One step up, one step back

The Sebi board has made progress on capital market regulation by permitting institutional investors to engage in short selling. The fundamental principle of financial markets is that diverse speculative views come together to generate price discovery. Some people believe a security will do well: they are able to borrow money and buy shares. If they are right, they will be able to sell the shares at a future date, repay the loan, and be left holding a profit. Such borrowing permits the expression of positive views on a security. In an exactly symmetric way, the financial markets must permit the expression of a negative view on a security. If a person believes a security will do badly, he should be able to borrow securities and sell them off. If he is right, he will be able to buy back the securities at a future date, repay the loan, and be left holding a profit. Such symmetric expression of views by optimists and pessimists is usually good for market efficiency. For liquid stocks, the presence of derivatives trading on individual stocks has already addressed the problem of giving a pessimist the means to express his views. But even here, stock lending is a fundamental requirement for achieving market efficiency on the derivatives market, by supporting arbitrage.

The important next step should be the construction of an effective system through which access to borrowed shares is ubiquitously available as supporting infrastructure for the stock market, while avoiding the difficulties of the "badla" system. It is to be presumed that the onus of this will now lie with the two main stock exchanges, the NSE and BSE. Sebi and the exchanges need to build common scalable infrastructure which works for all securities; it should be possible for users to borrow shares, government bonds, corporate bonds, gold ETFs, dematerialised warehouse receipts, etc""all through a single scalable borrowing mechanism. This would harness economies of scale, and deliver the benefits of short selling on all these markets.

While the decision about short selling by institutions is on the right track, the Sebi board has made a mistake in introducing mandatory "IPO grading" by credit-rating agencies. In mature market economies, the credit ratings of bonds are optional in the hands of the issuer and "grading" IPOs is non-existent. In India, credit-rating agencies have been delivered a bonanza by the government by making both mandatory. In the case of credit rating, at least, a rating agency can work for a decade or two, and then there can be accountability in the eyes of the market because rating decisions can be compared against the default experience. In the case of IPO grading, this slow and remote accountability is absent. Fluctuations in stock prices take place for all kinds of reasons, and no rating agency can be held accountable if some companies do well and others do badly. More importantly, it is impossible to hold the rating agency accountable for the IPOs that it blocked. Sound thinking in financial sector policy requires the elimination of IPO grading, the elimination of mandatory credit ratings for bonds, and a requirement that each rating agency report quarterly statements about the performance of its credit ratings of the last five and ten years.