With the completion of the report of the badla committee and the near completion of the work of the derivatives committee (both appointed by Sebi), the badla controversy, that has dogged the Indian capital market since the securities scam of 1992, has been revived. The intensity of the controversy is also being fuelled by the rivalry between the two largest stock exchanges, with the National Stock Exchange (NSE) supporting introduction of derivatives and opposing introduction of the modified carry-forward system (MCFS), and the Bombay Stock Exchange (BSE) supporting the introduction of MCFS. The debate, based less on objectivity and more on emotions, is doing considerable harm to the cause of the Indian market.
The derivatives committee, as can be gathered from press reports, has severely criticised badla on the grounds that it distorts prices of securities by facilitating speculation. Transactions that do not result in delivery have been regarded by the committee as speculative. Empirical evidence from the last two and half years data on the operation of the NSE, which does not permit carry-forward of transactions, shows that the proportion of delivery in relation to the volume transacted (at the NSE) has consistently been well below 20 per cent. This clearly demonstrates that badla is not a pre-requisite for speculation. Thus, the basis of the committees argument against badla is not supported by empirical evidence.
A deeper examination of the argument put forth by the derivatives committee against badla, throws up an internal inconsistency in its arguments. If the committee indeed regards speculation as being undesirable for financial markets, then how is it recommending the establishment of a derivatives market, with introduction of index futures as the first step in developing such a market? Index futures contracts would be far more speculative compared to carry-forward of transactions. In addition to being cash-settled, they are of a much longer duration and are far more leveraged because of much lower margin requirements, compared to carry-forward transactions. There is thus complete dichotomy between the committees views on speculation (in the context of badla) and its recommendations (on derivatives market).
What needs to be done at this juncture to accelerate the development of the Indian market? One of the major lacunae in the Indian market today is the absence of risk-hedging mechanisms. Had hedging instruments been available, at least some of the mutual funds would have avoided the blood bath wreaked by the long bear phase. An obvious measure to remedy the situation, as rightly recommended by the derivatives committee, is to establish a derivatives market. The further recommendation of the committee that index futures should be the first instrument to be introduced is also correct, given the need for an instrument which could provide protection against an overall decline in the market. One also agrees with the caution sounded by the committee that for the derivatives market to function effectively, it is desirable to have a liquid cash or delivery market.
The committee, however, undermined the credibility of these sensible recommendations by lambasting badla, using arguments which undermine the very basis of its own recommendations. It has, perhaps, taken this stance because it views badla as an alternative to futures, and, therefore, it has attempted to deal a knock out blow to badla, the competitor! However, such a combative view is entirely misplaced. Badla, being at best an imperfect hedging tool, would never be able to compete with futures as a hedging instrument. Its main utility lies in what the committee would like to achieve, namely, a liquid cash or delivery market.
One of the peculiarities of the Indian market is the risk faced by investors in transfer of shares. Investors have to contend with a plethora of reasons for which shares may not be transferred. As long as physical certificates dominate transactions, this risk would be substantial. Though the process of dematerialisation has begun, one does not see physical certificates disappearing from the Indian market in the near future. The response of investors to this transfer risk is to avoid delivery-based transactions, even when they have the requisite resources to support their transactions. The badla system facilitates in transacting in the market without transfer risk and thus enhances the liquidity of the market. Its other utility is that it considerably enhances the flexibility with which investors can react to changes in the prices of securities. Such flexibility is good for the market, since it dampens extreme fluctuations and by letting relatively less endowed but more skillful investors to operate with
ease, ensures that a small group is not able to dictate terms in the market. Through this, badla enhances market efficiency of the market.
Therefore, badla and futures complement rather than compete with each other. The antagonism between the NSE and the BSE in this context is, therefore, quite misplaced. They should instead co-operate to introduce both the MCFS and index futures. Over time, both the markets would benefit from larger volume of trading and greater liquidity of markets. It is conceivable that over time, there would be a natural segregation in the functions of the two markets, with NSE emerging as the premier futures market and BSE emerging as the premier cash market of India.
Acceptance of a collaborative approach to the issue would still require finalisation of implementation details. Given the long experience of market participants with badla, it would be easy to introduce the proposed MCFS. The introduction of index futures, however, would require careful planning, given the lack of familiarity of market participants with futures. One of the main issues to be settled would be the composition of the index on which the futures contracts would be based. NSE-50 (which has been chosen by the committee) may be an inappropriate index for futures contracts, since the set comprising NSE-50 has far too many highly illiquid stocks. Stale prices and high costs of transacting in the cash market would significantly weaken the linkage that should exist between the futures and the cash market. The committee needs to examine the issue of defining another index, comprising may be just 10 to 15 scrips, for the first index futures instrument. Such an approach was successful in South Africa. Over
time, as the markets becomes more liquid, futures on more representative indices could be introduced. In addition, it would also be worthwhile to organise seminars for brokers and other market participants on derivative instruments. These should be based on relevant empirical work on the Indian capital market.
Sebi should bring the combating sides together to facilitate establishment of both a futures market and the MCFS. The goal should be to build futures on the foundation of badla! The finance ministry too should play a more positive and supportive role to ensure that misinformed criticism in political circles does not derail these much-needed market reforms again.
Samir K Barua is Professor, Indian Institute of Management, Ahmedabad.
