Short delivery

Every trade on an exchange creates two promises. The buyer must bring the money. The seller must bring the shares.

Short delivery is the seller's promise failing. On the settlement day the member cannot pay in the securities, either fully or in part. The workbook also calls this a securities shortage.

The buyer is not left out of pocket. The buyer has already paid, and still needs the shares. So the clearing corporation fills the hole. It runs an auction session, buys the shares in the market and delivers them to the buyer.

The cost of all that lands on the clearing member whose side failed. Not on the buyer, and not on the clearing corporation.

What the buyer does notice is the delay. The auction has to run first. So the shares can reach the buyer's demat account a few days after the normal settlement date.

The deadline that is missed. Members must pay in funds or securities on the settlement day. Since 27 January 2023 all trades in equity shares, exchange traded funds and bonds traded in the equity segment of a stock exchange are settled on a T+1 basis, and SEBI has since introduced an optional T+0 rolling settlement cycle alongside it. Miss that pay-in on the securities side and you have a short delivery.

Step 1 — close out the shortage in cash. The clearing member responsible has to pay the clearing corporation an amount equal to the value of the short delivery. That value is the number of shares that are short multiplied by the last closing price of the shares on the settlement day.

Step 2 — buy the shares. The clearing corporation then buys them through an auction trade in the market, conducted on the trading system, and delivers them to the buyer.

Step 3 — the member pays the difference. Any difference in the price paid to acquire the shares in the auction has to be made good by the clearing member.

Bad delivery takes the same route. Where a security is delivered but rejected by the depository for technical reasons such as incorrect signatures, names or details, that is a bad delivery and it has to be rectified. In both cases the buyer has paid good money and needs shares, so both go into the auction.

A funds shortage is an entirely different regime. Where the money side fails there is no auction. A penal charge on the amount outstanding at the end of the day has to be paid until full payment is made; the trading or clearing facility is withdrawn until the shortages are made up; and repeat defaulters may be asked to maintain a deposit equal to their cumulative funds shortage as funds shortage collateral.

One way to avoid the shortage. Among the uses the workbook lists for the securities lending and borrowing mechanism is that it helps in meeting delivery shortages for settlement completion. A member short of stock can borrow it through stock lending and borrowing rather than fail to deliver.

Where this paper stops. XII gives the close-out valuation and says the auction price difference is borne by the member. It does not print the prices used where an auction finds no sellers at all. That grid belongs to the clearing and settlement paper, which sets it out under close out.

Illustrative figures.

Meena buys 300 shares of Deccan Cements at Rs 610 on a Monday. Settlement is T+1, so the shares are due in her demat account on Tuesday.

On Tuesday the selling broker's client does not deliver. It is a short delivery of 300 shares. The last closing price on the settlement day is Rs 618.

Close-out amount paid by the selling side's clearing member = 300 x Rs 618 = Rs 1,85,400

The clearing corporation buys 300 shares in the auction at Rs 631:

Auction cost = 300 x Rs 631 = Rs 1,89,300

Difference = Rs 1,89,300 − Rs 1,85,400 = Rs 3,900

That Rs 3,900 is made good by the clearing member, which will look to recover it from the broker and its client.

Meena's side is unchanged in rupees. She pays 300 x Rs 610 = Rs 1,83,000 and receives 300 shares. What she loses is time: the shares reach her a few days after Tuesday, because the auction had to run first.

Now flip the failure. Suppose Meena were the one to fail, with only Rs 1,50,000 in her broker's clearing bank account against the Rs 1,83,000 obligation. There is no auction for money. The shortfall of Rs 33,000 attracts a penal charge on the amount outstanding at the end of the day until it is fully paid, and the trading or clearing facility is withdrawn until it is made up. Were this a habit, the clearing corporation could also require a deposit equal to the cumulative funds shortage.

Two failures on the same trade, two completely different machines.

Chapter 4 (Secondary Markets), section 4.6.5 (Short Delivery and Payment), which sets out the auction for a securities shortage and then the separate funds shortage regime. The chapter's settlement section states the same rule earlier in a single line — a security that is not delivered comes into auction — and the online trading section returns to it from the investor's side, noting the delay of a few days in receiving the security where the counterparty broker defaults on securities pay-in.

Expect a definition question separating short delivery from bad delivery; a valuation question on the close-out amount (number of shares short x last closing price on the settlement day); a question on who bears the auction price difference (the clearing member); and a question on what happens instead when the shortage is in funds (penal charge, facility withdrawn, funds shortage collateral for repeat defaulters).

• Short delivery means not delivered; bad delivery means delivered and rejected. Short is an absence, bad is a defect. Both end in the same auction, which is exactly why candidates fuse them.
• The close-out is valued at the last closing price on the settlement day — not the trade price, and not the auction price. The auction price only decides the extra the member pays.
• The auction price difference is borne by the clearing member. Not by the buyer, and not by the clearing corporation.
• A securities shortage goes to auction; a funds shortage does not. A funds default draws a penal charge and withdrawal of the trading or clearing facility, and funds shortage collateral is demanded only of repeat defaulters.
• Short delivery is not short selling. In this paper a short sale in the margin segment must be squared off before the time the broker specifies, and short sale positions cannot be carried overnight — so a squared-off short sale never reaches settlement at all. Short delivery is what happens when a delivery obligation does reach settlement and is not met.
• The buyer is made whole in shares, but later. Guaranteed settlement does not mean same-day delivery when the counterparty fails.
• An internal shortage is a special case. Where a selling client and a buying client of the same member net off, no obligation reaches the clearing corporation at all, so the shortfall has to be handled through a self-auction. XII does not cover that route; the clearing and settlement paper does.