Why Badla Must Stay

Although Sebis concerns were justified, there was a widespread feeling that suspending badla altogether without having a viable alternative in place was harmful to the Indian capital market. In response to these rumblings, Sebi appointed a committee under the chairmanship of G S Patel to review the badla system. It was widely felt that a reformed badla system would bring in the much-needed liquidity and buoyancy to the stock market. The broad thrust of the committees recommendations were:

Imposition of a 90-day limit on carry forward of transactions.

Imposition of a four track trade segregation, namely, jobbing, carry forward transactions, trading for delivery and trading on own account.

 

Impounding of 25 per cent of profit on carry forward transactions.

Acceptance of margin payments in the form of securities.

The final version of badla trading approved by Sebi on July 27, 1995 appeared to be essentially in line with the G S Patel Committee recommendations. The difference was an additional feature: the introduction of a step-wise margin structure. Under this, the steps would go up from 20 per cent in the first settlement to 50 per cent for the fourth settlement. The condition was that the carry forward business may not exceed 25 per cent of the total business of a broker.

These proposals remained unacceptable to the market and badla trading never revived. The reasons were not far to seek. For one, there was little justification for limiting carry forward transactions to 90 days. For, a contract carried forward with the obligations of the previous contract being fully honoured, is as good as a new contract. Secondly, there were problems with the four-track trade segregation system which had margins going up to 50 per cent in four steps. The main concern was that it would be near impossible to administer such a complicated system, especially as the bourses had failed to follow a simpler, single-tier system with margins as low as 10 per cent.

In fact, the M S Shoes episode showed clearly how poor margin enforcement could cause serious problems even in cash trading. It will be a mistake to believe that defaults and payment crises are products of badla trading alone, and that it is necessary to segregate carry forward transactions from other transactions.

Sebi must recognise that mere stipulation of various restrictions is not enough to ensure market compliance. Especially if the stipulations do not enjoy a broad acceptance in the market. Also, Sebis excessive concern at there not being enough deliveries or settlements under the badla system is misplaced. Even the derivatives markets are not really meant for actual deliveries or settlements. All in all it would appear that notwithstan-ding Sebis intentions, the proposed sche-me not only alte-rs the basic character of the badla system developed over the decades rather abruptly, it is also difficult to operate.

Making badla palatable

In the badla system, typically, there are myriad margins, namely, carry forward margins, daily margins and adhoc margins. It may be far more desirable to adopt a system where a single transaction margin of, say, 25 per cent is paid on the day a transaction is done both by buyers as well as sellers. On the weekly settlement day, the margin amount could be reviewed and adjusted to account for deliveries and the prevailing prices, ensuring that the margin continues to be 25 per cent of the value of the transactions carried over. This system of paying transaction margin should be applicable not only to scrips listed in the specified category but also to those listed in the cash category.

The carry over facility may be denied to the cash scrips. In this system of carry forward trading, whenever a transaction is carried forward, the badla / undha badla and the price differences are settled in keeping with the traditional badla system. The margin carried forward would be computed on the basis of the net outstanding position at the end of each week. The transaction margin will ensure that:

Unless the prices change by more than 25 per cent within a week within a settlement period the margins would provide complete safety from default on all transactions.

There would be no incentive to indulge in Chalu Upla since the margin is to be paid on the basis of transactions struck and not on the basis of carrying them forward.

Both bulls and bears would have to lock in their own funds to the tune of 25 per cent to sustain their positions.

Since the contango or backwardation charges and the price differences are settled, as they have always been under the traditional badla system, and the margin carried forward will be on the basis of the net outstanding position, a broker does not have to pay hefty margins when he squares off his position.

The derivatives market

Let us take a look at some of the issues relating to derivatives that concern badla trading. Technically, it should not be difficult to introduce derivatives in the country in a relatively short time. However, in this context, it is pertinent to take a leaf from the Chinese experience with derivatives. In the last five years or so, about 15 official exchanges (and several unofficial ones) were set up. These trade in a whole array of derivatives ranging from commodities to government bonds. The absence of an effective clearing house mechanism and the consequent slackness in enforcing the margin calls combined with the Chinese predilection for punting created such havoc that China is on the verge of banning all derivatives altogether, at least for now.

It must be recognised that a daily marking to market will call for a nationwide computerised clearing house capable of handling huge volumes several times that of the current level of trading in the BSE.

What is more, it will call for a degree of discipline that comes only after years of self regulation, so that the derivatives are used primarily as hedging tools and not as instruments for punting in their own right, as has been the case in China. This calls for enforcing margin payments with a weekly settlement with badla trading for, say, three years before we move on to derivatives.

In a nutshell, what is important is that we give the badla system a renewed lease of life in a manner which will train us adequately to move into the more advanced world of full-fledged derivatives without the kind of hiccups that China has had. Introducing derivatives by banning badla, combined with our poor enforcement record, may be a prescription for ensuring the failure of the derivatives experiment. Even if the derivatives market were to be ushered in, it would be best to let market forces decide the exit of badla rather than ban it forcibly. It is essential that our transition from badla to derivatives is smooth and irreversible, unlike China.

(The author is a professor of finance at the Indian Institute of Management, Ahmedabad)