The coming turmoil in the capital markets

In part one of a series, the author says the capital markets and the securities ecosystem have remained broadly untouched by the progress in India's payment infrastructure

No, this isn’t an article about where the equity or debt markets are headed in term of valuation and returns. It’s about a bigger turmoil which will render many market institutions and participants redundant.
 
Recent years have seen fantastic progress in India’s payment ecosystem. First with the real time gross settlement (RTGS) and then with the national electronic funds transfer (NEFT), transferring money from one bank account to another became a breeze during market hours. The role of instruments issued by one’s bank, indeed that of the bank itself, reduced sharply in managing payments when compared to the earlier cheque and draft era. But this was just the beginning.

 
With the immediate payment service (IMPS) and unified payment interface (UPI), the bank itself has become irrelevant in payments. Even if one’s bank doesn’t have an app or a net banking facility, one can still transfer money from one’s account to any other in the country round the clock without any involvement of the bank itself. While such transfers have a daily limit of Rs 1 lakh per account, this limit is in excess of that needed in an overwhelming majority of transactions. More recently, with NEFT available round the clock for transfers of up to Rs 2 lakh, banks have tried to claw back some of their lost relevance.

 

However, if one looks at the capital markets and the securities ecosystem, it has remained broadly untouched through the years. Taking the equity markets as an example, we still have the daily rolling T + 2 settlement system introduced in 2003. The access that one investor has to other investors is only through the exchange-clearing corporation-broker-depository participant framework and very few investors even have an app- or web-based direct access to their own demat accounts in the depository. This makes the transaction flow quite convoluted.
 
When investors wish to buy securities, they place an order with their broker who executes the transaction on the exchange. The investor then transfers money to the broker, who in turn pays it to the clearing corporation. An even more complicated sequence is followed on the selling side of the transaction. Sellers instruct their depository participant (DP) to transfer the shares sold to the broker’s demat account through the broker’s DP. The broker then instructs its DP to transfer them to the clearing corporation.

 
The reason this is more complicated is that, unlike the payment of money which is now possible without the involvement of the bank, the movement of securities still needs the full involvement of the DP and its processes. And the transaction isn’t yet complete.
 
The clearing corporation then gives the securities received from the selling broker’s DP to the buying broker’s DP who, in turn, transfers it to the buyer’s DP and then to the buyer’s demat account. The clearing corporation also gives the money received by the buyer’s broker to the seller’s broker, who, in turn, transfers it to the seller.

 
The reason exchanges need clearing corporations is to prevent any settlement failures that may happen at any stage during this transaction process. It enters each transaction as a central counterparty, guaranteeing settlement irrespective of what happens at the other end of the transaction. For example, if the buying broker fails to deposit the money required to buy the securities, the clearing corporation will still pay the selling broker. Clearing corporations and exchanges further manage the risk of settlement failures by only allowing brokers to transact on their platform, thus restricting the number of entities they deal with. In addition, as a condition for this access, these brokers comply with various financial and regulatory requirements designed to impart further protection to the exchanges and clearing corporation. Needless to say, the existence of powerful intermediaries who control market access comes with its own set of complications, as was evident recently.

 
Also, there is a cost associated with maintaining this elaborate ecosystem which is borne by investors. And while this elaborate structure was needed at a time when neither current technology nor the current payment ecosystem existed, it has now clearly outlived its usefulness. As things stand, there is no reason why investors should not have a direct app or web-based access to their demat account.
 
But most importantly, there is no reason why investors cannot link their bank and demat accounts to a trading account with an exchange, such that when they transact directly on the exchange, the settlement of both securities and funds happens seamlessly on a real time basis.

 
In this transaction model there is no difference between transaction and settlement. A purchase transaction is only possible if the buyer has the funds available for transfer. A sale transaction is only possible if the seller has the securities available or, as is the case with derivatives, the ability and the funds needed to create these securities.
 
Since no settlement failure is possible, the need for a clearing corporation and brokers disappears. Depositories acquire the nature of banks by allowing investors direct access to their accounts, eliminating the need for DPs. Exchanges provide an electronic platform directly to investors and continue to manage listing, ensuring that listed companies comply with all the rules and regulations designed to protect investors.

 
All of this is within the reach of existing technology. So the question isn’t whether this will happen. The question is when.
 
(Concluding part, “Capital market disruption”, will appear on March 18)
The author is an economist, capital markets expert and the former CEO of Essel Mutual Fund