`Margin-trading did not cause the crisis'

Interview with L.C. Gupta, director, Society for Capital Market Research and Development, New Delhi.

SANE voices are hard to hear in the cacophony of the markets. Dr. L.C. Gupta, director, Society for Capital Market Research and Development, New Delhi, is one such. A former member of the Securities and Exchange Board of India (SEBI), he chaired in 1998 a committee appointed by the regulator to examine the issue of derivatives trading. He has also served on several committees appointed by the Reserve Bank of India and the stock exchanges and taught in several institutions, including the Delhi School of Economics.

Author of several books and research publications, L.C. Gupta has been a consistent champion of reform that would deepen the securities markets, discipline the trading regime and arrest volatility. In this telephonic interview he articulates his perceptions of what is wrong with the Indian bourses. Excerpts:

Markets have crashed in the past. How is this crash different from earlier ones? Commentators have given various reasons for the recent happenings. What, in your opinion, makes the markets behave the way they have done in recent weeks?

Every market crash is different from the other in terms of the specific causes. No two are the same. This is as true for the Indian markets as it is for other markets. For example, in the U.S., the 1929 crash was different from the one of 1987. In India, the crash of 1992 related to the Harshad Mehta phenomenon and the crash associated with Ketan Parekh in 2001 happened for apparently different reasons. In 2004 the market crashed after the UPA [United Progressive Alliance] government assumed office.

One common element in these crashes is that they happened after a period of - to use [former Chairman of the U.S. Federal Reserve] Alan Greenspan's expression - "irrational exuberance". One can find any reason to justify the sharp increase in stock prices. One could say the Indian economy is strong, or one could say profits of companies are going to increase sharply. The point is that euphoria is taken to extreme levels.

Why are Indian markets regarded as among the most volatile in the world?

Historically, our markets have been more volatile than markets in developed countries. I had compared the volatility in the Indian markets vis--vis markets in 10 developed countries between 1990 and 1999 using SEBI data. In the U.S. and the U.K., throughout this period the volatility - measured by the standard deviation of percentage daily returns - was generally less than 1. In India, the volatility was much higher throughout the period, almost double, and in some years even three times higher. The volatility in the Indian markets was also higher than that of markets in Australia, Hong Kong, Singapore, Thailand and Malaysia, except in 1997-98 when the markets in Asia were affected by the financial crisis.

The volatility was felt to be because of the badla system, against which I led a crusade. But even today the volatility in the Indian markets remains high. A study I conducted recently, comparing the volatility of the Sensex with that of the Dow Jones Industrial Average between February 1, 2006 and May 19, 2006, establishes this. I compared the percentage daily movements of both indices. While in 61 per cent of the days the Dow's volatility was less that 0.5 per cent, the Sensex exhibited this range of volatility only in 21 per cent of the days. At the higher end of the volatility range, in none of the days was the intra-day movement of the Dow more than 2 per cent. In contrast, in one out of every six days [about 17 per cent] the intra-day movement of the Sensex was more than 2 per cent.

People have given different reasons, but they are generally superficial. They have claimed that the crisis in margin trading or the Central Board of Direct Taxes draft instructions caused the crash. But why did the margin-trading crisis happen? It did not cause the crisis. It is itself the result of high volatility, which is the much deeper malady.

You have spoken about the "architectural" weaknesses in the Indian markets. What are these and what needs to be done?

These weaknesses are the fundamental reasons why our system is so vulnerable. There are several architectural weaknesses. The most important one relates to our trading structure and the dominance of single-stock futures. I chaired the committee on derivates trading which submitted a report to SEBI in 1998. It did not recommend trading in single-stock futures, which commenced in 2001 after the Ketan Parekh crisis. Badla was abolished and brokers complained that they had lost their bread and butter.

Single-stock futures started as a result of lobbying by brokers. Index futures had started earlier but brokers were not interested. They were not interested in hedging activity. They were only interested in speculative activity.

Why are single-stock futures so much preferred by the speculators?

People who were earlier badla traders are the ones who indulge in this. In single-stock futures trading you do not have to pay for the full value of the shares you buy; you only have to pay a small margin. In contrast, if you buy in the cash market, as most household investors do, you have to make the payment in full. The fact that you can buy shares by investing only a fraction of the price of the share makes it possible for speculators to manipulate the single-stock futures market.

In futures trading the margins are very low as it allows for large-scale speculation. In fact, prices can also be manipulated if there are cartels in the market. The FIIs can do this very well. In my opinion, FIIs should not be allowed to trade in single-stock futures. The dominance of single-stock futures is the most important architectural weakness. It arises from certain other features of the futures system.

When single-stock futures trading was introduced, it was originally envisaged that there would be a physical settlement when the futures contract matures [typically, on the last Thursday of the month with contracts for three months running simultaneously at any given point of time]. This would require actual delivery of the shares by the seller to the buyer. SEBI said that this would happen within six months after the introduction of single-stock futures. That would have been the right thing to do, but it is now four years since then and it has still not been implemented.

Who is stopping this?

Lobbies of speculators do not want a physical settlement system. The number of shares available is always in short supply. But speculators can always arrange for cash, after paying interest, instead of physical settlement. Insisting on physical delivery will ensure that the volume of trade is related to the number of shares available for trading. If a person knows that he will not have to deliver shares physically he can indulge in excessive speculation.

What are the other weaknesses?

Day trading has been adopted merely to appease the speculators. Day traders do not have to pay the full price of shares, they just have to settle the difference between the price at which they bought and sold the shares. This is a purely wagering contract. This kind of day trading is not allowed in other markets, such as the U.S. and other developed markets. There, you cannot sell a share unless you own it. This has been adopted only to accommodate the brokers. In Indian markets only 25-30 per cent of delivery-based trades are settled by actual deliveries; in other countries it is 100 per cent.

What has been the impact of FIIs? How have they amplified the volatility?

FIIs are fair-weather friends. They shift quickly from one country to another. FII funds are also huge. The amount they are investing in India would be only about 1 per cent of their portfolio, but even that 1 per cent is huge by our standards. Their individual transactions are huge, and they move the markets. This is the reason why in China FDI is more important. On the contrary, in India, FIIs are the primary source of funds.

We have been so anxious to get them here that we have given them very favourable terms. For instance, we have allowed them to operate through sub-accounts of brokers and to use the mechanism of Participatory Notes. They now have the portfolios and their operations are naturally destabilising, leading to greater volatility. The latest boom was FII-driven. They were the ones who said the India-story looks good.

When too much money enters the market, chasing few securities, a crisis is bound to happen. You may recall that in the early 1990s after a lot of small investors put their money, there were the vanishing companies. New companies were floated because they thought their shares could be highly priced. This has happened again. I do not think there are many long-term investors.