Carry-Forward Crisis

Last week's stock market crash has been attributed to a range of reasons from the Southeast Asian currency crisis to the bulk selling by foreign institutional investors. But in the flood of analysis that followed, one little-understood cause has been overlooked: the revised badla trading system.

As the payments imbroglio showed, the resumption of badla has increased the systemic risk and the dangers of manipulation in the market without matching measures of stringent surveillance. To understood why, take a close look at what happened on the Bombay Stock Exchange (BSE) last week.

Last week BSE was in a grip of nervousnesss on fears of payment crises as a number of brokers offloaded their huge positions built up in Harshad Mehta's pet scrips BPL, Videocon International, Penatfour Software and Sterlite. On June 16, brokers offloaded around 10 lakh shares of BPL and 10-15 lakh shares of Videocon International without any buy orders on the BSE terminals. The total value of these shares was Rs 80-100 crore.

 

The cumulative net sale positon in BPL on June 16, stood at 525,500 (almost four times the floating public holding), while the net long position stood at 1,005,700. The problem was similar in the other three stocks. The short sale position in Videocon International, Pentafour Software and Sterlite in volume term was 1,067,600, 190,800 and 443,900 respectively. The long positon was 365,600 for Videocon International, 467,400 for Pentafour Software and 137,300 for Sterlite. These huge sale orders come on the heels of a record carry-forward (badla) rates of 150-180 per cent.

This panic in the market saw the BSE-Sensex touching a new 18-month low at 3,152.96 on June 15, 1998. A further slide in the market was averted when Sebi imposed an additional 10 per cent margin on incremental carry forward position and five per cent on concentrated positions in scrips with effect from the next settlement.

On June 16, Sebi further tightened the screws on market players with fresh measures, which effectively bannned short sales for a temporary period. According to Sebi's instructions, from June 17, net outstanding sale positions at the end of any trading day in each security will have to result in delivery. However, for carry forward trades, all outstanding short sales positions at the end of trading on June 16 will have to be squared up in the following manner: at least 50 per cent in the current settlement and the balance in the succeeding settlement.

SEBI's measure had its impact on the market as the BSE-Sensex jumped 240 points to 3400.95 points on June 17. But the Sensex continued to dip subsequently on both days.

Badla - the root cause

There would be few takers for the fact that badla is the root cause of the present panic on the BSE. But nothing highlights this point better than the fact that most NSE brokers were comfortably placed against BSE brokers.

Badla, as everyone knows, is essentially a facility for borrowing funds or shares with which speculators obtain leveraged positions on the market. The motive for is inherently speculative but this is not a bad thing: 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.

Leverage, that is buying shares using borrowed money, is a potent tool in badla mechanics. A highly leveraged position would be one where a person with funds of only Rs 100,000 is able to take position of Rs 1 crore on an asset. The major rationale for leverage is quick gains: a price rise of two per cent would yield a profit of Rs 2 lakh, that is 200 per cent of the initial capital investment.

But leverage is a twin-edged sword, when the price drops by two per cent, there is a loss of Rs 2 lakh, which could result in bankruptcy. These bankruptcies lead to payments crises, which should never take place in a healthy market. This is what has happened now.

Leverage also goes well with market manipulation. If a leverage of ten times is made available, then we can visualise Rs 10 crore in the hands of a speculator turning into positions of Rs 100 crore on the market. And most speculators prefer to choose scrips with a relatively small floating stock as it would be difficult for sufficient liquidity to exist in the market.

Thus, the essential problem with badla is the lack of transparency and dangerous levels of leverage it allows. It is the leverage embedded in badla that fuelled the 1992 stock market scam and the steady stream of payments crises in India's markets in the past.

Revised badla is even more fragile

The revised carryforward system suggested by the J R Verma Committee report is fragile and should be blamed for the present payments crisis on the BSE. The modifications included reduction of the daily margin on carry forward to 10 per cent from 15 per cent. Moreover, only half of this had to be paid upfront. Further, the carryfoward limits per broker and per settlement were raised by almost three times to Rs 20 crore from Rs 7.5 crore. The sub-limits imposed on sales and purchase positions for individual scrips were withdrawn. The limit of Rs 10 crore imposed on financiers of carryforward trades was also removed. The net effect was to give a major thrust to the growth of the carry foward business which did succeed in boosting the markets but the costs of doing so are becoming clear now.

To be fair, the Verma committee had emphasised the need for a proper surveillance system before implementing its recommendations. The breakdown of BSE's surveillance system seems to suggest that this warning was not heeded. The BSE failed to collect margins

promptly and brokers who had built up huge positions were allowed to trade further - their terminals were only switched off this week which is probably a little too late. The exchange has also been lenient in collecting margins from brokers.

Possible alternative

The crucial question now is how do we measure the quality of badla in operation? Watching trading volumes flowing through badla as a measure of quality is quite wrong. The litmus test consists of watching interest rates in lending. If the interest rates resemble junk bond rates, as badla financing charges frequently do, then the risk of default the same as junk bonds. For example, the annualised badla rate for Reliance, one of the most liquid stocks on the market, is only 8 per cent while that of BPL was 185.56 per cent (for the week ended June 13, 1998).

How do we resolve this situation by balancing the useful access to borrowed funds and securities while avoiding the dangerous leverage and manipulative potential? We can isolate four principles and a litmus test:

* The clearing house must intervene, becoming the legal counterparty to each leg of every loan, so that if one party 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.

* Margins should be strong enough to disallow such positions and protect the integrity of the clearing house. Both types of margin are essential for safety. Without the mark-to-market margin, losses could accumulate, wipe out the initial margin and cause bankruptcy. Without the initial margin, dangerous positions can be adopted without collateral, where small price drops would yield bankruptcy.

For the small investor, besides watching net long and short positions, the badla rate would be the only indicator of risk. Higher the rate, higher the stocks can fall in adverse conditions.