69. Essay Writing Format, structure and Examples. ‘THE INDIAN STOCK MARKET: PROBLEMS AND PROSPECTS OF REFORM’

THE INDIAN STOCK MARKET: PROBLEMS AND PROSPECTS OF REFORM

INTRODUCTION: Liquidity and price continuity are very essential for the healthy functioning of the stock market.

DEVELOPMENT OF THOUGHT: If all transactions were only between ‘genuine’ buyers and ‘genuine’ sellers, there would be hardly any crisis in the stock market. But such a market would not have much liquidity and it would not be easy to buy or sell. If a market has to function successfully speculation must be of moderate dimension and financed largely out of one’s own funds rather than through substantial borrowings from the system. Speculative excesses could result in failures to honour commitments, and this would have wide repercussions on the financial system, corporate finance and thereby on investment activity. In other words, it is extremely difficult to ensure a trading system which is moderate and stable and at the same time provides liquidity and price continuity. But such a system can work if the Government and the Central Bank ensure a proper system of regulation for trading in securities and check any large scale financing of the speculative transaction which can lead to scams.

CONCLUSION: Up to a point markets must have a free play but irresponsible speculators must be made to pay for their folly by the regulatory authorities.

 No stock market can function wholly on the basis of what is called cash transactions, that is to say, a purchase which is consummated in taking delivery shares sold. There has to be something of forwarding business which means entering living delivery of the shares through payment of the agreed price and in into a purchase transaction, not with the intention of taking delivery of the shares at least in the near future, but in the expectation of making a profit on anticipations of an increase in the price of the shares bought. The counterpart of such a transaction is the sale of share by a person who does not wish to give delivery of the shares, at least in the near future but in expectation of making a profit through an anticipated decline in the price of the shares.

These are obviously speculative transactions in the sense that there is no absolute certainty that the expectations of the two types of operators would materialize. Even if the price goes up, it may not be to the extent that the speculator had envisaged. Likewise, the anticipated fall in price may not take place and even if it does it may not be to the extent anticipated by the speculative seller. In fact, things may go totally against one’s expectations. The speculative buyer may face the prospect of an actual decline in prices: likewise, the speculative seller may find the price of the shares he has sold actually going up.

 The operator, who enters into a transaction to purchase shares in anticipation of a rise in prices, is called a Bull. The other operator, who enters into a sale transaction in the expectation of a downward movement of prices, is called a Bear. So, a stock market, and for that matter a market in commodities for foreign exchange, has at any time bulls and bears, operating actively.

Such operations can, under favourable conditions, contribute to reasonable stability of prices and provide a great deal of liquidity. Both these features, namely, liquidity and price continuity, are very essential for the healthy functioning of any market, in the present instance the stock market. If all transactions were only between ‘genuine’ buyers and ‘genuine’ sellers, there would be hardly any crisis in the stock market. But then, such a market would not have much liquidity, that is to say, it would not be easy to buy or sell.

 If a market has to function successfully other than on a purely. cash basis (or ready business only), speculation must be reasonably well informed, of moderate dimensions and financed largely out of one’s own funds rather than through substantial borrowing, from the banking system or personal funds from those wanting to invest their surplus temporarily in stock market transactions. These conditions are sometimes satisfied and sometimes not. In the latter event, there would be speculative excesses and would result in failures to honour his commitments, the defaults having wide repercussions on the financial system, corporate finance and business sentiment and thereby on investment activity and inflow of funds for either domestically or from abroad.

In other words, it is extremely difficult to ensure a system of trading in shares that provide liquidity and price continuity and; at the same time, ensures that it is done in moderation, leading to a stable system of trading on the whole. But such a system can work if there is a proper system of regulation of trading in securities and the control of the Central Bank and the Government on the financial system is such as to check any large-scale financing of speculative transactions.

Legally, all forward transactions have to be completed within the stipulated settlement period, which may be a week or a fortnight or a month. All transaction are compelled to be completed either by delivery of the scraps or by payment of money. If such a stipulation is not there, then they become wager contracts, which are illegal. However, the market mechanism is such that while de jure transactions are completed in the above manner, in de facto there need be neither payment for the purchase nor delivery for a sale transaction. The transactions are carried over from one settlement to another, but then it must be noted that some payment of money or some receipt of money would be involved, depending upon whether speculation has been excessive and in what direction, that is to say, bullish or bearish.

The person who has bought shares for the current settlement will, before the close of the settlement, offset the transaction by a sale transaction. If that is all and he is getting out of the transaction, there is not ordinarily much problem. If the market has gone up as he, expected, he would get the difference from the clearinghouse. If, on the other hand, the price of the shares he bought has declined, he pays the difference to the clearinghouse, representing his loss.

 However, real speculation, the one that causes many problems, is the speculator, who does not want to close the transaction. He wants to keep it alive because he expects the prices to recover substantially even though they may have fallen for the time being, or even if they have risen, he may feel that the rise is not over; they are bound to rise further and so he must keep the transaction alive so that he can reap profits from time to time. Most markets provide the facility of carry-Over of transactions from time to time.

This is achieved in the case of a bull operator by his making a sale contract for the current settlement and a simultaneous purchase for the next settlement, at the closing price, of the current settlement. As far as the present settlement is concerned, he may have to receive money from the clearinghouse or pay money, depending upon whether there has been a rise or fall in price since his first purchase. It should be noted that this payment has to be made by the operator, whether out of his own funds or monies borrowed from banks and other sources.

 In addition to paying the difference between the purchase and the subsequent sale price, the bull operator has to pay a charge, for the carry-over facility, called `Contango’, which is really in the nature of interest for the duration of the settlement. The bull operator who is carrying over his transaction is in effect borrowing money from someone for making payment for the purchase he made.

 Does this mean that the Contango is just equivalent to the prevailing short-term money market rate of interest? The answer is, “yes, broadly”. But the Contango has also a risk premium. For the person or bank or any agency which has provided the money for making payment for the current transaction, is, in effect, lending to the bull operator without any margin. The risk premium can at times be very high if the market has risen considerably and is rather vulnerable, that is to say, it has every danger of a reaction in the downward direction, sooner or later. In such cases, Contango rates can be very high. Instead of say 15 per cent per annum, it could be on the basis of 30, 40, 50 per cent, per annum. That is why it is dangerous for those who want to make short-term investments of surplus funds to go in for Contango financing or, in the Indian bazar terminology, for the bad transaction. If banks and other financial intermediaries keep out of bad business, there will be an automatic check on irresponsible and excessive speculation.

The bear operator’s getting the equivalent of Contango is different from whether he is getting something or paying something to the clearinghouse by virtue of price movements. Thus, if the market has fallen, he would get a difference from the clearinghouse, while if the market has risen since his first sale, he would pay the difference to the clearinghouse. However, on those occasions when there have been excessive bear operations, the hear operator, has, in fact, to pay a charge for having the facility of simultaneous carryover of the transaction from one settlement to another, in that event, the charge is known as ‘ backwardation.’

 The natural tendency of a speculator is to persist in his speculative transaction, even when the market is going against him. If the market is moving in his favour, the bull hopes that it would move further in the same direction. Therefore, he would like to carry over the transaction from one settlement to another.

Obviously, no market would move up or down continuously. After some time, there must be a reversal, which may be’ of long duration. Therefore, a speculator may not only lose whatever he gained earlier, but he may be a net loser, sometimes of an enormous magnitude. This happens because, in order to maintain the price trend, the speculator would be tempted to enlarge the volume of his transaction, either as a seller or as a buyer. Thus, a bull operator has to ensure that not only is the higher price of a share maintained but that it keeps on rising. Since the market also has bears who would be working to bring down the price, the bull operator has to buy more and more to impart bullish strength to the market. Often this becomes like a noose which the operator is putting on his own neck.

All this is not just a theoretical possibility but something that happens in every market day in and day out. If the operators engage in excessive speculation out of their own monies, it does not matter much, but often, they operate with substantial borrowed funds. especially in a system where bank lending is rather loosely organized, with comparatively little regulation of lending for speculative purposes either by the Central Bank or the government. There is a limit to how much one can operate from outside sources. In such cases, the speculators are unable to meet their dues when the market goes against them. They become defaulters, upsetting the settlement system of the stock exchange, with wide repercussions on investors, companies and financial institutions. The major crisis of this sort may produce far-reaching adverse effects not only on the national economy but also on the international economy, in view of the fact that world economy and financial markets are becoming very closely integrated.

 Let us look for a while on the comparative strength of bull and bears. The main problem of the bull is to find money either to take delivery of shares or at least to pay the differences from settlement to settlement, besides Contango.

The bear, on the other hand, is much more vulnerable. The problem of the bear is to produce the shares for delivery at the time of settlement. To some extent, the bear may possess the shares and in a critical situation, he can give delivery of his shares. Such a bear is called a “protected bear”. However, most bear operators are not protected. Borrowing of securities is not also generally easy. Therefore, if the bulls are very powerful, with secure resources of money and can take delivery of the shares they have bought, the bears can be trapped very badly.

In other words, the bull-bear tug-of-war is one of unequal strength, the odds being against the bear. Oftentimes, the market is going down on account of excessive bull speculation, bears are criticised. The reason for this is that in most countries, the corporate sector, the banking system and the government too generally feel happy when share prices are going up and the share market is buoyant. In the case of the corporate sector, if the share prices are rising, it is comparatively easy to raise money in the form of shares and bonds. In the case of banks, a buoyant share market means that there is adequate security for the loans made against shares. In the case of the government, the rising share market is considered to be a sign of satisfaction about the government’s general economic, fiscal and monetary policies.

 Therefore, there is a general bias against bears. What the authorities should do is to have a fairly comprehensive regulatory system to prevent excessive speculation of either side and after they have done this they must remain strictly neutral between bulls and bears.

At this stage let us turn to a brief discussion of the broad spectrum of measures to check excessive speculation. The basic requirement is a system of well organized and managed stock exchange with a careful selection of members, prescribing reasonable deposits to be maintained with the stock exchange, prescription of adequate capital requirements in relation to the volume of business handled by a member, both overall as also on net positions. fixing reasonable settlement period, prescribing margins of trading on individual shares and/or on turnover of a combination of the two, making adequate enquiries in the event of excessive fluctuations in individual shares and in the extreme cases to suspend trading in selected shares and, finally, closing the market itself for a number of days, formulation of the strategy for restoring healthy trading conditions.

 Experience has also shown, in the developing as well as the developed countries, that it is not wise to rely wholly on self-regulation of the stock exchange. A measure of statutory regulation is very helpful, to give proper guidance to stock exchanges, to warn them when they are not doing a good job of self-regulation and finally for the government and the central bank of the country to take steps that would check, directly or indirectly, excessive speculation.

Of course, it is a tricky business, whether it is regulation by the stock exchange or by governmental agencies, as to where to draw the line between healthy and moderate speculation on the one hand, and excessive and unhealthy speculation on the other. While theoretically, this is a difficult matter; in practice, it is not so difficult, especially if the regulatory authorities are honest and objective, without being victims of political and other unhealthy influences. The problem becomes more difficult when there is a lot of insider trading, that is to say, trading by persons connected with a company as senior executives, directors and other close associates.

 Looking at the history of the functioning of stock markets and the behaviour of, share prices in the last 15-20 years or so, the standards of self-regulation by the stock exchange and statutory regulation in India leave much to be desired. Very sharp movements in share prices have been witnessed. First, share prices are taken up to what are generally regarded as giddy heights and later on, naturally, a reaction sets in. Of course, to a considerable extent this feature of share markets generally reflects the fast growth in financial intermediaries, the growth of new financial instruments, the birth of new forms of trading, especially futures trading, integration of international money, capital and exchange markets, the vast movements of investible funds, short-term and long-term, across national frontiers. The task of regulation has thus become more difficult. But it is a fact that the ability and the earnestness to do a good job of regulation is also generally weak.

For about two years the Indian stock markets boomed to unprecedented heights. There was obviously tremendous speculation of an unhealthy sort, in which consciously or unconsciously, directly or indirectly, the financial institutions in particular mutual funds, participated freely. Everybody was trapped in bullish fervour, leading to “errors of optimism”. In the light of the substantial rise in prices that took place for a while, mainly by way of correction of rather low prices in relation to the fundamental factors concerning the performance of companies generally, institutions began to mobilise huge sums of money, promising the investors substantial capital gains, with substantial current profits and dividend payments. It was really a mad rush for buying shares, with supplies obviously not keeping pace. The disinvestment of a portion of the share capital of public sector companies by the government, with a view to raising resources for the budget, further gave a stimulus to the bullish fervour.

It is also clear from various evidence that a substantial amount of bank finance was also provided in fuelling the stock market rise. However, as is natural, some time or the other the speculative bubble had to burst and the market moved downwards. The government and the monetary authorities did not utter even one word by way of friendly warning about the excessive bullish speculation that had developed. In this situation, the bull operators got the feeling that the authorities liked the bullish fervour and would take measures to keel) up to the bullish tempo. It was also obvious that the investment institutions, which had put a lot of money in acquiring shares at very high prices would be interested in extending support to the market if any substantial decline in prices set in, especially since they have the problem of investing continuously accumulating funds. This is in fact what is happening.

 Judging from still very high price-earnings ratios, of 40, 50, 60, 100 when the general long-term rate of interest in the market is around 15 per cent. The question is whether the decline in prices that has taken place in recent months is adequate or a further decline is indicated, in the nature of a further correction of an unhealthy bullish situation. On the basis of long observation of the stock markets, it looks like there is considerable scope, and need, for a further decline in share prices.

 In the circumstances, it would not be proper to put undue restrictions on bear operators who, as already mentioned, are inherently in a risky position. What the government should turn its attention to is to ensure a healthier functioning of stock exchanges through better regulation of stock markets by the government authority for the purpose, namely, SEBI. Unfortunately, the SEC does not have enough authority to do a thorough job of regulation. The politicians and bureaucrats in Delhi are reluctant to part with the power to a statutory organisation like the SEBI.

There must be a stringent system of margins on share transactions, buyers as well as sellers. This must be on gross positions of members. Control becomes easier if the share ownership and transfers are done by the Stock Holding Corporation. This is now optional. It must be made compulsory. There must, of course, be suitable safeguards about ensuring the confidential nature of the information maintained with the Stockholding Corporation. If a giant all India institution is regarded as not suitable, for a variety of reasons, about 5-6 such corporations may be set up, and specific shares allotted to them for speedy operations.

It is of the utmost import to protect the monies and securities of investors, as buyers and sellers. The present practice of the buyer making the cheque in favour of the broker and the seller handing over the securities to the broker must be stopped. This must be done through banks or the stock holding corporations.

Stock exchanges must do a better job of self-regulation. This is not possible unless this responsibility is taken away from the Board comprising members, who have vested interest. It must be done by an independent president and an advisory board, comprising experts in finance, appointed by the Board, with a nominee each by the SEBI and the Reserve Bank.

 For a healthy functioning of stock exchanges, a healthy corporate sector, with a lot of transparency about its affairs, including accounts, is very essential.

Insider trading should be curbed. Happily, the SEBI has taken some initiatives in this regard, but the proposed procedures in this behalf seem to be complex.

The investment and financial institutions all seem to be caught in the web of speculation, with a vested interest in having a bullish fervour, They have been mobilizing huge sums of money, promising high capital gains. Their operations, especially those of big ones like the UTI, ought to be reviewed at an expert level to ensure that their operations do not fuel speculative excesses and do not lead to scams, major and minor.

There is also the danger of over liberalization of the financial sector. It is an illusion to think that the mere growth of the financial sector will play a vital part an economic growth. There is a tendency in the country for financial institutions to show huge growth figures of lending and investing, regardless of their quality. The result is huge sick loans and investment portfolios with financial institutions. Successful economic liberalization calls for an efficient sector, ever watchful.

 On the whole, fill recently the Indian share markets have functioned well. It is the enormous growth of financial and investment institutions and the volume of trading that has brought some problems, what can be solved if only there is political will. There is no cause for alarm about the functioning of the Indian share market, but fundamental factors must be allowed to guide the market.

Up to a point, markets must have a free play and irresponsible speculators must be made to pay for their folly. There must be no bullish or bearish bias on the part of the regulatory authorities.

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