Sebis Irrational Folly

It is all very well for the finance minister to berate stock markets for reacting on rumours rather than fundamentals, but the folly of investors cannot compare with the irrational absurdity of the minister's own regulators. In an astonishing press release on April 26, Sebi has ruled that when a transaction is carried over from one settlement to the next, sellers who cannot demonstrate that they own or can borrow a particular stock should not be paid interest charges. Thus, the new rule denies the legitimacy of interest payments to a seller in the case of what is technically known as a "naked" short.

 

Apparently the wise men of Sebi have discovered an asymmetry between the buyer who has to pay carry-over charges and the seller who does not.

"On the contrary," says the press note, "generally the short seller receives carry over charges. To provide level playing field to long buyers and short sellers, the Committee decided that the short seller who does not own shares or has not borrowed shares, the carry forward charges shall not be payable to the short seller. These carry forward charges will be credited by the stock exchanges to the Investor's Protection Fund."

This directive, if it is a directive, is probably illegal. It is surely not within a regulator's power to divert money to any cause of his choice (not even to a cause as worthy as the Prime Minister's Relief Fund let alone an Investor's Protection Fund). Sebi should be sued for issuing this directive. However, what is far more disturbing than the potential illegality is the economic ignorance and folly it demonstrates.

To understand these issues let the reader reflect on what the forward stock price should be if we had frictionless markets and perfect foresight. Economists call this sort of world as an Arrow-Debreu world. In such a world the forward stock price in equilibrium would have to be today's stock price plus interest. If that were not the case no one would buy or sell shares at today's prices. For if with perfect foresight the share price next year is expected to be the same as it is today, the optimal solution would be for everyone to sell all now put the money in the bank, earn interest, and repurchase shares next year.

The link between today's price and tomorrow's price is the rate of interest. It, therefore, follows that so long as interest rates are positive tomorrow's price has to be higher than today's price. This proposition is quite general and applies to all durable commodities. It follows that at least in the world of theory -- the price of stocks should be rising daily by the interest cost. Now, if you substitute rational expectations for perfect foresight you get the same result. The price of a stock is what it is because a buyer expects to earn at least his cost plus interest. Equally a seller expects to realise the sale price plus interest. Rational pricing, therefore, requires both seller and buyer to adjust their prices to take into account interest. This is the basic elementary model for rational pricing.

Ownership is irrelevant to rational pricing. The price is objectively calculated. The optimising rules of economics determine the price. In the case of consumable commodities the price is determined by marginal utility, and in the case of stocks and shares by expectations. It, therefore, follows from a rational pricing model that for any delay in settlement, for whatever reason, the buyer must pay interest and the seller must receive interest.

The confusion displayed by Sebi is not a small matter of semantics. It reflects their failure to comprehend a rational pricing model. Perhaps it also reflects their irrational prejudice against market systems that they have not designed themselves. However, since prejudice exists it is necessary to describe the carry forward system in detail.

The first and most important point to be aware of is that both the buyer and the seller are under an absolute and contractually binding obligation to fulfil their contracted bargain. Both the buyer and the seller are entitled to insist that the transaction be honoured. Thus, if a seller delivers stock and the buyer has no money he is forced to go and borrow funds from whatever source he can find. Equally, the buyer can insist on stock being delivered on date, which may require the seller to beg borrow or steal some for the purpose. There is no exception to this fundamental rule of stock exchanges world over.

Now, it so happens that in all markets, indeed in all contracts, there is the possibility of things going awry. Stock market contracts are no exception and, therefore, brokers and dealers plan for these contingencies. If a buyer does not have cash to meet his obligations, stockbrokers facilitate the transaction by borrowing from moneylenders. One of these potential lenders could be the seller himself who may be happy to postpone receiving money provided he is paid the interest. However, there is no obligation whatsoever on any seller to be a lender. If he wants the cash he must be paid the cash on the agreed date.

Equally if a seller does not deliver stock on the due date brokers can facilitate the transaction. One way is by matching off the seller against a buyer who needs credit; another by asking buyers if for a premium they will settle later, a third facility is by arranging to borrow the stock, by paying interest. Finally, if none of these options work, the seller's position is closed out so that he is forced to buy back on or before the due date whatever the price. If the stock is not readily available the cost of repurchase can be prohibitive but that is precisely the risk that sellers take.

And it is this point about risk that Sebi has ignored. That risk is taken on at the time of contracting and is not enhanced or decreased by all the subsequent events. "Naked sellers" take this risk. If the stock is liquid or readily available the risk is relatively small. However, if the time period for final settlement is extended the risk is renewed. At the end of each settlement both buyer and seller must compensate for any losses.

It is in this matter of compensation that the Indian badla system is greatly superior to systems in other parts of the world. Before the transaction can be carried forward, both the buyer and the seller are required to pay and entitled to receive all price differences between the contract price and the market determined settlement price. This sensible Indian system evolved as a result of a historical accident, and ingenuity, which compelled them to emulate the practices of commodity markets, where delivery seldom takes place and price differences are settled in cash. The new contract of differences now trading in London is a step in the same direction. That is what the rest of the world is moving towards. It is, therefore, a great pity that the most modern part of the Indian system is under attack through the irrational folly of inexperienced regulators.