Drawing the line

Regulators should step in only when there is systemic risk involved

The events of the past few days have demonstrated that there's a big worry in the minds of several people about the sharp run-up in the market.

It is to the Finance Minister's credit that he has been quick to dismiss loose talk of a scam. Nevertheless, it's worth examining just what it is that's worrying people.

One concern is that there is a lot of manipulation in penny stocks. That is almost certainly the case, and instances of unscrupulous promoters and fund managers colluding to rig prices happen all the time. There are two points that need to be remembered, however.

First, investors in penny stocks know very well what they are letting themselves in for, and it's high time that the halo surrounding the so-called smart investor is taken off. Second, stocks in the BSE Small Cap index account for 6 per cent of total market capitalisation.

Is it worthwhile to disrupt the entire market merely because some of these stocks are being rigged? Whatever happens in small cap stocks is unlikely to pose any systemic risk to the market, and is not worth losing sleep over. To be sure, these cases need to be investigated, but that's what the market regulator is for.

The other big worry relates to the source of funds. A large proportion of FII investments, it is said, comprises participatory notes. It's worth noting here that the rally is part and parcel of a global rally in emerging markets.

And even if participatory notes are being used to route money that has fled the country back into it, what's wrong with the money coming back?

The obsession with participatory notes arises from the belief that quality (non-PN) investors will be more long-term in nature. Recall, however, that during the Asian crisis, investors of all hues and stripes deserted the Asian markets.

The big worry is, could such a crisis happen again? One reason we escaped the crisis is because we don't have capital account convertibility, and this time our reserves are far larger.

Even Indonesia, which faced a run on its currency a few days ago, has been able to stabilise its markets, and no other country has been affected. More importantly, since January 1993, FIIs have been net sellers in only 22 months of a total of 151 months. The selling has never been exceptionally large, except during parts of 1998-99, when the year ended with FII selling a net Rs 729 crore.

The other worry is regarding the source of funds into the market. What needs to be monitored here is whether public money, whether from commercial or co-operative banks, is being diverted into the market, as happened during Harshad Mehta's time.

If speculators put their own money on the line, it's nobody's business but their own. In short, unless there's a systemic risk involved, it's best to let the market regulator use measures such as margins and compulsory delivery to control the market.

Short selling

It's interesting that Sebi is looking at allowing short selling at a time when there's ample selling already going on in the markets. But it's not often that investors are in a mood to sell.

Allowing short sales would, for instance, help immensely when share prices rise far too rapidly and some traders want to take advantage of that by going short. This would bring a better balance into the market, especially for stocks that aren't part of the derivatives list.

Traders can short stocks on which derivatives trading is available even now. It's not that allowing short sales will not help this section of the market. In fact, a large portion of the pricing anomalies that exist in derivatives would disappear when institutions are allowed to go short in the cash market.

For instance, to take advantage of a discount in futures , traders need to buy futures and sell in cash market to correct the anomaly. Allowing short sales will, in turn, allow institutional investors to benefit from such situations.

But there first needs to be a working stock borrowing and lending system which facilitates short sales. Indian markets have thus far been unsuccessful with stock borrowing and lending, but hopefully when institutions are allowed to use this segment things could be better.

Circuit filters

Circuit filters are back to haunt the markets, with a large number of small cap stocks stuck at the lower end of the circuit filter for three (in some cases four to five) consecutive sessions.

Investors in these stocks, not being able to sell shares for a number of days at a stretch, pile on sell orders at the beginning of the day's trading session, which causes these stocks to hit the lower end of the circuit filter again.

Some experts have suggested that the way to get out of this vicious circle is to do away with circuit filters altogether. While this could result in a free fall in share prices of these stocks, investors would at least be able to sell since buyers will always emerge at a particular price point.

Unlike the current scenario, where there seems to be a huge queue of sellers, order books would look much better. Detractors would say that circuit filters help curb manipulation and that operators would go on a rampage in a world without circuit filters.

But there are plenty cases of unjustifiably high price movements in small cap stocks despite stringent circuit filters of even 2 per cent.

In summary, while circuit filters may protect investors from sharp fluctuations, it's much worse when investors suffer bigger losses because they can't sell.

With contribution from Mobis Philipose