When you purchase or sell stocks, the entire trade is completed online. For purchase transactions, money is debited from your account and you receive the shares and for sale transactions, shares are debited from your Demat account while the selling price is credited to your banking account. However, this does not happen instantly. To ensure smooth operations and minimal risk, regulators have designed a trading cycle, as well as, a clearing and settlement process. As an investor, you don’t need to get into the technical details of these processes. Today, I will talk about things that you need to know about the clearing and settlement process in the stock market.
This is going to be a simple article keeping in mind what you need to know as an investor. We will look at the process for purchase and sale transactions separately.
To buy or sell shares, you need a Demat account where your shares are stored, a banking account for monetary transactions, and a trading account to enter the trade.
Clearing and Settlement Process When You Buy a Share
I will use an example to explain the clearing and settlement process in Indian stock market:
Day 01 – June 22, 2020
Let’s say that you buy 100 shares of HDFC Bank Ltd. on June 22, 2020, at Rs.500 per share. Therefore, the total purchase price is Rs.50,000.
The day you purchase the shares is known as the Trade Day or T Day.
Once the trading day ends, your broker debits Rs.50,000 plus the brokerage and all associated charges from your linked banking account. However, the stocks are yet to reach your Demat account. The broker also shares a contract note that details all the transactions done during the day along with the breakup of charges made by your broker. This is like a bill that you need to preserve for future reference.
Day 02 – June 23, 2020
The day after you purchase the shares is known as Trade Day + 1 or T+1 Day.
Nothing happens on this day. The money is still debited from your banking account but you haven’t received the shares yet.
Even if you don’t have the shares in your account, you can sell the ones that you bought yesterday called the BTST or Buy-Today-Sell-Tomorrow trade. This is a high-risk transaction and is usually not recommended to investors who are new to stock trading. Since this article is about the clearing and settlement process, I will skip the details of the BTST trade.
The stock exchange collects the purchase amount and charges from the broker on T+1 Day.
Day 03 – June 24, 2020
The second day after you purchase the shares is known as Trade Day + 2 or T+2 Day.
On the T+2 Day, the shares are debited from the Demat account of the person who sold them and credited to your broker’s account. Your broker credits them to your Demat account by the end of the day. On the same day, the money that was debited from your banking account is credited to the seller’s banking account.
So, in a nutshell, when you buy shares, on T Day, the money gets debited on the same day and you receive the shares on T+2 Day.
Clearing and Settlement Process When You Sell a Share
Using the example cited above, the process is as follows:
- You sell shares on June 22, 2020 (Day 01 or T Day). The shares are blocked in your Demat account immediately. Hence, you cannot sell the same shares again.
- On Day 02 (T+1 Day), the broker gives the shares to the exchange.
- On Day 03 (T+2 Day), you receive funds in your banking account post deduction of all charges.
This is the core clearing and settlement process in a stock exchange.
This process is divided into three parts:
- Trade Execution – where the buy or sell order is executed by you. This happens on T Day.
- Clearing – where the responsible entity identifies the number of shares that the seller owes and the amount of money that the buyer owes for every trade. It also determines the obligation of all parties and assesses risk. This is done on T+1 Day.
- Settlement – where the shares are moved from the seller’s account to the buyer’s account and the money is moved from the buyer to the seller. This is done on T+2 Day.
To ensure that this process is smooth, the Securities and Exchanges Board of India (SEBI) has created several entities as described below.
Entities Involved in the Clearing and Settlement Process in The Stock Market
Here is a quick look at the entities involved in the trade clearing and settlement process in stock markets in India and their respective roles:
While traditionally shares were held in a physical certificate format, today it is mandatory to hold them in the electronic or dematerialized form. Hence, a Demat account is mandatory for share transactions. SEBI has created a structure to ensure optimum performance and maximum control over Demat accounts by creating Depositories – entities that hold your Demat accounts. All participants like investors, brokers, and clearing members need to have a Demat account to trade in the stock exchange.
#2. Clearing Corporation
This is an entity associated with a stock exchange that handles the confirmation, settlement, and delivery of shares. It acts as a buyer for the seller and a seller for the buyer. In simpler terms, it facilitates purchase on one end of the transaction and sale on the other. It ensures that the settlement cycles are short and consistent while keeping the transaction risks in check and providing a counter-party risk guarantee.
#3. Clearing Members and Custodians
The clearing corporation fulfills its role by transferring every trade to a clearing member or custodian. Their core responsibility is ensuring that the funds and shares are available on T+2 Day. They need to have a clearing pool Demat account with a depository for receiving and sending shares pertaining to the trade.
#4. Clearing Banks
Since there is a movement of money, SEBI has created a list of 13 clearing banks that aid in the settlement of funds. Every clearing member has to open a clearing account with one of these banks. If the clearing member is settling a purchase transaction, then it needs to ensure that the funds are made available in this account before the settlement. On the other hand, if it is settling a sale transaction, then the funds are received by the clearing member in the clearing account. Here’s a list of clearing banks.
- HDFC Bank
- ICICI Bank
- Kotak Mahindra Bank
- Axis Bank
- State Bank of India
- HSBC Bank
- JP Morgan Chase Bank
- DBS Bank
- Deutsche Bank
- Stock Holding Corporation of India
- Infrastructure Leasing and Financial Services Ltd.
- Orbis Financial Corporation Limited |
How Trades are Cleared and Settled in the Stock Market
Here is a quick overview of the actual process of clearing and settlement in the stock market:
- The stock exchange transfers the details of every trade to the clearing corporation on T Day.
- The clearing corporation informs the clearing members and custodians about the details of the trade and asks them to confirm if they are willing to settle the trade or not. Upon receiving the confirmation, the clearing corporation determines the obligations of the clearing member or custodian.
- The clearing corporation sends the details of the obligations and pay-in advice of securities or funds to each clearing member/custodian.
- Once the details are received, the clearing members or custodians to:
- Clearing banks to make the funds available; and
- Depositories to make securities available by the pay-in time
- The clearing corporation receives funds and securities from the clearing banks and depositories for purchase and sale transactions respectively. So, if a clearing member is settling a purchase transaction, then the corporation receives the money in its clearing account via the clearing bank. Also, for sale transactions, the corporation receives securities in its pool account via the depository.
- Once this is done, it instructs the depositories and clearing banks to transfer the securities and funds to clearing members/custodians for purchase and sale transactions. So, if a clearing member is settling a purchase transaction, then the corporation transfers securities to its pool account. Also, for sale transactions, the corporation transfers money to the clearing account via the clearing bank.
There are many ways in which SEBI ensures that the clearing and settlement process ensures market integrity by becoming the counterparty to each trade. This is essential to ensuring the availability of liquid and effective markets.
I hope that you are clear about the clearing and settlement process in stock markets. As an investor, understanding this process gives you a complete grip over how trades are executed and settled. This set of processes work in perfect sync to ensure that the stock market functions in a smooth manner.
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