Stock markets: start of a new era?

The end of the badla is a watershed. But the post carry forward scenario is hazy.

By C. R. L. Narasimhan

The Securities and Exchange Board of India's (SEBI) decision to ban the badla and introduce a host of new products/reforms in the stock exchanges is truly momentous. The badla which is the common thread in all these measures is a 135 year old institution. Although it has been modified substantially - the existing carry forward systems are its variants - the fact that it will be banned in toto calls for a hard look at what went wrong and equally pertinently whether the new measures proposed instead will work.

Or is it because of the present context - a JPC and all - that has tilted the scales against traditional products and favoured the new?

From July 2 all the existing carry forward products (deferral products) including ALBM, BLESS, MCFS will cease to exist. Derivatives including new ones such as index-based options will make their entry. The much talked about rolling settlement - on a T plus 5 basis - will finally be applicable to a majority of the widely traded stocks from that date. All these, according to the SEBI, will make the exchanges follow the best international practices.

Not proactive

For all the advantages claimed for the new measures, no one in authority is saying that these are the result of some visionary long-term planning. Stock market reforms in India have always been crisis-driven. The latest moves, some of which have been talked about for almost a decade, fit into the pattern of reacting to a crisis. By no means they are proactive.

A SEBI spokesman has said that when the times are good, it is unwise to introduce drastic changes. The regulator will be blamed for spoiling a good thing. But such rationalisation hardly helps when new measures that require considered debate and a consensus are to be introduced. Crisis-driven regulatory measures suffer from a variety of deficiencies which might in the end negate their very purpose.

For instance, this time there appears to have been no consultation with the market participants, without whose support some of these measures will not succeed.

Another way of looking at the issue is to find out whether the substitutes will do all that the badla did without, of course, subjecting the system to the badla type risks. One essential function of the badla is to inject liquidity. A second is to provide a hedge and tone down excess volatility. Besides, the carry forwards provide market participants with avenues to take a view of stocks over the term. It is difficult as of now to visualise the badla substitutes fulfilling a majority of these functions, at least over the near term.

Take the liquidity enhancing character of the badla. In December 1993, when the then existing carry forward systems were stopped (a fallout of the 1992 crisis), there were sharply reduced volumes on the bourses with the consequent reduction in liquidity.

A thin market in turn contributed to extreme volatility. It was then that the G. S. Patel Committee which went into these aspects suggested the reintroduction of the carry forwards but with safeguards. Until very recently the SEBI was reposing full faith in the existing arrangement. Curiously, the SEBI chairman, while announcing the new measures, did not specifically say what went wrong in the carry forwards necessitating a drastic change-over.

Banking on derivatives for liquidity

This time the liquidity diminishing consequences of the badla ban are sought to be countered by introducing new derivative products. Unlike carry forwards there will be a segregation of cash and futures markets.

World over it has been proved that derivatives can, because they are highly leveraged, contribute to increased liquidity. However, in India, derivatives of any type will take some time to develop. There are practical problems in understanding these products by many outside a small group of specialists.

Writing an option (for instance) is even more complicated. The new products will have the inevitable consequence of pushing the stock market even further away from common investors. Experience in other countries and over different markets has shown that a futures market in derivatives will succeed only if there is all round participation. For now, the regulators as well as leading market participants will have to embark on a massive programme of investor education.

Of the other measures, the introduction of the rolling settlement in a big way from July 2 is noteworthy. There could however be a serious logistics problem here given that the time is short and past experience has not been happy. It is true that the impetus for this change has come from the Finance Minister himself but is the SEBI overreaching itself?

A case for phased introduction of rolling settlement looks strong but at this juncture the regulator is not likely to go slow. The proposal to shift stocks not on a rolling settlement to a uniform (Monday-Friday) settlement is welcome as it will diminish the scope for inter-exchange arbitrage.

Another welcome move is to introduce index-based circuit breakers in place of stock specific ones. The latter has provided a handle to those who can bend the system insofar as it allows stock specific information to be reflected in stock prices over days. Moreover trading in individual stocks need not stop because of the circuit breaker effect. The big question: what index will the SEBI choose?

All in all, the SEBI moves are in the right direction. Yet one wishes that a more satisfactory explanation of what has gone wrong in the existing carry forwards is provided.

Another question: have the unique characteristics of the Indian stock market environment been reckoned with? We will know soon, in less than two months. Never has a date been so significant as July 2 will be for the Indian capital market.