J Mulraj: Reminiscences of the 'badla' age

With the options market hardly working, the retail participation of the 'badla' days has died.

On Monday, May 22, the BSE Sensex fell 1,315 points, or a phenomenal 11.8 per cent off its day's high, of 11,142. From its peak of 12,624 on May 10, it fell nearly 2,800 points in just eight trading sessions, with some sharp bounces in between, implying huge volatility. (It then bounced from a low of 9,826 to 11,050 quickly, before falling further to just over 9,000). Now go back down memory lane and you will find that high volatility was the accusation hurled at the old "badla" system, and one of the reasons for its banishment in favour of the more modern F&O (futures and options) system. It doesn't seem to have worked quite as well as intended, now, does it?

The reason, if one cares to study it, is that the indigenous system allowed for retail participation. So if someone held a bearish view on a stock, he could short it, and there were thousands of punters doing that. Now every short becomes a potential buyer of stock, acting as a cushion on the way down. If, for instance, someone had short-sold Reliance at, say, around Rs 700, and saw it going up to Rs 1,150, he would be so nervous and so impecunious that he would be rushing to buy when it started falling. Imagine thousands doing that, at different price levels, and you would appreciate why a system that allows short-selling by individual investors, with adequate margin payments to ensure integrity to the system, is a healthy one.

To replace the "badla" system, the F&O segment was introduced. The F&O segment has two parts, futures and options. The options market would have worked, as a replacement, had it been developed and had the quotes been viable. Sadly, it has not been. Option premiums usually do not leave investors with any gain even if they are right, except in such exceptional moves as witnessed last week. Punters thus flock to the futures segment and this is where a lot of the problem occurred. It was the inability of buyers to meet margin calls once the market started tumbling, that led to forced squaring off of over bought positions. This exacerbated the fall. The 1,315 point free fall on Manic Monday 22 was a consequence of this.

The large investment banks have developed the derivatives market and derive substantial income from trading in derivatives. An article on Goldman Sachs, "On top of the world" (The Economist, April 27) says that "from small beginnings in 1987, the face value of contracts in interest-rate and currency derivatives is now more than $200 trillion "" 16 times America's GDP. A further $17 trillion is outstanding in (even newer) credit-default swaps, which allow bond investors to lay off the risk of issuers defaulting." Successful trading in derivatives has enabled Goldman (and other large investment banks who dominate the industry) to earn slurpy returns on equity, close to 40 per cent in the case of Goldman. On the flip side, it also imposes tremendous risks. "The face value of Goldman's derivatives exposure is more than $1 trillion, although the bank says that its net exposure, once you offset all its positions, is $58 billion, against shareholders' funds of $28 billion."

It was overexposure in the derivatives market that has led to several past crisis, the most notable being the LTCM crisis, which nearly caused a meltdown in the US, until the Federal Reserve intervened. Overexposure to derivatives also led to bankruptcy of Orange County and to Black Monday on Wall Street. This is because the investment world is getting hugely institutionalised, and institutions tend to have a herd mentality (often based on a "heard" mentality).

True, there used to be abuses of the system as a few brokers used to collect margins from both long buyers and short sellers, show the net position and use the margin collected for their own use. Pity that the system was blamed for its abuse by the players and the baby was thrown out with the bathwater. The system is hardly likely to be revived but an alternate system, allowing for retail participation, ought to be developed.

We, therefore, need to have a speculative market that allows for retail participation. We need to either develop the Options market so that pricing becomes viable, by encouraging large institutional players to write options, or, re-examine the assumptions under which the homegrown "badla" system was jettisoned and work out an alternative. Without an option for sensible retail participation in speculative activity, such volatility will exist. Now that "badla" is not there as a whipping boy, whom would Sebi and the finance ministry blame?

The views expressed are personal. Comments on the article can be emailed to jmulraj@hathway.com