Farewell to the badla old days?

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Speculators may be the stars in a bull market but in a falling one they are the villains.
After a precipitous market fall in March led to a default on the Calcutta bourse and the arrest of a Bombay broker, Indian regulators decided to accelerate reform of the stock markets. Few are cheering. The Bombay Stock Exchange 30-share Sensex is down by one-fifth since early March and the crisis snuffed out trading volumes. Daily turnover of over Rs100 billion a day in early March shrank to about a quarter of that by June. Many fear worse is to come after the reforms are introduced.
Indian stock markets were a curious amalgam of a cash and futures markets. Speculators thrived on an antiquated settlement system and only one tenth of trades were actually settled. From July 2 the cash market will be separated from the futures. Trading in 414 of the most liquid stocks - of the 7,000 listed companies - that account for about 98% of turnover, will be settled every day as India's 23 stock exchanges move from a weekly settlement to T+5.
Many firms that made money arbitraging between exchanges will go of business. Badla, a futures and stock financing product popular with local speculators, will cease to exist replaced by derivative products such as index and stock options.

No-one expects the transition to be easy. Jayanth Varma, a former board member at Securities Exchange Board of India who headed its risk management committee, quit just days before the reforms, which he helped design, were to come into effect. Varma says he is returning to teaching and has not "taken the decision in any haste", but fends off criticism of the regulator's actions.
"It is easier to build a modern stock exchange from scratch than change century-old trading practices," he says. Traders loathe any change in the market because many thrive on its imperfections. When trades were settled once a week, speculators could bet on share prices during the week and net off trades without having to deliver any shares. Sebi's move to introduce daily settlement for 163 stocks last year came in for sharp criticism after an alarming fall in trading volume.
Badla - which allowed trades in certain shares to be carried forward by a week without settling them, essentially taking a view on future prices - was banned after a stock market scam in 1992. But a safer version with risk controls was reintroduced after hard lobbying by brokers. Many trace the cool response to trading in futures, which started last year, to the continued existence of badla. Says Varma: "By separating the cash market from the futures, each will be better able to do its job." The days of products such as badla are numbered, he adds, when superior products such as futures and options are in the market.
Yet badla played an important role in financing stock trading, a role that Indian banks are reluctant to take on. The lack of access to alternative institutional finance is perhaps the sole reason why badla's demise could be considered premature. UR Bhat, chief investment officer at Jardine Fleming, says: "Banks do not have any significant exposure to the equity market despite the recent easing of regulation."







View graph.

Bhat says the March crisis might have precipitated too many reforms in one go, making the transition harder to manage. "Badla could have continued for a specific transition period till investors got familiar with trading options and futures," he points out. Bombay Stock Exchange, the oldest and second largest of India's equity markets, is virtually on auto pilot after all broker directors were sacked in the wake of the crisis. Ajit Sanghvi, a BSE broker, says tax rules are unclear about how profits or losses from trading in futures are to be treated, but feels brokers are too discredited to get anyone to listen to them.
Foreign investors, who have invested $14 billion in Indian equities, fear the drying up of liquidity will mean higher transaction costs. "Rampant speculation on Indian bourses helped foreign investors put through large transactions without moving the market. A smaller cash market dominated by institutional investors will mean higher impact costs in the near term," says a US investor.
Alok Vajpeyi, chief operating officer at DSP Merrill Investment Managers, points out that institutional investors incur higher costs when they are unable to hedge portfolios. He points to a recent study by a leading US investment bank that says transaction cost could be cut to 1/5 if fund managers used the derivatives market to hedge rather than hedge themselves in the cash market selling and buying back stock.
The actions of institutional investors will have a magnified impact in a less liquid market, says Anup Maheshwari, a fund manager at DSP Merrill Lynch. There are too few Indian institutional investors to provide a divergent view. Current rules do not allow pension funds to invest in the stock market. Those that can - such as the two state insurance companies and development banks - cannot borrow or lend stocks.
Foreign investors will be the main market movers. They have pumped in $2 billion so far this year, buying when the markets were in free fall. But Sebi says fresh investment is slowing, particularly after the 3% fall in India's weighting in the MSCI Emerging Market Free Index.
If the derivatives market takes off, it could bring new life to the cash market.. Foreign investors have shown little interest in futures so far and domestic mutual funds may not use derivatives for speculative trading. But if there is money to be made in options, Indian speculators will find a way to trade them.

No. 6: If you don’t give it to me you’ll only lend it to someone else and look where that got us

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Farewell to the badla old days?

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