Not just another scam

The episode involving the high-profile, Internet-based broker Home Trade and a few cooperative banks, among others, is not just another scam but one more indicator of the systemic faults and fragility generated by financial liberalisation.

IN the era of liberalised financial markets in India, it appears that even before the dust settles on one financial crisis there is a new one in the making. The latest is the ongoing revelation that a number of cooperative banks and financial institutions like Provident Funds have "purchased" government securities (G-secs) through means that flouted Reserve Bank of India (RBI) guidelines, only to discover that the instruments they paid for are not going to be delivered by their brokers. The matter came to light when on April 19 a NABARD (National Bank for Agriculture and Rural Banking) team scrutinising the accounts of the Nagpur District Central Cooperative Bank (NDCCB) reported to the RBI that while the bank had made huge investments in government securities, it was not in possession of the certificates for the same. The high-profile Internet-based broker Home Trade, it transpires, had obtained Rs.124 crores from the NDCCB for investment in government securities, but had not delivered the certificates. Caught out by the NABARD team, the chairman of the NDCCB, Sunil Kedar, was the first to file a complaint against Home Trade on grounds of cheating.

Since then it has been discovered that the disease was more widespread, involving an as-yet-unfathomed number of banks, financial institutions and brokerages. According to Union Finance Minister Yashwant Sinha, besides the NDCCB, purchases of G-secs without delivery have been made by the Wardha District Central Cooperative Bank (Rs.25 crores), the Osmanabad District Central Cooperative Bank (Rs.30 crores), the Sadaguru Jangli Maharaj Cooperative Bank (Rs.40 crores), the Amravati People's Cooperative Bank (Rs.9.5 crores), the Swarnayug Cooperative Bank (Rs.58 crores) and the Raghuvanshi Cooperative Bank (Rs.5.4 crores). According to the Finance Minister, besides Home Trade the brokers involved in the transaction, which were not completed, were: Indramani Merchants Ltd, Kolkata; Syndicate Management Services Ltd, Ahmedabad; Giltedge Management Services Ltd, Mumbai; and Century Dealers Pvt. Ltd, Mumbai. In his view the sums involved were close to Rs.275 crores.

Yashwant Sinha's statement, of course, referred only to the reports he received from the RBI, which relate to the set of banks in Maharashtra. But meanwhile evidence has emerged that the spread of the crisis is far greater. The NDCCB's complaint opened the floodgates. Besides the cooperative banks in Maharashtra, at least four banks from Gujarat (the Surat Nagrik Cooperative Bank, the Surat Mahila Cooperative Bank, the Karamsad Urban Cooperative Bank and the Navsari Urban Cooperative Bank) and, in an unusual turn, the Seamen's Provident Fund, have reported having invested large sums in as- yet-undelivered government securities.

When assessing the current crisis we have to take note of the fact that this crisis comes in the wake of a series of financial disasters over the last decade or so. We need only recall the engineered boom in stock markets in the early 1990s which involved all major Indian and foreign banks and the "big bull" Harshad Mehta, the subsequent periodic instances of alleged insider trading and price rigging by corporations and broking firms, the near collapse of the Unit Trust of India (UTI), the evidence of fraudulent lending practices by some of the apex financial institutions and, more recently, the infamous Ketan Parekh episode involving, among others, the Madhavpura Mercantile Cooperative Bank. In all these cases, investigations focussed attention on the ease with which one or more high- profile brokers or firms could access huge sums of money to play the market.

This time too the government and the principal regulatory agencies are seeking to dismiss the revelations as one more "scam", involving rogue traders operating in collaboration with unregulated financial institutions that have access to public savings. The description of the episode as a scam is facilitated by the fact that though the investments in government securities was legitimate they were made in an unlawful manner. Thus, they were not made in dematerialised (demat) form through a subsidiary general ledger account as required, but in physical mode. And some of the brokers, including Home Trade, had not been recognised fully as brokers for transactions involving such securities. But with the "physical mode" transactions not having led to delivery of securities the question as to where the money went remains. Not clear, say the investigating agencies, but diversion to the stock market for speculative purposes is a "hot" suspicion. But there is nothing to fear, says Yashwant Sinha, since the event is unlikely to disturb the financial system and deposits up to Rs.1 lakh are insured under the Depositors Credit Insurance Fund Scheme.

The emphasis on events such as these being a scam is not without motives. It helps detract attention from the fact that there are systemic faults in India's increasingly liberalised financial system. Those fault lines allow agencies authorised to mobilise household savings to divert, in this case through unlawful transactions involving legitimate investments in government securities, to cross the walls which separated different areas of financial activity during the interventionist, pre-reform years.

Consider, for example, the core of the current "scam" constituted by transactions involving a set of cooperative banks and Home Trade, which has once again seen a few hundred crores of rupees disappear into thin air. What is surprising is that this was a "scam" that was in the making before the very eyes of the regulators. Home Trade was an unusual venture inasmuch as at the time of its launch around two years back it combined activity in two areas which were both at a low if not in a state of collapse. The first was an Internet venture, in the form of a portal that provided information and entertainment to satisfy visitors interested in its principal activity. And second, its principal activity, which was to encourage Internet trading of stocks and shares.

This dotcom brokerage, ostensibly aiming to attract small investors who had fled the markets after burning their fingers, was launched with a high-profile advertising campaign that roped in celebrities like Hrithik Roshan, Sachin Tendulkar and Shah Rukh Khan. The campaign, estimated by one source to have cost as much as Rs.65 crores, was mysterious, since it long remained silent on the product being sold, and was geared at establishing the "Home Trade" brand and win customer confidence in the name. What it did not fail to do was to attract public attention, leading to much media discussion on the campaign itself.

The experience with dotcom failures abroad and in India, which spent huge sums of money even before earning a single unit of currency, should itself have alerted the authorities into scrutinising the venture. More so because, unlike conventional dotcom firms, this one had a revenue model that made it even more risky and suspect: to earn money through brokerage fees from small investors at a time when the market was by no means booming. The case for suspicion and a modicum of scrutiny would have been strengthened if the regulatory authorities had examined the antecedents of the promoters and its chief executive, Sanjay Agarwal.

Agarwal came to Home Trade with a reputation built during his days with Lloyd's Brokerage set up by Lloyd's Finance, one more Mumbai-based finance company that had picked up the name of an internationally known entity. Established in 1994, with a paid-up capital of Rs.2.2 crores, Lloyd's Brokerage soon acquired the reputation in market circles of being a "dynamic", market-mover. However, when the BSE Sensex fell by 367 points on a single day in mid-January 1997, the Securities and Exchange Board of India (SEBI) launched an investigation that came to the conclusion that there was prima-facie evidence that Lloyds Brokerage was responsible for the unusual volatility. By then the firm had changed its name to Euro Asian Securities (EAS), consequent to a sale of 75 per cent of its stake to Mauritius-based S.N. Investments. Speculative transactions, it appeared, were key to the strategy of the EAS, as it has been known to be of most financial entities. However, whether for lack of adequate evidence or other reasons, in October 1999, EAS was let off with an admonition by SEBI, which even permitted the promoters to offload 25 per cent of their stake through a public issue valued at Rs.32.94 crores.

Armed with those funds the EAS transformed itself into the Internet-based brokerage Home Trade, which was soon favoured with venture funding from two new sources, Euro Discover Technology Ventures and Euro Discover, which also established a second company called Ways India Ltd that functioned as part of the Home Trade group.

Given this rather labyrinthine evolution of Home Trade from sources that had been investigated for possible market manipulation, and given its seemingly irrational choice of area of operation and timing, the company was seen by many, barring the regulators, as being an operation that was suspect from the point of view of market prudence. Yet investigations into Home Trade's activities had to wait for the NABARD report on the NDCCB.

The route to discovering that Home Trade was a fragile venture that was bound to collapse from losses suffered by investors who had handed over large sums of money to the company, is indeed circuitous. After all, by March the financial press was reporting that both Home Trade and its sister company Ways India Ltd were downsizing operations and retrenching staff, many of whom had not been paid for some time. But neither the regulators nor the media found reason to investigate a company that had burnt up crores of rupees in a few months.

Sanjay Agarwal, who has since been arrested, is reportedly unapologetic. While admitting to some "mismanagement" in his debt servicing division, Agarwal is reported to have claimed that Home Trade has a "great financial model". At one level he is perhaps right. His was a model of changing form to pursue every option of speculative return that existed. When the project of earning huge commissions through Internet broking was found to be not working, he hoped to make large sums by garnering funds for temporary speculative transactions, by convincing clients to invest in G-secs in the expectation that their prices would rise since the government was keen on driving down interest rates. To find investors who would make their purchases through him Agarwal offered an extra 2 per cent return on investments, and targeted cash-rich but poorly regulated sectors such as the cooperative banks and small provident funds. His gamble did not work, leading to his being unable to deliver on his trades. But in keeping with what is the true business of finance, he at least gambled.

THE difficulty about making Agarwal the whipping boy when he is already well on the way down is that the exercise only serves to divert attention from larger issues. These are that financial markets, where information available to some is not available to others, are prone to speculation and failure. They therefore need to be tightly controlled or regulated. But India's economic reform programme has not only liberalised these markets substantially and devalued regulation, it has made the garnering of large profits by financial entities a sign of "efficiency". This legitimises speculation, so long as you are not caught out because of failure.

One result is that when failures occur it is not the system put in place by reform that is blamed, but the individuals who have been caught out because of failure. Liberalisation is persisted with and financial failure recurs. The problem is that failures affect not just the speculators or those involved in the bank-broker speculative nexus. They also threaten to wipe out a part or the whole of the savings of individuals, who have invested sums exceeding Rs.1 lakh in entities they do not control, but which they believe the government regulates. It is this trust in government rather than the confidence bought by huge publicity campaigns that finally explains the willingness of small investors to hand over money to entities similar to those who are known to have misused them in the past. Given that, it is not enough if the government wakes up each time it is faced with what it dismisses as a scam. It must undo the regime and the structures that render the system fragile.