In the Indian stock market system, shares are delivered to a demat account of the buyer one day after the transaction date. Brokers also permit the buyers to sell these shares before they have them in their demat account, provided that the exchange will deliver them in a timely fashion.
On the other hand, if the exchange is unable to deliver the shares to the buyer, it implies that the seller in this deal has failed to give the shares to the exchange. Failure to deliver shares is known as short delivery. When such a situation arises, the exchange organizes an auction for the same quantity of shares and delivers it to the respective buyer.
Short delivery can occur in stocks with low liquidity or if a short MIS (Margin Intraday Squareoff) /CO (Cover Order) /BO (Bracket Order) has not been squared off in some situations.
If a short delivery of shares occurs, and the exchange is unable to find fresh sellers in the auction market, then they are considered to be closed out. Instead of delivering the shares to the buyers, the exchange makes the settlement in cash, which depends on the close out rate.
The close out rate will be higher of:
(A) Price from the trading day till the auction day
(B) 20% above the official closing price on the auction day
This will then get passed to the buyer. This works as a compensation to the buyer for the non-delivery of the shares.
Let’s understand this with an example.
Assume you have bought 100 shares of TATA Motors for Rs. 500 each on Monday (T). You will expect delivery on Tuesday (T+1)
These shares were short delivered, which is why you didn’t receive the delivery on Tuesday (T+1).
The exchange will organize an auction on Tuesday (T+1) from which it will attempt to find fresh sellers who can deliver 100 shares of TATA Motors, so that they can finally be delivered to you on Wednesday (T+2).
If no fresh sellers happen to be in the auction market, then the trade gets settled by closing out on Thursday (T+3).
Suppose the official closing price of TATA Motors on the auction date, i.e., T+1 was Rs. 600 and the highest price from Monday to Tuesday was Rs 620.
In this scenario, the exchange will close the trade at Rs 720, i.e. higher of:
(A) Rs. 720 (20% above Rs. 600)
(B) Rs 620 (Highest price from Monday to Tuesday)
The seller of the stock who defaulted will have to incur an auction penalty of Rs. 12,000 (720 – 600 x 100). So the buyer would get Rs. 72,000 in total, i.e Rs. 60,000 which is the closing price on the auction date along with Rs. 12,000 which is the auction penalty.
However, if the price of TATA Motors had reached Rs. 760, i.e., from the trading day till the auction day, then the close out would have been done at Rs. 760 and not Rs. 720 as it is higher than the closing price + 20% of the closing price of TATA Motors.