Why track down Rooplaben?

Business Standard, 18 January 2006

A few months ago, when Manjunath was murdered, at first there was an uproar about bad law and order. While concerns about bad law and order are certainly well placed, in this case, the incentive for criminal activities clearly came from government-induced pricing distortions in petroleum products. Just as the problem of smuggling was caused by India's trade barriers which went on to corrode the police, the problem of Manjunath's murder was caused by India's oil pricing policies, which went on to corrode the police.

A similar situation has shaped up on the IPO market. The root of the rot is a pricing policy which gives supernormal returns to "individual investors". In the IPO market, a "small investor" is defined as someone applying for less than Rs.50,000 of shares. In the Yes Bank IPO, the oversubscription for such "small investors" was 9.96 times while the oversubscription for the remainder was 43.68 times. This gave "small investors" a four-times bigger allotment of shares.

If you got shares of Yes Bank at the IPO and sold at first listing, this gave you an instant profit of 36%. How do you think people will respond to such a situation? By tossing in more applications! A family of five will put in five different applications, each at Rs.49,999. A family of five will create five fake identities each, and thus have 25 applications. And so on it will go, to a point where some people will muster thousands of applications. It is hypocritical to pour invective upon someone who puts in 5,000 applications, while ignoring the ordinary household that puts in 25 applications.

When the IPO market is structured in this fashion, there is endemic falsfication, and ordinary citizens engage in fraudulent behaviour. When a certain activity endemically takes place amongst ordinary, middle-class households, no police force in the world can stop it. In a democracy, when there is a collision between law and mass behaviour, ultimately it is the law that has to budge.

In some countries, there are strong notions of a citizen's identity, which uniquely identifies each person. An enormous enforcement infrastructure has been developed in those countries, to enforce stringent penalties against people who have multiple identities. If such identity infrastructure existed, then it becomes feasible to enforce rules such as "no more than one application per citizen". But even there, it is unfair that a family of six can toss in six applications while a family of two can only put in two applications. In the Indian case, given the absence of identity infrastructure, enforcement against multiple applications is just infeasible.

The Finance Minister has promised a crack down on the "IPO Scam". Hundreds of staffpersons at the Ministry of Finance, RBI, SEBI, NSDL, etc. are now expending their energy in hunting down multiple applications in recent IPOs. Is this an efficient use of scarce regulatory and governance capacity?

The core problem lies elsewhere. The core problem lies in a pricing distortion that has been created by SEBI. The solution that is required is to eliminate this distortion.

There is no case for special allocations for "individual investors". The ultimate aim of a good IPO mechanism is that the price discovered in the IPO auction should be practically the same as the price at first listing. If an IPO takes place on Friday, and trading starts on the next Monday, then on average, the Monday closing price should be the same as the IPO price.

Once this is done, there is no "special profit" in buying at the IPO, that can be politically allocated to "individual investors". Individual investors who didn't obtain shares in the auction would be able to buy them on the secondary market on Monday at essentially the same price.

The way forward, thus, consists of removing the frictions that are in our IPO process, which are generating a gap between the IPO price and the first listing price. Our IPO mechanism has made enormous progress compared to the bad old days, when people filled out forms and sent them out with a cheque attached, by post. We have started using computer technology to reduce the frictions. But partly owing to the business interests of investment bankers, we have stopped short of the logical destination : IPO by pure auction through NSE and BSE.

Here is how it would work. The investment banker would help the company to write the prospectus, and do roadshows across India, but have no other role in the IPO. On a Friday, the auction would take place from 9:55 to 3:30. As with secondary market trading, there is no need for a "price band", which only limits price discovery. Investors would go to a broker to place orders in the auction. All brokers in India would be able to accept orders for the IPO, exactly as is the case with the secondary market today. Exactly as with the secondary market, the broker would be held financially responsible for the orders placed by investors.

The screen would continually display the market-clearing price and the demand schedule. Investors would have the ability to revise their bids if they change their minds based on looking at the demand curve. At 3:30 PM, the computer would calculate the cutoff price, and apply it to all successful bidders. By definition, there would be no oversubscription.

The greatness of India's secondary market for equity has been that all investors -- retail or institutional -- participate in a single unified price discovery. The success of unification of all orders in the secondary market shows that this is feasible in the IPO auction also. A financial market is about prices, where the highest bidder gets the securities sold in the auction, and not about the identity of the participant.

The ultimate cause of smuggling was our trade barriers. The ultimate cause of Manjunath's death is our pricing distortions on petroleum products. The ultimate cause of the "IPO Scam" is mistakes in the design of the IPO market. Instead of expending thousands of man-hours of staff time in hot pursuit of Roopalben, we should solve the problem at the source. This requires moving up to the next level: an IPO market based on a pure auction. Everyone benefits in such a scheme, except for the investment banker who makes less in fees.

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