Payments crisis: Frequently Asked Questions
The equity market has experienced massive volatility in recent weeks. Market institutions are always tested in times of exceptional volatility. The BSE has not come through this test with flying colours.
- Did a payments crisis actually take place?
- There is little doubt that the BSE went through a major bailout operation in order to avoid a crisis, and entities such as UTI helped in the bailout. The last two settlements are supposed to have gone through successfully in the sense that all longs brought funds and all shorts got their shares. If this did happen as claimed, then the integrity of settlement has indeed remained inviolate, but there are persistent reports that the payout was incomplete, that one custodian (SHCIL) has a ``backlog'' of Rs.50 crore of shares that haven't arrived from BSE's clearinghouse, and that some institutions are now in the process of formulating policies to strictly avoid doing any trades on BSE owing to these risks.
From an economic perspective, there is something highly unsatisfactory about the spectacle of exchange administrators putting together a bailout. Promoters should not be exposed to blackmail to aid in a bailout. Securities markets institutions should function in an impassive and reliable manner. The ``rules of the game'' should be established and well--known, and these rules should be able to adequately cope with episodes of volatility. Even if the BSE administration is motivated by purely altruistic objectives, the bailout process is fraught with accusations about why shorts were helped at the expense of the longs. The focus of markets should be on prices, risk and return; politics should not play a role.
- Why did the crisis take place?
- On BSE, badla enabled the buildup of massive open positions on a few stocks (e.g. Videocon, Sterlite, BPL). These open positions were extremely large when compared with the floating stock of these securities, i.e. a short squeeze was in the works. These positions also reflected extremely high leverage on the part of both longs and shorts given the weak margin requirements of badla and their imperfect implementation. When prices rose in the manipulation, the shorts were unable to post margin. They requested the exchange for help, and the BSE chose to help them.
- What was the experience at NSE?
- In the absence of badla the open positions on these stocks on NSE were around five times smaller than those present on the BSE. NSE's systems and procedures worked smoothly. There were some failures in posting margin, and these were handled by the clearing corporation in routine fashion (erring brokers had their trading terminals disconnected, the settlement guarantee fund was used to fund their obligations, and the credit recovery process began). Exchange chiefs were not seen organising a bailout.
- Brokers failed at NSE also -- so how is NSE different?
- Prices on both exchanges are linked by arbitrage so when a stock is manipulated at BSE, the spillover takes place at NSE also. The mode of failure at NSE was fundamentally different. Some members failed to pay the mark--to--market margin on time, and their trading terminals were unplugged. This is a perfectly normal event which goes on all the time. The important point is that the payout took place on time without a hitch. This is the essence of market integrity.
- Shouldn't margins have been able to control these problems?
- There are two parts to this problem. First, margin rules on BSE are much weaker than those on NSE, and margin enforcement at BSE is widely believed to be spotty. Second, margins alone do not adequately produce smooth functioning with highly leveraged trading on securities with a finite floating stock. Position limits, at the level of the entire market and at the level of an individual broker, are of central importance.
- Why was BSE's ``trade guarantee fund'' not used to obtain smooth functioning in the fashion of NSE?
- The BSE's TGF has a few design errors. The TGF can only be invoked after a broker committee decides to invoke it -- which implies a discretionary use -- and it can only be invoked after a broker has been declared a defaulter. Hence the TGF could often be too late in ensuring payout. On an exchange owned by brokers, there is a sense that declaring a broker as a defaulter is undesirable and all alternative courses should be explored instead. This structure is inefficient in the sense that once a broker has been declared a defaulter, there is little hope of recovering dues from him, so the TGF would shrink upon use.
- How does NSCC operate the settlement guarantee fund?
- NSCC becomes the legal counterparty to the net settlement obligations of every member. This principle is called ``novation'' and is the hallmark of modern clearing institutions (the BSE does not do novation). Hence NSCC is obligated to meet all settlement obligations, regardless of member defaults, without any discretion. Once a member fails on any obligations, NSCC immediately cuts off trading and initiates recovery. Declaring a broker as a defaulter is the most powerful weapon in NSCC's arsenal. It only gets used when credit recovery has failed, and would generally be employed a year after the settlement guarantee fund was used.
- What are the major lessons to draw from this episode?
- This is a reminder of the difficulties of running exchanges with highly leveraged trading. The leverage present today with badla at BSE greatly exceeds that which will be found in the supposedly leveraged derivatives markets that follow the L. C. Gupta recommendations. The skills of the worldwide derivatives community, and the insights of the L. C. Gupta report, could be quite useful in designing a risk containment system for badla. Two inputs would be required to produce a better--functioning badla: (a) the design of a superior risk--containment system, and (b) it's reliable enforcement.
- What role does a ``ban on short sales'' play in this problem?
- Given the fact that the ``cash market'' operates using futures--style settlement, truly banning short sales is equivalent to banning all trading. Another interpretation could be that stocklending through badla, which is used for undated short positions, has been banned. In this case, it should be more accurately termed as a half--ban upon badla.
- Are concentration margins the answer to buildups of positions in a few stocks?
- Position limits, at the level of a broker and at the level of a stock, more directly address the problem. The correct framework for initial margin is `Value at Risk'. The upfront capital of a clearing member should exceed the VaR of his portfolio exposure. A correct VaR calculation would automatically penalise undiversified positions with much higher margins. Once this is done, margin rules should not be modified in crisis management.
- Does running an equity cash market absolutely have to require such knowledge about risk management?
- It doesn't, if what is being run is an equity cash market. With futures--style settlement (weekly settlement) and/or badla, a market is no longer a cash market. The existing knowledge and enforcement practices at BSE actually might suffice for running a cash market.
- How should India's equity cash market operate in order to obtain systemic integrity?
- The equity cash market should be a cash market, i.e. a T+5 rolling settlement market. Moving to rolling settlement will obviate the need to think about sophisticated risk containment and unbiased enforcement. Once extreme leverage is removed from the equity cash market, it will be much easier for exchanges and regulators to produce a smoothly functioning capital market. An equity cash market should never involve blackmail of promoters.
- How should rules about badla be modified to make it function more reliably?
- It is possible to think clearly about designing a badla which works without generating systemic risk. The insights leading up to the risk containment framework seen in the L. C. Gupta report about exchange--traded derivatives are relevant when thinking about badla; a ``Bombay Badla Exchange'' could be setup which embodies these principles. For example, leveraged trading on BPL or Sterlite would never be permitted under this framework. However, we should hesitate before deploying this expertise for rescuing weekly settlement and badla. A genuine cleanup of the cash market, i.e. a complete move to T+5 rolling settlement, would fit better into a modern vision for market development.
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