A step in the right direction


Director, Banyan Tree Advisors

December 20, 2011

Those opposed to the new trading rules are looking only at the short term. Fact is, in the long run, the changes will do a world of good for the market.

THERE HAS been a lot of hue and cry over the string of systemic changes (rolling settlement, options, uniform trading cycles) introduced by Sebi (Securities and Exchange Board of India) with effect from July 2. Market-watchers had been
awaiting this day with bated breath, as the general perception was that the market would react adversely to the changes and take another dive.

The D-day has come and gone. And though the market rallied that day, the truth is that damage was inflicted on the market four months earlier. The BSE (Bombay Stock Exchange) Sensex, which was at 4,386 on 1 March 2001, collapsed under the triple whammy of the Tehelka expose, the Nasdaq crash and the announcement of rolling settlement. Now, given that the Tehelka revelations seem to have blown over and the Nasdaq, though still weak, has recovered from the
depths it plunged to in early-April, does that mean the blame for the market fall can be squarely placed on the new trading rules (follow this link to read about them)?

The old gives way… In order to answer that, let us first see how the current trading system is different from its predecessor, and what Sebi is trying to achieve with these changes. The erstwhile weekly settlement cycle spanned five days — for instance, Monday to Friday on the BSE. So, on the BSE, you could buy (or sell) shares on Monday, but you didn’t have to necessarily pay money (or deliver shares). Anytime during the same week, you could do a reverse transaction, and square off your trade. A five-day trading cycle encouraged speculation, as traders played for small gains accruing from the volatility in the market.

Another, more pernicious evil was the practice of switching positions across exchanges. This was made possible by the fact that trading cycles differed across stock exchanges. While the BSE followed a Monday to Friday cycle, the NSE (National Stock Exchange) had a Wednesday to Tuesday cycle. So, a trader could take a position on the BSE on Monday, liquidate it on the BSE on Wednesday / Thursday / Friday and simultaneously open up an identical position on the NSE.

Come Tuesday, the settlement day on the NSE, he could again switch his position back to the BSE. That way, he could skip paying margins on both exchanges; the only cost he incurred was the brokerage.

The BSE and the NSE were not the only exchanges used for such speculation. The CSE (Calcutta Stock Exchange), where settlement took place on Thursdays, was particularly popular for this purpose, as it is regulated less stringently. The net
result was that it was impossible to estimate the total open position in the market — and therefore, near impossible to regulate the market.

The different trading cycles allowed operators to maintain highly leveraged positions without having any collateral to back these trades in the form of margins. As a result, when Sebi announced mandatory rolling settlement in 246 actively-
traded stocks and uniform trading cycle (Monday to Friday) for other stocks across all exchanges, operators were forced to scale down their open positions, resulting in carnage on the market.

…to the new. Besides uniform trading cycles, much-needed to curb unbridled speculation, the other — more controversial — measure is the replacement of the age-old badla system with options (on stocks and indices). This is not the first time that Sebi has tried to do away with badla. It did so once before in 1993, only to reintroduce it around a year later.

Although badla worked well as a speculation mechanism for a long time, it suffered from two drawbacks. One, It didn’t allow a clear-cut segregation between the cash market and the forward market, as is the global norm. Two, the method
of calculating the badla/undha badla charge was not very transparent.

Options address both these problems — and more (for a primer on options, click here). Although there is plenty of initial scepticism among speculators on this new instrument, in time, it might turn out to be the best thing to happen to them.
Speculators tend to give a short-shrift to discipline. Most live on hope rather than on any sort of practical approach to business. Losing trades typically become long-term holdings — never mind the fact that some of these companies have
annual reports that would give even a trained analyst nightmares.

Options, however, enforce a discipline. If you go long by buying calls, you know your downside at the outset. You cannot lose more than the premium you pay on the call; the same applies for puts as well. From a speculator’s point of view, this
works like a stop loss.

Right now, volumes in options are abysmally low, as market participants don’t fully understand these complex instruments. The low liquidity in the market, however, might turn out to be a boon for retail speculators. In the high liquidity go-go period we witnessed till recently, select speculative stocks fluctuated wildly during the course of the day, creating possibilities of huge profits. This created a casino-like buzz in the market, a buzz that even turned on sedate investors. They punted on the market, only to pay a heavy price to the very operators who create the buzz. With volumes drying up, there is now less incentive for them to play the market.

That’s good because speculation is not a good, viable money-making strategy for retail investors.

Carry forward the reforms. From the market’s point of view, the most important function of a speculator is to infuse liquidity into the market, which is essential for efficient price discovery. Today, the top 10 traded stocks account for 90 per cent of trading volumes on an exchange. If you want to buy shares in companies other than these 10, you will have to incur a significant cost in terms of the bid-offer spread, which has, in fact, widened on account of the poor liquidity.

Here, Sebi needs to do more. It needs to promote stock lending more aggressively so as to draw in arbitrageurs and create liquidity. While investors are heaving a sigh of relief that their wealth is not deteriorating at a steady rate, the regulator needs to do everything possible to infuse more liquidity into the market – or else, the cure could be far worse than the ailment.

Overall, Sebi’s measures bode well for the long-term good of the market. The circumstances under which these measures were announced — a reaction to the events that rocked the market in March — can be questioned, but not their efficacy. These measures might also sacrifice the short term for the sake of the long term, but that’s okay. The market will take its own time to understand the new instruments that it has to deal with, but it will come around.

A few years ago, when Sebi announced compulsory dematerialisation of shares, brokers had raised a similar uproar. But today, aren’t we — as well as brokers — glad we don’t have to chase down registrars for share certificates and dividend
cheques lost in transit. A child has to fall to learn to walk, and then run. The transition the market is going through is similar in nature.

However, Sebi’s job is far from over. It still has many hurdles to climb. The biggest one confronting the markets right now is insider trading. Only when this problem is transparently resolved will we see the return of the retail investor to the market.

The sad story of our markets (as also of our economy) is that it always takes a crisis to usher in change. Some people refer to this as progress through chaos. All the changes that have been brought about by Sebi — be it paperless trading or
rolling settlement — have been opposed tooth and nail by exchanges. Yet, today the Indian stock market is one of the most mature among developing countries. In fact, the development of our stock market far exceeds the development of our economy – the sad part is that we have to thank Harshad Mehta and Ketan Parekh for that.