The budget, the bull and the BSE: Asiamoney cover story, June 2001

 So who’s right?

At the heart of this complex case are several key issues.

Firstly, there is the question of brokers running India’s stock exchanges. Opinion on this is polarized along predictable lines, and Rathi’s vigorous defence of his position can be read in the box alongside this article. But most of those who aren’t brokers believe that there is a clear conflict of interest in having active brokers in the senior management of an exchange on which their brokerages trade. “It is the general consensus that market players should not be in the exchange, so that there is no conflict,” says P Krishnamurthy, vice chairman at JM Morgan Stanley. Sebi chairman DR Mehta adds: “Brokers who are traders have the possibility of getting price sensitive information. To that extent, the system gets affected, and public perception is damaged. If they are totally separated, things will be different.”

Secondly, were Sebi’s moves justified? On the face of it, it seems very good news that Sebi, often criticized for being far too slow as a regulator, has suddenly become a dynamic supervisor of market behaviour. It sends a clear message that indiscretions will no longer be tolerated on the Bombay exchange, and that has to be a good thing. “What happened in the Indian stock markets was pure fraud,” Sinha told Asiamoney in May. “There were systems in place, and some people have violated those systems and indulged in malpractice. The regulator has made preliminary inquiries into the situation and they have come to the conclusion that some entities are guilty, and have proceeded to take action.” He continues: “We have noticed there are certain areas where we were somewhat weak in our regulatory framework. We have given greater powers to the regulators so they can deal with such situations more speedily.”

Sinha is not the only supporter of Sebi’s actions. “The steps Sebi has taken are in the right direction,” says Amit Chandra, executive vice president, investment banking and corporate strategy at DSP Merrill Lynch. “It will help professionalize the exchange [BSE] along the lines of the NSE, often praised for its comparatively high level of transparency, automation and efficiency. Strengthen the regulator, and the system will work.”

The problem is that many, and not just those in Mumbai, are puzzled about this seismic shift in Sebi’s drive towards transparency and justice after several years of relative inactivity. It is widely assumed that it came about because Sinha was livid about the drop in stock prices following his dream budget, and that he told Sebi chairman DR Mehta to do something about it, and quickly. Several sources say that a two-hour meeting took place between DR Mehta and Sinha in Delhi in which Sinha made it very clear he wanted to see people brought to justice. On this point, DR Mehta is adamant. “We act on our own,” he tells Asiamoney, forcefully. “We don’t act on the government’s pressure.”

Nonetheless, Sebi’s sudden and uncharacteristic zeal has not gone unnoticed. In April, the body suddenly banned three companies, BPL, Sterlite and Videocon, from accessing the capital markets – in a separate case that had been outstanding and dormant for three years. And many are curious as to why, in the nine years since Sebi’s first audit of the BSE described it as a “closed club of brokers”, it took until March this year to put in place proper separation. Sebi’s defence is that it has been working on the problem for several years. DR Mehta says Sebi issued directives that the majority of brokers of any exchange board should be non-brokers back in 1994, followed by another ordering separation of broker directors and the surveillance department in December 1995. Demutualization was decided on last year but only formally announced in parliament on March 13. And things do usually move slowly in India.

Given this phenomenal change of pace, did Sebi go too far to the opposite extreme? If nothing else, several people are alarmed that the BSE’s seven broker-directors were removed without a hearing, and that the media often seems to know considerably more about precise charges against institutions than the institutions themselves. The barring of brokerages that are still being investigated has also raised eyebrows.

Besides, there are many questions surrounding these claims. Let’s start with Rathi’s taped telephone conversation in Bombay. The strange thing here is that Rathi himself designed and installed the recording system that monitors calls to the surveillance department. He, not Sebi, was the architect behind its appearance in the first place, he insists. He also says he personally, along with his team, was behind the plans for corporatization and demutualization of the Bombay Stock Exchange, and that any suggestion that his removal clears the way for an overhaul of the exchange is absurd.

Furthermore, the fall in value of the BSE that is at the heart of this situation occurred between 2.30pm and 3pm on March 2. According to documents obtained by Asiamoney, Rathi’s submission to the High Court attests that his conversation took place after this fall – between 3.10pm and 3.16pm – to try to find out what was causing it. (He also claims the information he got was not price sensitive; see The Accused p22.) In fact, there was no further fall in the value of Sensex after this conversation – if anything, there was a slight rally.

By the time Sebi passed a re-confirmatory order against Rathi on April 23, banning his businesses from trading, it had become more specific in its allegations, claiming that Rathi had executed several trades on March 5 on the back of information he had obtained in the call three days earlier, and that there was prima facie manipulation in prices. Rathi, in turn, claims that his businesses made about 1,600 trades on March 5 accounting for just 0.2% of the NSE’s turnover. Although the report has not been made public, Asiamoney believes that the specific trades Sebi is referring to involve the sale of Rs36 million of shares in technology stocks Satyam, Infosys and Global Tele, by one of his brokerages, Navratan Capital. Rathi’s response to this is that on the same day, that brokerage had a combined purchase position of Rs49.8 million – so in fact had a net purchase position rather than acting as a bear. Sebi has declined to comment on the precise details of these cases, nor on that against the brokers – see the box on CSFB for a detailed investigation into those charges.

Sebi has certainly come in for a lot of flak in this investigation – particularly from Mumbai brokers – but DR Mehta still has Sinha’s support. It is not easy to find anyone in Mumbai prepared to leap to the defence of Ketan Parekh, or to criticize Sebi for investigating him. Critics of the regulator call for streamlining rather than a wholesale overhaul. Many point out that this whole scandal has emerged out of an apparent feeling that a bear market is a bad thing, when in fact as much irregularity can be found in a bull market. “Nasdaq fell from 5,000 to 2,000 points and nobody talked about a scandal,” says Chandra at DSP Merrill Lynch.

“The regulator is there to manage the integrity of the market,” says UR Bhat, director and chief investment officer at JF Asset Management in Bombay. “It has to be clued in to risk management. There is risk in both the bull and bear markets. Things would have been different if they had investigated what was happening to the market during the bull phase instead of coming in only after the market collapsed.” He continues: “Sebi would probably like to correct the impression that they are against bear players. They would probably like to be seen as treating both bull and bear players equally.”

 What next?

Over time the market has begun to find its shape again. Whatever the outcome of this scandal, when the dust settles the fact will remain that Sinha’s budget, and many of his subsequent remarks on market reform, are extremely positive.

“I am very impressed by the labour reform [suggested in the budget]” says Kothari at DSP Merrill. “At present people are afraid of taking on more staff because the labour laws are very rigid. A lot of foreign investors have this psychology that labour is a major problem in India.” Labour reform will have a vast impact on the privatization process, where the year’s only success to date – a sale of a controlling stake in aluminium company Balco to Sterlite – is stalled because of strike action. “Everything was done completely transparently and openly [in Balco] according to the recommendations of the independent committee, but politicans and other traders and unions have stopped work there,” says minister for disinvestment Arun Shourie. “But once you go through these four or five initial privatizations, things will then become much smoother.” Next month’s edition will feature a full interview with Shourie about privatization in India.

As for the stock markets, it will be interesting to see how T+5 rolling settlement goes after its introduction on July 2 – the same day that Sebi reintroduces short selling. Rolling settlement is actually nothing new. It has been in place for several months on 163 scrips, yet its arrival then was greeted with a drop in volumes and prices. But given the momentum of new stocks moving to rolling settlement, it should improve the market by providing a safer equity spot market and shortening delays for the conversion of securities into cash, or vice versa. From this time onwards we should also see the development of India’s nascent derivatives market with the removal from July 2 of badla, a way of carrying forward obligations from one account period to the next, which is basically a form of hedging that is conducted off-exchange and exists in the absence of a more established derivatives market. The fear is that the removal of badla will hit liquidity, as the ban on short selling and the earlier introduction of rolling settlement did.

The independence of the stock markets from broker directors will also help the system, and a much discussed proposal to merge the BSE and NSE seems unlikely to  go through now. “In the financial world it is always good to have competition,” says DR Mehta. “If the US can have Nasdaq and the NYSE and six other exchanges, we can have more than one too.” And a stronger regulator, providing it acts sensibly, is also good news.

Perhaps the biggest issue is education. Do people fully understand where the lines are drawn when it comes to market manipulation, insider trading or Chinese walls? “The answer is, unequivocally, unquestionably, no,” says one broker. DR Mehta at Sebi takes a slightly different tack. “The laws are simple. But insider trading anywhere in the world is very difficult to establish. That is not a question of not understanding. It is a question of catching. Our powers are limited.” But whether the issue is one of regulatory power, regulatory ability, investor understanding or broker honesty, India continues to find itself tantalizingly short of genuine progress despite the best efforts in the right direction.

Three steps forward, two steps back.