What are the lessons SEBI, the stock exchanges, the RBI and the government need to
learn from the recent stockmarket-cum-banking crisis? What are the possibilities that
these lessons, if learnt at all, will be diligently followed by these regulatory
Prevention, Not Cure: Lesson No. 1 is definitely that the authorities must adopt a "prevention is better than cure" policy at all times. If you don't want artificial crashes, ensure that artificial booms also don't take place. But how do you prevent price manipulation and the conesequent crises? Says economist Ajay Shah: "Prevention is possible with a proper market design which has the spot market in rolling settlement mode and the hedging and leverage activities occurring in the derivatives market. In addition to stock lending, leverage is best imparted through margin trading where banks finance trades and keep the bought shares as collateral subject to prudential norms."
Ketan Parekh was able to rig prices in his select 20-30 stocks between April 1999 and March 2000 and also thereafter in a handful of other stocks (mainly media stocks) using four basic sources of leverage:
- The stock borrowing and lending mechanisms of the NSE and BSE;
- Banks' loans-against-shares schemes;
- The unofficial badla financiers of Calcutta; and
- Different exchanges having different trading cycles enabling an operator to switch positions between exchanges.
Parekh tapped all the four sources and traded in amounts which were in high multiples
of actual cash in his possession. Says Zubin Tampal, equity dealer with Jet Age
Securities, an NSE and BSE member: "It was too easy to buy, say, Rs 100 worth of
shares, lend them to a bank or an unofficial badla financier in Calcutta and get Rs 50
with which you bought more of the same stock, lend them again. The system allowed you to
build such a dangerous pyramid of leveraged positions that breaking out of it unhurt was
always going to be difficult."
The Lending Mechanisms: Leverage in the financial markets allows one to enter into transactions by shelling out only a percentage of transaction value. Says Shah: "Leverage is not innately bad. It allows a person with knowledge but no capital to trade, which is not undesirable since it improves the information flow in the market." However, leverage can attain dangerous levels when risk management systems are absent or inadequate. Of the four elements that Parekh was using for leveraging, NSE's and BSE's stock-and-money lending and borrowing system could be considered the only one to have had reasonably adequate risk management systems.
Among the banks lending money against shares as collateral to operators, very few had proper prudential norms with respect to the margin amount and the type of shares accepted as collateral. This is one area where the RBI has to get proactive in terms of setting prudential norms for banks' lending to stockbrokers and other capital market intermediaries, and then monitoring their exposures on a continuous basis.
In the build-up to the recent crisis, the RBI did not adequately fulfill its monitoring responsibilities. Will it do so in the future? Maybe. Though looking at the current pay-order scam and banks' lending to brokers without adequate and prudential checks, one might say that the RBI did not quite learn from its regulatory lapses during the buildup to the 1992 Harshad Mehta-initiated banking-cum-stockmarket scam.
Casino Kolkata: The unofficial badla financiers of Calcutta were always known to be an excellent source for funds against shares. Since their operations were outside the official badla system of the CSE, SEBI may not have been able to take any legally viable action against them even if it wanted to. What, however, many believe SEBI ought to have done was to ensure that CSE's settlements and badla system was insulated from the unofficial market.
Which, in the recent crisis, was not to be. The CSE was plagued with over Rs 50 crore worth of defaults by its brokers due to their linkages with the badla financiers or losses emanating from their own initiated dealings in the unofficial market. Can it recur? It could if SEBI's monitoring of CSE and its risk management systems continues to be off the mark.
Switching Cycles: The fourth element in the huge leverage available to operators was the fact that they could keep their positions open for a week since the trading cycles were weekly and they could prolong their positions further by switching it across the NSE, BSE and CSE which had their weekly trading cycles beginning and ending on different days of the week.
This element can easily be taken care of in one shot if all the exchanges operate compulsory rolling settlements where the trading cycle is only of one-day duration. An operator who then wants to keep positions open beyond one day without wanting to pay or deliver for it will not be able to do so. He will also not be able to switch positions between exchanges as all of them will be on daily trading cycles. Says Shah: "The spot market should be a boring market where open buy and sell positions result in payment and delivery. Leveraged trading's place is in the derivatives market where we would then have to focus all our efforts on obtaining a sound risk management system."
With leverage going to the derivatives market, the spot market will be easier to handle. Points out Shah: "Derivative is equal to leverage and leverage requires governance plus brains in order to handle it. However, a rolling settlement plus derivatives architecture does give us a spot market that just works with low requirements of governance and brains."
The good news is that SEBI, under pressure from the finance ministry, has now directed bourses to shift to compulsory rolling settlements from July. But there will be pressure from brokers to postpone its onset, citing a likely crash in trading volumes if it is made compulsory. It remains to be seen whether the finance ministry and SEBI buckle under such pressure.
Doing it Differently: Till such time as the market design improves and leverage is available under efficient risk management systems, what is it that regulatory bodies need to do differently? When prices were being rigged up last year by Parekh and his shell companies—and trading volumes were simultaneously skyrocketing—the first point of identification was at the stock exchanges' surveillance departments. Ditto when prices were being hammered down by bear operators and some fiis.
But since the operators were paying all the margins on time and making payment or giving delivery, it may not always have been possible for stock exchanges to take direct action against them. Moreover, stock exchanges do not have jurisdiction over the operator-clients of the brokers. Only SEBI has. If the stock exchanges were passing on the suspected price manipulation cases to SEBI (it is not clear whether they were doing so diligently.Neither NSE nor BSE responded to outlook's queries on the subject), then SEBI had the powers to question the operator-clients and gauge the sincerity of the trades from their response.
All this probably didn't happen. Had SEBI been after the operator-clients, it may perhaps not have been able to establish price manipulation in some cases, but it would have at least instilled caution among the operators which could have led to a reduction in the intensity of artificial booms and crashes. SEBI would have then also got a clear idea of the source of funds and acted accordingly. It is only now in the ensuing investigations that SEBI is finding the presence of slush funds from the underworld (see previous story) in the markets. Further, company managements and even fund managers were seen to be openly hobnobbing with Parekh which should have at least made it easy for SEBI to shortlist potential manipulated stocks and probe further.
If governance is slack, then rogue traders will have a field day. What are the chances of history repeating itself then? Not much, that is, if the top brass at SEBI, RBI and even the government are fearless enough to attempt instilling discipline among the deviant traders, regardless of political, corporate or underworld connections.