Put the horse before the cart

GUEST COLUMN/ MARKET STABILISATION FUND

After Black Monday last May, capital market regulators are happy that the markets have weathered the storm and it is business as usual despite huge volatility. But investors are angry and dismayed.

They are angry because they had to bear the brunt of the sudden fall. They are dismayed because there is no rational explanation for Black Monday's fall.

While the fall and recovery of the markets may have resulted in high financial losses to investors on an actual or notional basis, the biggest loss is in terms of credibility of prices.

Regulators may have ensured the credibility of the settlement system, but how does one assess the loss of investor confidence? This instance is enough to show that the Indian markets are still fragile and shallow.

It is in this context that the recent suggestion for a 'market stabilising fund' bears re-examination. The fund is proposed to be created to intervene on special occasions to provide stability. But, prima facie, the concept of a market stabilising fund is against the tenets of a free market.

If the objective of the fund is to support markets - as it is prone to capital-loss risk - the operation of the fund also will be complicated. It should not so happen that we end up funding speculative losses in markets through the fund.

To my mind, there can be no such fund. This is not different from the minimum support price (MSP) advocated for agricultural markets. Such a fund will only breed inefficiency and cannot stop with the equity markets.

All importers and exporters will demand one for the forex markets to compensate them for any adverse movements in the rupee-dollar exchange rate.

Instead of a market stabilisation fund, we need a set of stabilisation measures. For example, the fund may provide temporary lines of credit for three-four days to help brokers and other entities tide over the situation.

The announcement by the RBI to support brokers caught in any crisis should be the starting point though the central bank may provide temporary credit to clearing corporations.

To start with, banks may set up lines of credit to clearing corporations so that the latter do not run into cash mismatches that occur while mobilising funds due to a sudden fall in market prices.

Sebi has rightly said that trade guarantee funds (TGFs) are more than adequate to meet any eventuality. Available TGFs would far exceed the daily pay-in liability.

However, TGFs are in the form of liquid shares, bank fixed deposit receipts, bank guarantees and cash. While the bulk of TGF is in near-cash equivalents, it can only be converted to cash after undergoing a certain procedure which requires some time.

In the absence of lines of credit, exchanges go into a tizzy to collect cash - in the form of advance pay-ins - increasing margins during the market hours and debiting brokers' accounts for pay-ins after banking hours.

All this, in turn, leads to a panic situation as brokers desperately try their best to keep terminals working. Shutting down terminals gives a wrong signal to investors that the broker is in financial trouble. As a consequence investors stop paying up.

The panic filters down to investors since brokers force them to square up open positions and sell additional stocks to meet their commitments. The situation corrects itself when markets recover, but the distress sale leaves a big hole in the investor's pocket. This can be avoided if we contain the trigger that sets it in motion.

Banks, specially the ones which participate as clearing banks with exchanges, should not have a problem in giving lines of credit. They give bank guarantees secured with a 50 per cent margin.

Hence they can provide immediate cash to clearing corporations to meet brokers' short-term needs. These limits should not, however, be computed within the RBI-stipulated 5 per cent cap on lending to stock markets. Otherwise the brokers' regular limits will suffer.

The next shortcoming that we saw in the crisis was with respect to the banking infrastructure - remittance and payments at different centres. The so-called online banks have a system where cheques are put in a drop box. The box is cleared infrequently. The cheques are then sent for clearing and the amount is shown as float.

It takes at least four-five days to credit the depositors' accounts. In the case of banks that do not have on-line banking, it takes three-eight days to get a money or telegraphic transfer to be credited.

In such situations, demanding advance pay-ins is nothing but an invitation for panic. Some banks do cooperate by giving temporary overdrafts against float but most do not have a guidance from the RBI to help in such situations.

Next comes structural deficiencies in the market. In the absence of physical settlement of shares in the derivatives market, we have willy-nilly permitted short sellers to precipitate a free fall in the cash markets.

The physical settlement of derivative contracts will bring about a stabilising effect since goods move from the cash to the derivatives market, avoiding one-sided movements and volatility.

There is an urgent need for steps that may recognise buyers' rights and sellers' obligations for delivery on derivative contracts. The introduction of physical settlements needs vibrant margin-trading and stock-lending schemes. Neither is in place. Clearing corporations should be permitted to do stock lending.

Margin trading also needs to be investigated. Distress selling of shares under margin trading is done by brokers who are not registered for margin trading. The volumes reported too are minuscule compared to the alleged quantum of stocks sold by various brokers.

Margin trading rules announced by the regulator are most impractical; hence there is no large scale business being done legally. An efficient scheme could serve as a leveraging mechanism in times like this.

Another issue that needs to be looked at is the depth of the market as only a handful of stocks are traded actively. We need more good quality paper to ensure that our stock markets represent all sectors.

Today stock markets are not the barometer of the Indian economy; they reflect only investor sentiment. Important sectors of the economy like transport, insurance and minerals are not represented.

The last suggestion is on the handling of crisis situations by market regulators. Big falls are not business as usual. Markets and participants do require someone to guide them.

So support measures, be it in form of a better financing mechanism for trade settlements or margin trading for medium-term stability or permitting social security schemes to invest in markets in a small way for long-term stability, must be implemented urgently.

If we fail to do this, the situation in the markets will be no better than a traffic jam where government facilitates the production of millions of cars but does little to invest in roads!

(The author is managing director, Asit C Mehta Investment Intermediates.)