Making sense of badla
Market practice is hard to change. The world over, when a community of traders develops skills in certain market practices, it generally opposes change. Institutional evolution is hence slow, and can only come about through a combination of intellectual clarity coupled with conviction.
Badla is a classic example of these problems. It was swept away in the aftermath of the Scam of 1992, along with a host of other `market practice'. However, for some market participants, a deeply cherished desire has been a reversion to badla in something close to its original form.
In a few weeks, SEBI will decide whether badla should be brought back as a major aspect of the equity market. A host of questions remain unresolved. What is badla? How would the original badla hurt the markets? Do we need badla in the first place, and if so in what form?
We cannot discuss badla without first disposing of the suggestion that we need badla because it is like a futures market. This is factually incorrect. A futures market on shares of ITC would have two properties:
- The futures would trade separately from the cash; i.e. there would be one screen trading ITC for spot delivery, and another screen trading ITC for delivery in the future.
- The futures would have an inflexible expiration date; e.g. we would trade ITC for delivery on 31 December 1997. Many different expiration dates would all trade at the same time, distinct from each other.
Neither of these describe badla, which is neither forward trading nor futures trading. We should recognise badla as a facility for borrowing funds or shares, using which speculators obtain leveraged positions on the market. Hence badla should be judged in comparison with methods prevalent worldwide for securities lending and moneylending on the stock market.
The fact that the motivation for borrowing is inherently speculative should not cause discomfort; speculators perform a valuable social function by enhancing market efficiency and liquidity. Safe leveraged positions using borrowed funds or securities have a valuable role to play. Indeed, SEBI is independently nearing the release of a well-articulated plan for stocklending.
If stocklending, moneylending and leveraged speculators are a valuable part of the market, then why do regulators fear badla? They are worried about payments crises and market manipulation.
Leverage, i.e. buying shares using borrowed money, is a potent tool in investment. A highly leveraged position would be one where a person with funds of Rs.100,000 is able to own Rs.1 crore of an asset. The appeal of leverage is that a 2% price rise yields a profit of Rs.2 lakh, i.e. 200% of the initial capital. However, leverage is a twin--edged sword: when the price drops by 2%, there is a loss of Rs.2 lakh, which could generate bankruptcy. These bankruptcies lead to payments crises, which should never take place in a healthy market.
Leverage also goes well with market manipulation. The funds with the typical would--be manipulator are not large enough to influence prices of large stocks. However, if ten-times leverage is made available, then we can visualise Rs.10 crore in the hands of a manipulator turning into positions of Rs.100 crore on the market, which could move stocks like IDBI or Hindustan Lever.
The essential problem with badla of old is non--transparent, dangerous leverage. It is the leverage embedded in badla which helped enable the Scam of 1992, and the steady stream of payments crises in India's markets in the past. Looking beyond India, most crises in markets worldwide are born of dangerous kinds of leverage. The dangers that we face with a resumption of traditional badla are enhanced systemic risk and market manipulation.
How do we resolve this situation, rescuing the useful access to borrowed funds and securities, while avoiding the dangerous leverage and manipulative potential? We can isolate five principles and one litmus test:
- The clearinghouse must interpose itself, becoming the legal counterparty to each leg of every loan, thus ensuring that if one leg goes bankrupt, the other would not be affected.
- Borrowers might often return counterfeit or stolen shares. Hence stocklending should only take place with dematerialised shares.
- Initial margin and mark--to--market margin should be required, and the initial margin should be large enough to pay for the worst possible loss that can be experienced in the two/three days which are needed to move funds.
- Any simple netting which goes beyond one security for one investor is dangerous.
- Anyone in the country should be able to lend funds or securities; this should not be the monopoly of a small coterie of badla financiers.
- How do we measure the quality of badla in operation? Watching the trading volume flowing through badla as a measure of quality is quite wrong. The key litmus test consists of watching interest rates in the lending. If the interest rates resemble junk bonds, as badla financing charges frequently do, then the risk of default is like junk bonds too. A safe borrowing facility is one where interest rates are close to treasury bill rates.
Margins limit leverage. No lender can ignore the risk involved when a borrower buys ITC using 90% borrowed funds. Margins should be strong enough to disallow such positions, and protect the integrity of the clearinghouse.
Both types of margin are essential for safety. Without the mark--to--market margin, losses could accumulate, wipe out the initial margin, and generate bankruptcy. Without initial margin, dangerous positions can be adopted without collateral, where small price changes would yield bankruptcy.
Are these requirements just ideals, or can they be turned into a practical method for stocklending and moneylending? Remarkably enough, a fully functional blueprint is seen in the institution of margin trading in the United States. A buy position who does not want to put up 100% funds goes through these steps:
- The buyer puts up 40% of the funds.
- The moneylender brings in 60%.
- Shares are purchased, and immediately pledged to the lender through the depository.
- ``Mark to market'' is done regularly to collect all losses made on the position, and to ensure that the funds put up by the buyer do not drop below 40%.
A beautiful feature of ``margin trading'' is the fact the cash market remains a pure cash market -- all open positions turn into delivery and payment. The lender is not exposed to any risk. Yet, leveraged positions, at low interest rates, become available.
Since individual stocks are highly volatile, the initial margin required has to be quite high. Safety in the US is obtained at 40%, but this may need to be higher in India given higher price volatility and slower banks.
This ``margin trading'' was not an alternative in the pre--technological markets of 1993. However, the markets have since been transformed by electronic trading, nationwide VSATs, and the depository. Margin trading has a legitimate place in a vision for the future of our markets. The Verma committee would have done well to simply recommend the adoption of margin trading in India. This would yield safe borrowing of funds/securities, and avoid the schizophrenia of SEBI norms for badla vs. SEBI norms for stocklending. Such a system is potentially safe enough to also obtain adoption at the NSE.
Back up to Ajay Shah's media page