What went wrong with the equity market?

In recent weeks, we have been treated to a rerun of an old script: a stock market crisis. The head of a stockbroking firm I respect greatly poignantly described it as "a fresh outbreak of violence in a riot-prone town".

The difficulties faced here are of the highest importance. We have given a large role to financial markets in shaping resource allocation. The "votes" of the financial markets determine who gets capital, to build what kinds of products, using what kind of technology. With this design of the economy in place, financial markets are central to the project of India's development and escape from mass poverty. Now our job is to learn how to make the financial markets work.

It is only a small exaggeration to say that every financial crisis is rooted in improper handling of leverage. Leverage describes situations where positions or portfolios are built out of borrowed money. For example, banks are extremely fragile institutions because at their foundation is frightening leverage: for every 10 rupees of shareholder capital is 90 rupees of borrowing. Leverage magnifies risk, and risk requires risk management.

We obtain crises when the intellectual capital and governance available for risk management are incompatible with the leverage that is present. It is important to have a nuanced view of this point. Leverage is not innately bad. Leverage is a great tool, and derivatives markets, which are the personification of leverage, perform an extremely precious function. However, leverage requires strong intellectual capacity, for soundly designing and implementing risk management systems, and leverage requires high quality governance, in order to prevent these systems from being subverted from within.

The Indian equity "spot" market suffers from highly leveraged trading. This is owing to (a) the lack of rolling settlement and (b) the use of mechanisms like "badla". These features imply that it is common for market participants to build up large positions when compared with their own liquid capital. In roughly every country in the world, the spot market operates using "rolling settlement", where leveraged positions are limited to exist within one day. The typical recipe that is used worldwide is to have a simple, boring equity spot market using rolling settlement (which works smoothly without requiring great inputs of knowledge or governance) coupled with a strong derivatives market (which serves up leverage while requiring strong inputs of knowledge and governance).

Rolling settlement. The finance minister has announced that we will move to rolling settlement by July. This is clearly the right step to take immediately, and marks an important milestone in the history of India's financial markets. However, we should be careful in understanding the issues. Is it possible to have a safe and sound equity spot market without rolling settlement? The answer is clearly yes: witness NSE. NSE has largely worked well through the numerous major and minor crises which took place since 1994, while having leverage which is only a little lower than the other exchanges.

In this case, why is rolling settlement important? There are two reasons. First: rolling settlement will give us a safer and less violence-prone equity spot market even with exchanges which have inferior risk management and governance. Second, rolling settlement is innately superior from an investors standpoint, because it shortens the delays for converting securities into cash and vice versa.

Novation at NSCC. This crisis has also highlighted the strength of NSCC. The trade guarantee funds have been exposed as being poorly designed, and replete with governance difficulties. In contrast, the NSCC structure has displayed superior financial and legal engineering. NSCC has lost money in this crisis, but it has worked flawlessly as far as the external world is concerned. One simple strategy which can greatly reduce the systemic risk of India's securities markets is to have NSCC do clearing for other exchanges.

Improving BSE, CSE. The next question that has been asked is: Why do BSE and CSE have failures of knowledge and governance, and what can we do about it? For the forseeable future, a government bureaucrat will run BSE (and probably CSE also), but where do we go beyond?

The notion of brokerage firms having management control of a stock exchange has always been replete with conflicts of interest. The path to improved governance clearly lies in separating the brokerage business from securities infrastructure. The modern view is that brokerage firms should be McDonald's franchisees: focusing on running brokerage firms with no control over how the exchange runs. NSE is an eminent success story of this approach.

The limitations of demutualisation. Demutualisation is a necessary condition for obtaining a franchisee arrangement, but it is absolutely not a sufficient condition. If we only convert BSE from an association of persons (where each card has one vote) into a limited liability company (where each firm has one share), nothing changes about the conflicts of interest. We would have the same board, the same organisational culture, and we would have achieved nothing.

There have been newspaper reports about SEBI steering the demutualisation process for BSE. I think such a strategy would be a mistake, for two reasons. First, it is not for government to solve BSE's management problems. Further, as the above arguments suggest, demutualisation by itself will not achieve improved governance.

Dealing with BSE, CSE. Government should instead operate on two principles. First, stock brokers should be prohibited from being on the board of a stock exchange, or from performing administrative functions. Second, episodes like the Scam '98 or the Scam '01 should generate restrictions upon the activities that errant exchanges are allowed to undertake. BSE was a malfunctioning exchange in 1998, so SEBI should not have allowed it to enter into new areas (e.g. depository) for a period of (say) five years. Such restrictions would give the exchange an incentive to produce atleast five years of scandal-free functioning in order to then obtain growth opportunities.

SEBI. The crisis has shown SEBI in poor light. Since 1996, experts have known about the superiority of NSCC's financial and legal engineering; SEBI supported the trade guarantee funds. Since 1996, experts have known about the need for rolling settlement; SEBI resisted this. It is a stroke of good fortune for SEBI that CDSL has proved to be largely inconsequential. BSE's standards of governance could have generated a large crisis at CDSL, raising questions about why SEBI gave BSE the green light for doing a depository immediately after sacking the BSE president.

Scam '01 could well be the last major crisis on the equity spot market, if public policy positions are crafted with care. Once rolling settlement comes about, we will be playing with fire on the derivatives market, which is where the next crisis will appear. There will surely be an exchange which will want to trade futures on the "K-10 index" or options on PENTAFOUR.

At that time, SEBI should be asked questions about how permissions were given out for product designs and management teams behind derivatives trading. More than any exchange, SEBI requires acutely high standards of intellectual capacity and clean governance. We have many miles to go in terms of institution building in this area.

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