indian equity market has functioned by clubbing trades into pre-set periods, for instance, from Monday to Friday on the Bombay Stock Exchange (BSE). On the National Stock Exchange (NSE), the account period now is between Wednesday and Tuesday. Then the trades for the period would be settled (exchange of money and shares) at one go. This is called the account period settlement.

Account period is a system that encourages liquidity in the market because people can buy and sell without having to pay immediately -- almost like using a credit card. But the flip side of the system is that the longer it takes between a contract (a buy or sell) and actual settlement, the riskier the system.

The rolling settlement

To reduce the risk associated with the system, SEBI introduced the rolling settlement. Unlike the account period, the settlement process for today's contract has to begin at the end of the day. If you buy a share today, the settlement process commences at the end of the day. The quicker the settlement, the lower the risk.

The price paid to reduce risk is that it drives away those despised speculators. A speculator may not be the regulator's cup of tea, but he performs a useful role. Speculators add to the liquidity in the market and, thereby, make the price movement smoother and also provide easy opportunities to enter and exit for other investors.

Sometime back when SEBI introduced the rolling system for select stocks, there was an immediate fall in liquidity in these counters. A fall in liquidity does not do any good because there never seem to be enough opportunities for investors to exit the counter.

New liquidity drivers

To provide the right amount of lubrication in the form of liquidity, the carry-forward system for the rolling settlement (CFRS) was introduced. CFRS is the system that is used on the BSE. The NSE has a similar system to provide liquidity -- Automated Lending and Borrowing under Rolling Settlement (ALBRS).

Click here for Table

CFRS AND ALBRS operate for 15 stocks (see table) at present. And both are derived from the systems that exist in the account period market -- the badla on the BSE and the ALBM on the NSE. These account facilities have now been modified and extended to the rolling settlement cycle.

Rolling forward facilities: An overview of the CFRS and ALBRS results in the following key facets of the new facilities, now available under the rolling settlement cycle for the 15 designated stocks:

*CFRS can be carried out in 15 stocks that are to be traded only through the rolling settlement category.

*Unlike the account period, carry-forward system, CFRS is open to all brokers on BSE -- the other system (the regular badla) is open only to brokers who opt for the same.

*Under CFRS, traders have the option to carry forward positions for one, two, three, four or five days.

*If a trade takes place on Monday and the CFRS session takes place on Tuesday, traders can opt to carry forward their trade obligations for any period between one to five days.

The option of one-to-five days is common to CFRS and ALBRS. So far, the system described is the same as the carry-forward system that exists for the account period settlement.

In CFRS, after the deal is carried forward, the system deviates from the model that exists for the account period settlement. The difference is as follows:

Using the facilities

If a trader decides to carry forward a trade for five days, and then changes his mind; he can then enter into a position that reverses the original position. By doing this, he can get rid of obligations such as delivery of shares or payment for shares purchased. All that the trader will have to do is collect or pay the difference in price between original contract and the reversal of the same.

In the regular account period settlement, the reversal leg of the contract would be merged with the ongoing account period settlement. However, in the case of the CFRS, the reversal leg will be carried out only on the fifth day (the original date for the contract to end).

While traders can exit from an obligation before the date they originally agreed to, the actual settlement (settling the difference between original price and the price during reversal) will take place only after the day that was originally agreed to. ALBRS also allows for settlement only after the conclusion of the trading session indicated at the beginning. To use an analogy, a tenant may vacate the house before the end of the lease period, but accounts with the landlord may be settled only after the lease period is over.

Judgment pending

The carry forward system for rolling settlement has just been introduced. If the past trend is anything to go by, they may not gain popularity with traders immediately. To gain popularity, big players such as Infosys Technologies, Zee Telefilms and Reliance, may have to be brought into the ambit of the rolling settlement system. Only then one may get a better picture of the market preference or, otherwise for the carry-forward facilities under the rolling settlement mode. A judgment of the acceptance of the daily carry-forward and daily ALBM facilities may, therefore, have to wait.