Ban on badla, take 2

This is the full text of an article which appeared in Economic Times on 29 June 2001.

2 July will see badla banned once again. In addition, equity trading will move to rolling settlement for the largest stocks in the country. Settlement will be done on a T+5 basis. What this means is that those who are buyers and sellers at the end of the trading day, have to do settlement in five working days.

These changes are new for India's equity market. Until now, investors had to wait five to ten days to take delivery. Until now, speculators and arbitrageurs took leveraged positions by either switching positions between exchanges, or by using badla. Daily trading volumes were Rs.15,000 crores (this was before the ban on short-sales which will be removed). The question on everyone's mind is: What will happen to liquidity from 2 July onwards?

The market has had some previous experiences with rolling settlement and with banning badla. Rolling settlement was first done with stocks that had very poor liquidity to begin with. These stocks lost volume to the more liquid stocks. But now, the biggest stocks of India will go into rolling settlement. They account for 95% of trading volume.

When badla was banned in 1993, volumes of the A-group stocks decreased. Volumes on the B-group stocks actually increased (as seen in a paper by L. C. Gupta). The market which was smaller then, and dominated by the BSE broker community, was able to lobby to have badla brought back by early 1996. Their success was helped by the lack of good market mechanisms that could replace the older systems in providing liquidity.

Today, the markets are much more liquid, and it is clear that the market reforms of transparent and anonymous trading, safe and regular clearing, and reliable settlements have helped volumes grow by 50 times. At each step in this reforms process, some vocal brokers predicted that reforms would lead to a drop in market liquidity. Is there a reason to believe that these same fears might be valid now?

One factor to belie the fear is that rolling settlement does not directly affect the life of day-traders. These are speculators who open positions at the start of the day and end the trading day with no net positions. Such day traders are believed to account for 70%-80% of the daily traded volumes. They would continue to provide liquidity to the markets under rolling settlement.

To some extent, day-traders also depend upon long-term traders, against whom to trade. Some long-term traders are simply buy and hold investors, who stand to gain from rolling settlement. Other long-term traders are speculators and hedgers seeking leverage. There are two such mechanisms to access leverage:

How does the Indian equity markets fare on these leverage mechanisms? We now have a successful index derivatives trading market. The open interest on futures and options has grown to above Rs.100 crores, which indicates that traders are beginning to access the leverage in derivatives markets. On the other hand, the mechanims for lending and borrowing of either shares or funds are absent. Why is that?

  1. Banks have been encouraged to take a hostile attitude to loans against shares (starting from the RBI policies in 1993 to the announcements of 11 May 2001).
    The rationale for discouraging loans against shares is supposedly its volatility. But the risk in shares is actually easier to manage when compared to assets that a bank typically makes loans on. In the case of shares, risk can be easily measured, whereas the risk of assets like real estate or cars cannot be as well measured, because these prices are more difficult to observe. This policy needs a serious rethink.
  2. Lending and borrowing arrangements require infrastructure for swift movement of funds and shares between counterparties. This allows easy trading and easy risk management.
    A nation-wide payment infrastructure covering all the banks and their branches has remained at the proposal stage at the RBI for the last five years. What is available is rapid movement of funds between branches of some private sector banks. For instance, the clearing banks for the National Securities Clearing Corporation obtain daily payments from brokers all over the country. This is the natural infrastructure for margin trading.

When we examine the evidence above on leverage mechanisms, it appears that a bottleneck are regulators and their understanding of the development of market institutions. This reinstates the role of the regulator in making reforms successful. In 1995, incumbent brokers persuaded SEBI that the ban on badla was harmful, and it was brought back. How probable is it that SEBI will support these brokers again?

It appears less likely in 2001. In 1993, the BSE was India's largest stock market, and a dominant force in the brokerage industry. Today, the BSE is the second largest exchange, the brokerage industry is much larger than BSE members, and the BSE is a fractured organisation with limited political impact. In 2001, the finance minister has promised Parliament that the reforms will take place. In 1993, no other leverage mechanisms were available, other than weekly settlement cycles and badla. In 2001, we have rolling settlements and a thriving derivatives market.

So 2001 is likely to fare better than 1993. The reforms have strong political support. We have strong equity market mechanisms. We also have new local market participants, who have shown themselves upto the challenges of much more dramatic market reforms than mere rolling settlements or a ban on badla. To the naysayers who insist that the moment has to be right for reforms to be successful, paraphrasing Hamlet appears appropriate: ``Not a whit, we defy augury; the readiness is all.''

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