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Current State of the Indian Capital Market

In the early 1990s, India figured low in the global ranking of the state of capital markets. The adoption of sophisticated IT tools in trading and settlement mechanisms has now placed India in the lead. The National Stock Exchange has played an important role in this transformation. Shorter settlement periods and dematerialisation have been other major developments. But all is not entirely positive. The introduction of individual stock futures poses a major risk; so also the large inflow of funds through participatory notes.

Current State of the Indian Capital Market

In the early 1990s, India figured low in the global ranking of the state of capital markets. The adoption of sophisticated IT tools in trading and settlement mechanisms has now placed India in the lead. The National Stock Exchange has played an important role in this transformation. Shorter settlement periods and dematerialisation have been other major developments. But all is not entirely positive. The introduction of individual stock futures poses a major risk; so also the large inflow of funds through participatory notes.


ndian capital markets have witnessed a radical transformation over just one decade. There is hardly any country in the world which has witnessed such massive changes in its capital market during such a short period. During the early part of the 1990s, the ranking of the Indian capital market with reference to the standard global indices relating to efficiency, safety, market integrity, etc, was not at all flattering. With reference to the risk indices, in particular, the Indian capital market was regarded as one of the worst as it figured almost at the bottom of the league. The same was the case in regard to its efficiency levels in trading and settlement systems. Strangely, not many people appeared to be bothered about the dismal state of our capital markets. As we are all accustomed to find India figuring in the bottom league in regard to so many other indicators of development such as per capita income, nutritional standards, health amenities to its citizens, literacy levels, etc, we did not seen worried that the capital market was also ranked at the bottom of the global ranking sheet.

The same cannot be said about the current state of the Indian capital markets. From the viewpoint of both adoption of sophisticated information technology tools in trading and settlement mechanisms as also the efficiency of capital markets, not only is India ranked in the top league but it is also considered to be way ahead of many developed country capital markets. Even at the risk of being dubbed as personally biased I would affirm that the National Stock Exchange (NSE) has been largely responsible for significantly upgrading the Indian capital markets to the best global standards. I would be the last person not to agree with the proposition that the government and the Securities and Exchange Board of India (SEBI) have also played a very crucial role in this transformation process. But there is a limit to what can be achieved merely through official interventions or directives. It may be recalled that the government did seriously try to bring about several desirable reforms in the capital markets in response to the recommendations of the 1985 G S Patel Committee report. But it was not possible to make much progress in the desired direction as the stock exchange community was not receptive even to a marginal set of reforms. What is even stranger, the powerful broker community started talking about their fundamental rights to do business as they thought fit, although that may not always have been in the interests of the markets and the investor community.

But after the NSE was set up, the entire atmosphere changed. The broker-owned and managed exchanges started worrying more about the competitive threat that NSE posed to their business and how they should meet investors’ minimum demands so that they did not lose out completely to NSE. All these exchanges became more receptive to what the government and SEBI were telling about adopting clean business practices. NSE, in that sense, strengthened the hands of the authorities in making the other exchanges conscious of their social responsibilities.

How did the Indian capital market, which was considered to be one of the most inefficient and risky, get transformed into one of the best and the safest in such a short period of time? There appear to no parallels to this in any part of the world. In several countries, capital markets have improved in terms of quality and efficiency continually over several decades before they could be bracketed with the top league of the best capital markets of the world. To the best of my knowledge no other country, even in the developed part of the world, has been able to witness a quantum jump in the quality and efficiency of its capital markets in a short period, viz, a decade. Hence, a detailed study of transformation of the Indian capital markets during the last decade will certainly prove to be a fascinating story. All that I am planning to do here is to give a bird’s eye view of the developments in the Indian capital markets as I have seen them from close quarters since I was fully involved with the setting up of NSE right from day one and was also its managing director and the chief executive officer for the first seven formative years. It is my humble claim that the NSE has been the most important catalyser of the radical transformation of the Indian capital market during the last decade. Hence, I consider myself to be one of those few fortunate people who could witness and participate in the unfolding of this fascinating story from where most of the catalytic activity took place.

Let me begin my story by drawing your attention to the major disaster that struck the Indian financial system during 1991-92. It shook the stock market to its very foundations. During this scam several banks – both small and big, foreign and Indian, and public sector as well as private sector – lost huge amounts of money. Strangely, many stockbrokers prefer to refer to this disaster as a banking scam, as if the broker community did not have any role in perpetrating the scam. The real truth was that money was siphoned off from the banking system by the stockbrokers through many devious ways. Equity prices were manipulated by several prominent brokers with the help of money diverted form the banking system. Although brokers used to issue their contract notes, their concerned stock exchanges did not bother to conduct regulatory surveillance on these transactions. There is hardly any doubt or dispute about the proposition that the stockbrokers were the kingpins of the major fraud that shook the financial system and the capital markets. It was in this context that an urgency was felt to bring about necessary reforms in the capital markets so that such serious mishaps did not recur. This prompted the government of India to delegate powers to SEBI under the Securities Contracts (Regulations) Act, 1956 (SCRA) and later to enact a special legislation called the SEBI Act. But it was soon realised that merely empowering SEBI with more powers was not enough. Since the governance of the stock exchanges was very poor something more in the nature of setting up a new model stock exchange was needed so that competitive pressure would force other stock exchanges to reform themselves. The government agreed to bless/support the lead taken by IDBI to set up a modern stock exchange that would help introduce the best international practices, both in the areas of trading and settlement.

It is worth noting in this context that in the initial stages, there was not much enthusiasm in favour of setting up a new stock exchange even among influential official circles. There was some scepticism as whether there was any need for such an exchange that would compete with the broker-owned-dominated stock exchanges. It was widely believed that the right course of action should be that SEBI should crack its regulatory whip. It was hoped that this would ensure good corporate governance among the stock exchanges, make markets function more efficiently and protect investors’ interests. The then chairman of SEBI G V Ramakrishna did act tough to make stock exchanges fall in line. But the well entrenched brokers were in no mood to listen to wise counsel. Prominent broker associations as also some of the stock exchanges were almost on a collision course with the market regulator. Soon it became abundantly clear that, in the absence of competitive pressure from a well functioning and professionally managed stock exchange, market standards could not be significantly improved.

The second point that needs to be noted is that the NSE as has emerged was not the one to which we find reference in the Pherwani Committee. The concept of the stock exchange given in the Pherwani Committee was quite a timid one. The NSE, as proposed by the Pherwani Committee, was primarily meant for creating a corporate debt market as also creating liquidity in mid-range stocks that lacked liquidity on the main stock exchanges like the BSE. Foreseeing the opposition such a proposal would meet with from BSE and the powerful broker lobby the Pherwani Committee had suggested that such a stock exchange should be set up in New Bombay. Despite the fact that the NSE, as recommended by the Pherwani Committee, would have posed hardly any threat to the strongly entrenched BSE and other exchanges, there was tremendous opposition to the very idea of an exchange with different feathers. At that time the broker community a strongly believed that of stock exchanges were their exclusive preserve.

It was certainly a difficult journey as we faced several difficulties, often from quarters, which should have, in the fitness of things, supported us in our task. My intention is to share with you an insider’s story so as to dispel the wrong impression some people have, that it was cakewalk for us. It is also my desire to emphasise that the changes that the NSE has been able to bring about may appear to be irreversible; but it need not necessarily be so. If we are keen that our journey on the path of capital market reform is not slowed down or that the reform process does not get reversed, we should remain ever watchful of the games that the detractors play. We should try to see through the clever games which a number of powerful market operators repeatedly play to achieve their selfish objectives.

NSE as a Trend Setter

The anonymous order matching system adopted by NSE is perhaps one of the best in the world. The New York Stock Exchange (NYSE), for example, would have remained free from the bad name that the floor specialists brought to the exchange, had it adopted NSE’s automated trading system. In terms of the geographical reach of real time trading facilities to the nooks and corners of the country, the Indian capital market is way ahead of most of the global capital markets. Investors can trade from close to 400 cities/towns across the length and breadth of the country on a real time basis. Today, investors in distant parts of the country feel happy that they enjoy parity with investors located in Mumbai as they also have the same type of access to the best prices as are available to investors in Mumbai. Before NSE came into existence the country was not even aware of the ironclad settlement guarantee for all the trades done on an exchange. NSE is the only exchange in the country which has set up a clearing corporation which acts as the central counter party guaranteeing all settlements.

NSE happens to be the first truly demutualised stock exchange of the world; it has almost fully resolved the conflict of interest issues that arise when brokers are in control of the boards of the stock exchanges. NSE represents a basic paradigm shift as the ownership and management of the exchange have been fully separated from the trading rights. NSE is owned by a set of premier financial institutions/banks and is managed by professionals who do not trade directly or indirectly on the exchange. NSE is the only stock exchange in the country which decided not to seek exemption from corporate tax, which all other stock exchanges in the country routinely enjoy. NSE has been paying sizeable corporate taxes every year, right from the first year of its operation.

NSE believes in the philosophy of a fully competitive system insofar as its trading membership is concerned. There are no entry or exit barriers in regard to NSE membership. Since NSE does not limit arbitrarily as to how many members it will admit in any of its trading segments, any eligible corporate or non-corporate entity can aspire to become a trading member by paying the required security deposits and meeting other normal membership requirements. Similarly, its members are also to free to exit later if they find that they have other more profitable business opportunities; such exiting members can seek a refund of all the membership deposits kept with NSE once they meet the dues of the exchange and their clients.

Before we crystallised our architectural design for the proposed stock exchange we felt that we should have some idea as to how some of the best stock exchanges in the world functioned. We undertook a study tour of stock exchanges of Asia (Australia, Bangkok and Hong Kong), Europe (London, Paris), America (NYSE and NASDAQ, Vancouver). These visits convinced us that we should not copy the model of any particular stock exchange. Instead we felt that we should adopt an eclectic approach which implied incorporating in the conceptual design of NSE the best features that we found in different exchanges of the world. NSE thus incorporates today the features of (a) the big board of NYSE dealing mainly in very large stocks that are widely known across the length and breadth of a vast country like ours, (b) a nationwide presence of trading terminals on the pattern of NASDAQ, (c) a computerised order-driven trading system of the type found on the Paris bourse or in Vancouver, which is free from the manipulative behaviour of the market makers or specialists, and

(d) a settlement guarantee system akin to the Chicago’s futures exchanges.

We also needed a communication technology that would help us connect the trading terminals of our members to the exchange computers. In this area we borrowed the idea of the nationwide departmental stores of the US, many of which rely on their captive satellite communication network for executing instantaneous cash settlements. There was also another strong reason for choosing satellite-based communication technology (SBCT) in our context. When NSE was being set up, the terrestrial communication system provided by BSNL would not have provided a fault tolerant, time critical, and high bandwidth communication link between NSE and its members. Even within Mumbai, broadband telecommunication links were not highly reliable, besides the fact that they were relatively more expensive. For example, in Mumbai an end-to-end 64 kbps leased line from MTNL used to cost NSE members almost Rs 2 lakh per annum whereas NSE’s highly reliable satellite link cost around half that amount. Secondly, quick availability of leased lines was also a problem in those days as there was no competition to the BSNL or MTNL. In retrospect, NSE’s decision to go in for its own captive VSAT network proved to be a very wise decision. Such a highly reliable telecom link that enabled NSE to establish links with its rapidly expanding member community with a minimum time lag put NSE way ahead of all its competitors. This was perhaps one of the most important reasons which helped NSE’s trading volumes grow almost exponentially. Secondly, given the state of the terrestrial telecom infrastructure of BSNL and MTNL when NSE started its operations in 1994 it would have been practically impossible to establish NSE’s nationwide trading network, connecting such far off places like Srinagar, Jorhat (Assam), Nagercoil (Tamil Nadu), Nainital (Uttaranchal) and Salasar (Rajasthan).

Opposition to NSE

The proposal to set up NSE was met with tremendous hostility. The broker community was up in arms against any such idea for the simple reason that it was against their interests. They sincerely believed in the concept of mutuality of a stock exchange and firmly believed that only brokers should own and manage a stock exchange. They could sell such an idea to the lay people as the global history of the stock exchanges supported their contention. All over the world, almost all the stock exchanges are broker-owned and managed. Even in India history not only was in their favour but the spirit of SCRA was also in sympathy of their contention. The SCRA defines the stock exchange as follows: “Stock exchange means any body of individuals, whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities”.

The second objection was that NSE was given a mandate to spread to all the parts of the country, whereas the then existing stock exchanges were permitted to operate within a strictly defined narrow geographical territory. The area in which a stock exchange could operate, was most of the time coterminus with city limits where the particular exchange was set up. For example, the area of operation of BSE was confined to the municipal limits of Mumbai and that of DSE to Delhi. The design accepted by the authorities at that time was to divide the country into geographically non-competitive securities markets; in other words the then accepted policy frame was to create geographical monopolies for respective stock exchanges and to protect them from competition with other stock exchanges. With the arrival of NSE with a mandate to operate in all parts of the country, the monopoly status of all the stock exchanges came to an end abruptly. The smaller stock exchanges were particularly worried that they would have to compete with the proposed exchange which was backed by powerful financial institutions of the country.

They also took great objection to the proposition that NSE would enter in a big way into the equity segment by setting up computerised trading facilities in equities all over the country. Most of those who were opposed to NSE were under the wrong impression that we were implementing NSE as was conceived in the Pherwani Committee report. However, our design of NSE was radically different. All that we borrowed from the Pherwani Committee report was the attractive name of the NSE for the proposed stock exchange. The broker community therefore accused us that we were going beyond our charter, which, according to them, was merely setting up of an exchange for trading in debt instruments.

Misplaced Fears

It was then very widely believed that computerised trading would not succeed especially in a country like India where computer literacy was quite poor, especially among the stock market fraternity. When the NSE was being set up, most of the people that took up broking activity were not only not very well educated, most of them had not even touched a computer key board. In view of this, it would be very difficult to attract truly business savvy brokers into NSE’s fold as they would detest computerised trading systems. It was widely believed that computerised trading requires highly complex computer skills and those who have such skills are unlikely to be good brokers. In a way, we were also worried about the difficulties of enticing the broker community into the fold of the NSE. Hence we planned to provide training in computerised trading to our members before we actually commenced our formal trading on the NSE. We set up trading floors in NSE’s office premises by setting up a local area network (LAN) where members could be actually trained to do computer trading. We estimated that it would require at least three full days’ training for each dealer. Our LAN could accommodate almost 100 dealers at any point of time. After the training started we were in for a major surprise. Most of the dealers at these training courses took just about two hours to learn all the tricks of the trade and they became quite proficient in computerised trading system. The main reason for dealers learning the skills fast was due to the high quality trading software that we had procured from a foreign software company and the subsequent improvements/modifications/ customisation done by Tata Consultancy Services (TCS), our main software vendor at NSE. The trading software had kept all the complexities at the host computers at NSE and the dealer terminal or front-end was kept as simple and user friendly as possible.

NSE as Market Reformer

Concept of a Demutualised Exchange

The NSE brand of demutuality is perhaps unique in the world as it aims at a total separation of exchange ownership and management from the trading rights of members. In other parts of the world, demtualisation has meant converting the mutualised exchange into a corporate entity, with trading members having both ownership rights as also representation on the board of the company. Australia was the first country where a mutualised exchange got transformed into a demtualised corporate body in the latter half of the 1990s. In the Australian demtualisation case, brokers still have a strong voice in management as their shareholding in the exchange company continues to be sizeable. True demtualsation is one in which ownership and management of an exchange are totally separate from members’ trading rights in the exchange. In a broker dominated exchange, all the officebearers such as the president, vice-president/s, treasurer, and other board members are all elected by the general body of members who are trading members. It is also obvious that once you resort to election as a method for choosing office-bearers of the exchange, group politics is bound to emerge. As officebearers of an exchange continue to remain active in their own day-to-day brokerage business, there is always a temptation to misuse their official position to have access to information about other members’ market position in different stocks. It is not possible to prevent all such malpractices, unless all the officebearers in control of the affairs of an exchange are not its trading members.

This argument is sometimes countered by pointing out that a number of chief/senior executives of brokerage firms also sit on the board of NYSE. It is further argued that if that is considered to be reasonable in the case of NYSE – a premier stock exchange of the world – what is wrong in having brokers on boards of the Indian stock exchanges? The major point that should be noted in this context is that the senior member representatives on the board of NYSE are not only very far removed from the normal trading desks of their firms but that they scrupulously avoid having any contact even remotely with all those departments which are involved in the actual exchange activity. In spite of the self discipline observed by NYSE board members, there has been frequent criticism about the influence of powerful trading members on the management quality of functioning of NYSE. Recently, there has been intense criticism about the detrimental influence of the floor specialists on the price discovery process of NYSE and the role of powerful NYSE members firms in this.

As of now there is hardly any disagreement in our country of the necessity of having demtualised stock exchanges. After the stock exchange crisis in 2001, the government announced that demtualisation will be made mandatory. However, the actual move in that direction has got considerably delayed. The main difficulty that arose in this area is about the beneficial ownership of the property that belonged to the exchanges after they got demutualised. Many people including me have argued that most of the property that the exchanges had accumulated has been due to the favours by the government to the exchanges. They were exempt from all types taxes besides the fact that the land on which the buildings of most of the stock exchanges were constructed was given at almost throwaway prices to the exchanges. Since the exchange was considered to be a public utility it enjoyed so many other benefits including listing fees that are to be paid by the listed companies. Recently, SEBI has come out with a broad demtualisation scheme for the exchanges where brokers will have 49 per cent of the share capital of the new exchange company and broker representation on the governing board will be to the extent of 25 per cent of the total. It should be noted in this context that this scheme of demutualisation is materially different from that of NSE. Hence one is not fully sure as to what this will mean in reality for the quality of governance and resolution of the issues relating to conflicts of interests as noted above with broker members sitting on the boards of the stock exchanges. There is also one more puzzle that needs to be noted in this context. Before I turn to NSE’s attempt to set up a nationwide exchange let me draw your attention to the tremendous pressure that was brought to bear on NSE from highly powerful quarters to have broker members on its board. Very ingenious arguments were being put forth in justification of having brokers on the board of NSE. It was said that just as we cannot have bar councils without lawyers on the bar or medical councils without doctors as its members how can we have stock exchanges without stock brokers on their boards? The major point that was missed all along was that bar councils or medical councils are like clubs of their own members and they are not on par with stock exchanges, which are granted recognition by the regulator so that they scrupulously follow a code discipline, protect integrity of the market and fully protect investors’ interests. Common citizens do not deal with the bar councils or the medical councils in the same fashion that investors deal with the stock exchanges. Hence, it is meaningless to compare bar councils or medical councils with stock exchanges. Although NSE’s trading members were fully aware that NSE’s trading membership does not grant them any rights to its board membership, they also started an agitation to have board representation. However, NSE’s board stood firm on this issue and refused to yield to pressures of the vested interest groups.

Concept of Nationwide Exchange

When NSE got its recognition as a stock exchange these powers were being exercised by the ministry of finance, government of India. When NSE was given a clear mandate that permitted it to extend its operations to all the parts of the country it was not clear to the stock exchange community as to how we would be able implement such a difficult project. Hence most of them felt that this nationwide trading mandate would remain merely on paper. It is possible that most of the regional stock exchanges were not worried in the beginning that NSE would ever compete with them for business. With the resounding success of NSE’s order driven anonymous computerised trading system, which rode a highly reliable satellite communication system, all the stock exchanges got very much worried about its competitive threat. BSE also got much more worried as we started eating in a big into its order flow that used to originate from the rest of the country. As NSE’s trading volumes started spurting, all the stock exchanges started putting pressure on the regulator not to permit the spread of NSE to centres where the regional stock exchanges were located. We from the NSE took a stand that since NSE had been given a mandate to spread its trading network to provide real time and equal access to investors spread across the length and breadth of the country we cannot stop our drive of going to newer and newer places where investors existed.

This became a highly contentious policy issue; hence it had to be finally referred to the government as the original mandate to NSE for nationwide trading was given by the government itself. The government was requested to review the policy in regard to NSE so that it is also obliged to seek appropriate approvals for all its future plans to expand its network to new geographical locations. The logic was that since other exchanges had to obtain approval before spreading their trading terminals to locations outside their licensed areas, NSE should also be subjected to the same rule. However, we from the NSE were vocal that the ban put on other exchanges from spreading to locations outside their pre-approved areas of operations should be removed so that all the recognised exchanges freely spread their operations to places of their choice. Since NSE was conceived from the beginning as a model exchange to significantly upgrade capital markets of the country and put competitive pressure on the existing exchanges to reform themselves, it was not necessary to set up different NSE type model exchanges in all places where the stock exchanges already existed. The technology adopted by NSE facilitates spreading its trading network to all the parts of the country; therefore it is a cost-effective option to provide exchange infrastructure rather than duplicating the NSE model in different cities and towns. The NSE model discards the archaic then prevailing capital market concept which identified a market with a particular geographical location. Prior to NSE, the capital market of the country was divided into isolated markets which were identified with the cities of their location, viz, BSE in Mumbai, DSE in Delhi, etc. When the policy about NSE’s expansion was being reviewed, NSE had put on hold its expansion plans. However, it did not take much time for the government to reaffirm its earlier decision that NSE should be allowed to spread its trading network, without any hindrance, to all the parts of the country.

Settlement Guarantee

The concept of a settlement guarantee, which NSE currently operates, was almost unknown in India until 1995. Interestingly, the SCRA also does not talk much about settlement of trades done on the exchanges, except mentioning that the exchanges can set up their own clearing houses. We realised this was one area where a major reform was overdue. Our review of global practices indicated that even some of the major stock exchanges like NYSE, NASDAQ and LSE, did not have their own clearing and settlement infrastructure/entities. Even today, brokers of these exchanges trade on their respective exchanges but take their trades to an independent clearing corporation for the settlement. For example, NYSE brokers report all their trades to a clearing corporation which also clears and settles trades on other exchanges. But we realised this model was not suitable for the Indian conditions as there are even today no such independent clearing corporations that could take the responsibility of settlement by offering ironclad settlement guarantee. NSE therefore decided to set up a wholly owned subsidiary called the National Securities Clearing Corporation (NSCCL) for this purpose. The major advantage of NSE owning the NSCCL is that there is seamless integration of the two most important functions of trading and settlement with full guarantee. Investors’ interests can be thus be fully protected.

Some argue that NSE itself could settle all the trades with a settlement guarantee by having an in-house clearing and settlement arrangement called a clearing house. But this is not a highly satisfactory solution for some important reasons. The major reason for setting up a separate legal entity for handling clearing and settlement is that such an activity is a commercially risky proposition which the stock exchange itself should not undertake as an in-house activity. A clearing corporation may face the prospects of bankruptcy in extremely volatile market conditions, if the margin money and other funds on the basis of which settlement guarantee is extended to the clearing members is not adequate to cover the risks that may emanate when some of the clearing members become bankrupt and the guarantee fund is not enough to complete the settlement. From an overall point of view, an exchange is considered to be a public entity which should not ever face the prospects of bankruptcy. Hence there is justification to segregate the clearing and settlement activity by entrusting it to another corporate entity and not make it part of exchange activity.

Given the speculative instincts that dominate market players in India, NSCCL introduced some of the most stringent regulations for its members. The mechanism of upfront or initial margins was introduced by NSCCL right from day one in a different garb. Each member was given trading exposure limits (net in each stock and gross across all the securities), based on the deposits that the member placed with NSE plus NSCCL. To begin with, the net exposure ratio was fixed at 10, meaning thereby that no member can have, at any point of time, an aggregate exposure of more that, 10 times his deposits. If a member deposits say Rs 2 crore he can trade within an exposure limit of Rs 20 crore. To track member positions, NSCCL developed unique software which tracks each member’s aggregate trading exposure on a real time basis. The software has the capability of not only informing the member of his exposure position on a real time basis, but can also disconnect all his trading terminals the moment he crosses the limit granted to him on the basis of the deposits made with NSE/NSCCL. The NSCCL has been making variations in the exposure ratio depending on the market conditions. Later NSE calculated security-wise margins, based on the volatility which different stocks are subject to. As of now, it would be no exaggeration to state that India has one of the most sophisticated systems that implements a scientific margining mechanism. It is also one of the few countries that has built strong capabilities to deny trading connectivity to members who exceed their exposure limits on a real time basis.

When NSCCL introduced the concept of a settlement guarantee fund for smoothly managing the settlements, there was a lot of misunderstanding about the concept of settlement guarantee itself. In real life situations it is very rare that in each settlement all the pay-ins are made fully by the members. Temporary shortages of either funds or securities invariably happen for various genuine reasons, given the fact that members/investors trade on NSE from nearly 400 places across the country. For example, a member may find that his client has not been able to remit funds in time for the member to complete the pay-in before the predetermined time. In some cases, investors may not be able to give delivery of shares to the members in time if the members maintain their depository account with some other depository participant. It is also possible that the client of a broker or the broker himself has traded excessively and is not in a position to honour his obligations to the clearing corporation. In this context, it should be noted that just because all the pay-ins have not come forth the settlement should be aborted. In all such cases of shortages, the NSCCL which acts as the central counter-party for the whole settlement process steps in and completes the settlement. If there is a shortage of funds the settlement guarantee fund is used to complete settlement. If there are security shortages, NSCCL procures the shares by buying them through an auction or borrowing the securities as recently permitted by SEBI. Later the NSCCL recovers the dues from the members who are short in deliveries and also levies fines for not having made the required pay-in on time. It is only when the concerned member fails to pay up his dues to the NSCCL within the time frame stipulated by it that the procedure for declaring him a defaulter kicks in.

In the beginning, when this system was introduced there was a great deal of misunderstanding about it. Some even unfairly and maliciously accused NSCCL as encouraging speculation by funding settlement shortages. They ignored the fact that before BSE put up its own form of a settlement guarantee arrangement, it had to shut down the exchange during the mid-1990s for three consecutive days to resolve the problems caused by settlement default by a member of a relatively small amount. A settlement guarantee fund helps to fund settlement shortages as a bridging mechanism so that the settlement goes though smoothly and there are no cascading defaults. During its existence so far, NSCCL has been able to manage all the settlements on time with the help of the settlement guarantee fund even when there were large payin shortfalls. In most of these cases, NSCCL has been able to recover later the pay-in shortfalls from the members. In all those cases where members failed to meet their obligations to the NSCCL, even after they were given reasonable time to make good their shortfalls, such members were declared as defaulters and the shortfalls were met out of the incomes NSCCL earns by way of interest on the settlement guarantee fund as also the small fees it collects from the members as settlement charges. By now the concept of the settlement guarantee fund and guaranteed settlements have become accepted folklore in our capital markets. But it should not be forgotten that when we introduced them for the first time in the country, we had to face a lot of malicious criticism from the market players and hostility from unexpected quarters. Some market players even went to the extent of spreading falsehood that IDBI was continually funding NSE’s settlement shortages as also losses incurred by NSCCL, just because IDBI was the main promoter of NSE.

NSE: Third Largest Exchange

In terms of the number of number of transactions, NSE is today the third largest exchange in the world, next only to NASDAQ and NYSE. How did NSE come to occupy this position within a decade. It has also been able to establish another major landmark. It is the first stock exchange in the world to cross the turnover of an already well entrenched stock exchange in its own country, viz, BSE, in a very short period of one year. It is worth noting in this context that the initial run for the NSE was not at all that smooth. During the first few months of its existence, its trading turnover was quite modest, often less than Rs 10 crore a day. It appears that the investors as also our members were testing our systems and our management capabilities. When they saw that all the settlements were being completed absolutely on time without any hitches they started developing confidence in us. As our rules and regulations were absolutely transparent and once investors started seeing prices and quantities in different stocks on a real time basis at all places where our terminals were located, they came to recognise a major difference between NSE and all other exchanges. As NSE volumes started growing, the prices reflected on its screen became a benchmark for all other exchanges including BSE. It did not require much time for NSE to establish its leadership in the market. Another interesting thing that is worth noting is the composition of its investor class when it emerged as the largest stock exchange of the country. At that time more than 90 per cent of the value of trading was accounted for by non-institutional or retail investors. Strangely, even most of the promoters of NSE were not trading on NSE. That is why I consider that institutional investors are less market savvy and laggards as compared to retail investors. Although the institutional investors’ holdings have grown quite rapidly during the last decade the retail investors continue to be the backbone of our equity markets. Given the fact that NSE enjoys the maximum trust of the retail investor community, it will continue to grow both in terms of trading volumes as also in terms of market share.

Depository with Dematerialisation

As NSE spread across the country, it faced serious problems related to the paper-based settlement system. The first set of problems related to transport of share certificates to the central clearing location in Mumbai. Since NSE decided to shorten the settlement period it introduced a weekly settlement system as against BSE’s fortnightly settlement. Shortening of the settlement period along with the responsibility of clearing settlement of the net obligations during the next week put an excessive burden on NSE. The pay-ins of securities from all over the country at Mumbai and the re-dispatch of pay-outs thereafter at all the relevant locations in a week’s time created lot of difficulties for its members. NSE therefore decided to offer a helping hand to its members. It made arrangements to receive all the pay-ins at four major metros, viz, Mumbai, Delhi, Kolkata, and Chennai and also make pay-outs from these four metros. At its own expense NSE used to ship by air all the securities pay-ins from the other metros to the central location in Mumbai and reship by air the pay-outs to the other metros. On many occasions NSE had to airship share certificates weighing more than four tonnes a week each way at its own expense. The paper based system posed other more serious problems. Several anti-social elements tried to take advantage of the system by introducing fake and fraudulent securities and transfer forms that accompanied them. To deal with problem of fake certificates, NSE, with the assistance of registrars and transfer agents of the companies, launched a system of scrutiny of the documents before they are accepted as pay-ins. Despite all this, NSCCL as also several members, suffered loss due to the massive nature of the problem.

NSE therefore took up in earnest, the task of setting up a depository where ownership records would be maintained in a dematerialised form. The speed with which this task was also implemented could be noted from the fact that the depository went live in November 1996, just two years after NSE went live in November 1994. It was a great encouragement and relief for us when C B Bhave agreed to take up the responsibility as the first MD and CEO of the depository in the early part of 1996. He has done a wonderful job at the depository and taken it to great heights. NSDL therefore continues to be the preferred depository of the investor community. In this context, it is worth remembering that despite the obvious advantages of a depository there were some people who were not in favour. These were the people who could benefit from badla trading in paper-based environment. The true motives of some of these people got exposed during the 1998 stock market debacle when it was found that the physical share certificates were being misused in badla trading. If depository movement has become a resounding success in India in such a short period of time it is a tribute to both the government and the SEBI for consciously pushing the capital market players in that direction. The Indian depository is unique in the world in one respect. It is, perhaps, the only depository to have full data on investor holdings, which gets updated continually. The investors are therefore better protected from problems that may arise due to intentional or unintentional activities of the depository participants which are in the investors’ interest. The success of a dematerislised depository has also helped to usher in an era of rolling settlement. In a period of less than four years the Indian capital markets could make a transition from a weekly account period settlement first to a T+5 settlement, then to T+3 settlement and finally to a T+2 settlement. It would have been simply impossible to think of a rolling settlement if depository movement had not caught on in such a short period of time. India is one of the few countries where depository movement has become such a market-wide success.

Futures and Options

Despite the advice to the contrary even from many of our wellwishers we decided not to introduce badla trading system on the NSE. Some had favoured NSE introducing badla trading as they felt that we would be able to manage it more efficiently and in a transparent fashion. The main reason why we did not favour badla trading is that it is a hybrid product which muddies up the price discovery process as badla is a mix of the cash and the futures market. Badla grew rapidly in the Indian market after forward trading was banned in the 1960s because of the excessive speculation that it was leading to. Badla provided an escape route to the active market players; it gained in popularity with speculators as also many financiers who wanted to deploy their funds in a profitable way. The badla trading system also became a conduit for deployment of unaccounted money for traders in many areas. Right from day one of NSE, we were keen that India should graduate into the globally accepted most efficient form of futures trading, viz, futures and options. Hence our efforts were, at that time, concentrated on getting SEBI approval for futures and options. Being a totally new product it did take us quite some time to get the futures trading duly approved. A major part of the difficulty that we faced was on account of the powerful badla lobby which strongly opposed introduction of futures in the Indian markets. The main worry of the badla lobby was that, once futures were introduced in India badla would lose its attraction.

After a great deal of efforts, futures were allowed to be introduced. However, BSE managed to score over NSE by launching futures one day prior to that of NSE. But that has not helped BSE in any way as could be noted from the fact that futures have not taken off at BSE. As of today more than 99 per cent of the futures trading in the country happens to be on the NSE. One need not put in great efforts to find out as to why BSE has lost to NSE in the futures game. The reason for this is simple. When NSE was concentrating its efforts on building its in-house expertise, developing the trading and settlement software, and the spread of the message of futures countrywide through large number of investor seminars, BSE was emotionally pleading the case of badla even in foreign countries. As a result, it lost a great deal in terms of getting seriously prepared for the introduction of a relatively more complex options and futures trading. Once having lost the lead in this area it has become more difficult for BSE to attract investors to its futures segment. During 2000-01 the market witnessed exceedingly high speculative activity on the exchanges, aided by badla with diluted standards and interexchange position shifting. This led to a market crash forcing the government to ban badla and announce introduction of rolling settlements. My worst fears about the highly risky nature of badla trading were proved to be correct and our decision not to introduce it at any cost also proved to be the right one.

Risks of Individual Stock Futures

The original plan of bringing futures to the country in place of badla was to introduce index futures, index options and stock options. The SEBI committee that went into the whole issue of equity based futures was not in favour of futures in individual stocks which are, however, currently being traded on the NSE. In fact, all over the world the widely accepted futures products are the index futures, index options and stock options. In most of the countries, wherever equity futures are traded the individual stock futures either do not find any place or even if they are grudgingly allowed, not much trade takes place in them. Most of the market players either do not find individual stock futures to be useful products or they consider them…and very rightly so…as highly risky products.

The basic purpose which the equity futures are supposed to serve is to provide a mechanism for investors to hedge their risks arising from unanticipated broad market movements. It is universally accepted that index futures serve this objective of protecting investors eminently from risks arising from broad market trends by incurring a small cost in the form of margins paid to the exchanges. Let me briefly explain what this means. The price of a stock at any point of time reflects the influence of two factors. The first set of factors relates essentially to the performance of the company itself. For example, if you have invested your money in a cement company, the price of its shares would depend on the profitability of cement, relative locational advantages/disadvantages of the production facility of the particular company, type of production technology, quality of its management, etc. The other set of factors that influence the share prices of the that cement company would depend on the state of the capital market itself. Even if there is no change in the factors that influence working of the particular cement company, prices of its share will go up or down depending on the bearish or bullish conditions in the market. When an investor invests in a company after making a detailed study he can be reasonably sure about the price he should pay as of today. But it is not possible for the investor to predict as to what will happen to its price say after three months if the overall market conditions change. To protect investors against such risks which are associated with the future market trends, index futures have been devised. If an investor is interested in only specific stocks he might as well buy options contracts in such stocks which the option writers provide. In fact, the stock options are safest for an individual since his upside risk of buying an option is limited to the extent of the margin money paid for buying stock options. In the case of stock futures, the risk can be very high if the market moves in the opposite direction by a large measure.

The world over, stock futures are not favoured in view of the risks they pose to the investors as also to the markets. Futures in individual stocks are considered to be highly risky primarily because they can be manipulated by unscrupulous speculators. A group of large speculators can come together and manipulate the futures prices of an individual stock by acting in a concerted fashion. Since a trader in futures has to shell out only margin amounts and not the full price of the value of the contract, leveraging becomes easy. In other words, the amounts required to manipulate futures prices of an individual stock would not be very large if a group of speculators can act in concert to manipulate its market price. The same cannot be said about index futures. For example, the NSE’s main stock index, viz, Nifty has a huge market capitalisation of around Rs 12 lakh crore. It is, therefore, not as easy to manipulate Nifty as individual stocks are included in Nifty. There has been some discussion in the newspapers about the manipulations of Nifty index by some unscrupulous speculators. The mechanism adopted by such manipulators is relatively simple. They pick up a share of a company like HLL which has a large weight in the index but a relatively smaller floating stock. After the introduction of individual stock futures it has become much easier to manipulate shares like HLL as one needs much less margin money to be deposited with the exchange for buying futures in HLL. If there were to be no futures in individual stocks, speculators would need much larger amounts to take delivery of stocks and hold them for manipulating share prices. Thus we have introduced a futures trading systems which makes it much easier for market players not only to manipulate prices of individual stocks but also of the indices on which futures contracts are written.

Most of the countries that have introduced equity futures have preferred to introduce index futures, and options in index and individual stocks. Very few countries have taken the risk of introducing individual stock futures. Even in those countries where the individual stock futures have been introduced the relative trading volumes are quite modest. The Italian stock exchange which ranks next only to NSE in terms of value of traded contracts in individual stock futures, accounts for only 25 per cent of NSE’s volume. But when it comes to the value of contracts in index futures the volume of the Italian exchange is nearly twice that of NSE. This is indicative of the fact that individual stock futures are not considered as safe as index futures even in the countries in which such futures products are traded. All the major futures exchanges of the world in the US or Europe consider that individual stock futures are not only highly unsafe but also that they do not serve any justifiable purpose. Despite the obvious risks that individual stock futures pose to the safety and integrity of the capital market of the country, they have been introduced in a hurry in our country.

In my opinion it was not a wise thing for us to have introduced individual stock futures. I am fully conscious that I am in a hopeless minority to hold such a view. All those who had mourned the death of badla are very happy that a similar product is now available for them to play their games. Some prominent brokers also hold the opinion that the void created by the ban of badla has been filled up through an equally risky product like individual stock futures. I sincerely believe individual stock futures pose an avoidable risk to our capital markets because of the unbridled growth in their trading volume. Of the daily total trading volume of all the futures products, the individual stock futures alone account for over 60 per cent. Further, the daily trading volume of the individual stock futures is on an average more than twice the trading volume of the cash market.

Shortening of Settlement Period

Most of us remember that before setting up NSE, the settlement system followed by BSE – the exchange which accounted for nearly two-thirds of the trading volume of all the exchanges of the country until 1994 – was an account period cycle of trading for a fortnight and settling the net obligations after a period of 15 days. Thus, if somebody traded on the first day of the trading cycle he could get his funds or securities almost after a month. Often this period used to get extended to almost six to eight weeks if there was hectic activity in the market forcing the exchange authorities to club several trading cycles. After NSE started operating it reduced the cycle to one week of trading and settling the net obligations a week thereafter. But for more than four years we are all in a rolling settlement era. To begin with a T+5 cycle was introduced, meaning thereby that each day’s trades are settled five days thereafter. Introduction of the rolling settlement meant India entering into the global league of more efficient markets. This prompted the authorities to push this reform to shorten the settlement cycle further to a T+3 settlement mode. Later, with a view to score over even the developed countries in shortening the settlement cycle it was reduced further to T+2 mode. In this context it should be noted that the major developed country markets in Europe and America have been toying for the last several years with the idea of shortening their settlement cycle from the current T+3 mode to T+2. But they have refrained from the temptation of reducing the cycle to less than T+3 mode for the simple reason that the disadvantages arising from shortening the settlement cycle far outweigh the gains. All that the shortening of the settlement cycle means funds or securities are obtained a day earlier. But the hassles of managing such a short settlement cycle are far too many, besides there is the risk of several players not being in a position to complete their pay-in of securities and settle funds in time to complete T+2 settlement.

In India we face many problems due to differing levels of computerisation and risk management practices of several market players. It is simply not a question of availability or otherwise of RTGS at all places. Most of our banks do not have efficient electronic funds transfer (EFT) facilities which enable banks to move funds from one branch where a customer is located to the other branch which interacts with the exchange clearing corporation. Secondly, even though currently there is a depository mode of delivery, many investors find it too inconvenient to make their delivery in time for the settlement. Hence many investors either give the power of attorney (POA) to their broker or sign delivery slips well in advance and keep them with their brokers. Most of you might have read in the newspapers the horror stories that are coming to light where the brokers have cheated their investors. I do not want to dilate on this point too much as all of you are already aware of the risks that the investors are facing as a result of a shortening of the settlement cycle to T+2. One therefore often gets tempted to ask as what the investors have gained from shortening the settlement cycle except providing an opportunity to some people to claim that India is ahead of even the developed countries in terms of shorter settlement cycles.

Problems of Participatory Notes

With our stock markets passing through an unprecedented boom, the problems posed by the so-called participatory notes (PNs) are being discussed in several responsible quarters. Some of the FIIs which are registered with SEBI and are permitted to invest in our equity markets mobilise funds through PNs which are supposed to be subscribed by other eligible investors. When the FIIs invest funds mobilised through PNs for investing in the Indian equity markets, they have to give a written undertaking that they have not mobilised funds from non-eligible entities. Frankly, the current regulations governing the PNs are not satisfactory enough to ensure that absolutely the right type of funds are getting into our markets. Many people feel that the colour of money cannot be correctly known when it is flowing through the PNs. The worry about the PNs is that the current boom is largely fuelled by the FII money, bulk of which is flowing through the PNs. The vulnerability of the market to manipulations increases when it is difficult to know the source of money that fuels heavy trading activity in the market. Since a large amount of money has flowed into our equity markets through the PNs it is difficult to take any corrective action that may trigger a sudden outflow of money that has entered the market through the PNs. It is a big dilemma facing the policy-makers.

Short Selling and Securities Lending

Currently, SEBI is seriously examining the desirability of allowing short selling by the institutions which cannot execute other than delivery-based trades. The idea is to provide a level playing field to the institutions so that they can also freely trade in the market as other market players. This policy is also expected to be accompanied by two other measures. When institutions are allowed to sell short they will also be subjected to the same margining system as others who are permitted to do short selling. Secondly, to facilitate short selling, a scheme for lending and borrowing of securities would be introduced. Anybody who sells short can complete the settlement by borrowing the relevant securities from the willing lenders and delivering them at the pay-in time to the clearing corporation. The borrower of securities can then buy them from the market at an appropriate time to return the borrowed securities to the lender. The argument in favour of short selling is that it allows market players to take a view on security prices. If a market player feels that the current price of a security is too high he can sell the borrowed securities and cover his position at a later day when the prices are expected to fall.

In theory, the facility of short selling looks attractive since it may provide opportunities for intelligent players to introduce corrective market forces. But often the reality could be different as experienced by Hong Kong a couple of years ago. Several large players took advantage of the short selling facility together with the lending and borrowing facility to beat down prices. Large speculators can indulge in heavy short selling to push down prices steeply and cover their position at a later date at much lower prices. Such players can reap huge profits at the cost of other investors and market stability. One is really not sure whether it is desirable to introduce all such facilities which have the potential for destabilising the markets without any compensatory benefits.

Is the Boom Going to Last?

Most of those who have a large exposure to the equity markets are very anxious to know whether the current boom will last and how far the market will rise. Frankly, it is very difficult for anybody to make any reliable forecast on a subject like this. If anyone knew the right answer he could make a huge amount of money. It is for this reason that both astrologers and the chartists are so much popular these days. My simple suggestion to all those emotionally involved in the stock markets is that, do not believe anyone who is certain that the market is bound to move in a particular direction or that the stock index will be at a particular level by say June 2006 or some such date. If some “market experts” give such forecasts they are trying to play with sentiments. If, however, they are a part of one of the powerful manipulator groups they would perhaps be the people to know in which direction the market will move. But one can be certain that such manipulators will never tell the truth because their attempts would be to fool the market so that they can make money. If they want to buy particular stocks they would like to say that this is the best to time sell them so that they can buy them when the market goes down as a result of large sales.

Like in most areas of our lives we should try to depend on native intelligence and not be misled by the quacks or scamsters. Investors should make their own careful study before jumping into the fray. The stock market is not meant for people who are governed by emotions and are likely to be carried away by the mad frenzy of bulls and bears. I would, therefore, like to provide some tools with the help of which investors should try to analyse market trends and the likely direction in which the market may move in the near future. The first question that comes to anyone’s mind is how to judge as to what is the right or justifiable level of the market and when can it be said to be at an artificially high level or a depressed level? If one has the correct answer to such a question one can judge as to whether the market has the potential to go up or down in the not so distant future.

There are two types of approaches to this problems. One set of people vouch by the technical analysis of the market and depend heavily on charts. The charts no doubt help us understand how the market moves. But that does not mean that an investor can make a huge amount of money with the help of charts. This approach is as good as what an astrologer can say. There is another set of people who can be said to be rationalists who believe that fundamentals of a company should be used for assessing whether the market price of a company’s share is at a reasonably right level. A company with a high level of earnings and the prospect of future growth always commands the attention of investors who are willing to pay a good price to keep it in their portfolio. Even though a company is not currently earning a high level of profits, its share will also command a premium if there is a fair chance that its future earnings will be at high levels. Certain industries at particular points of time are considered growth industries and the companies belonging to these industries will be considered valuable. Companies belonging to stagnant industries will be valued cheaply even though they are profitable. My personal sympathies are with this group of rationalists who attach the maximum importance to a careful study about the current and future levels of profitability of companies before taking an investment decision. Since investors buy shares from return considerations, they should attach maximum importance to current as well as potential future growth in earnings. Company shares are not pieces art or culture, which are valued on totally different considerations. Hence investors should not be emotionally attached to particular companies and hold on to them even if there is clear evidence that many things are wrong with particular companies that are in the portfolio. All the same I would like to say a word of caution even about this rationalists’ approach to investment decisions. It should be noted that fundamentals do not help much in deciding the right price of a share at any point of time. Equity markets are subject to cycles of boom and depression and the same company’s shares even with unchanged earning conditions will be priced differently at different points of time. In a booming market even relatively dud shares command high prices. This phenomenon could be better noted from the fact that the levels of P/E ratios of individual shares as also of stock indexes are very high during a boom and are much lower under depressed market conditions. Boom conditions are often the results of irrational exuberance while prolonged depressed market conditions are many a time caused by irrational gloom. Thus fundamental analysis does not help to determine levels of prices of shares at all times and under all market conditions. All that the fundamental analysis tells us is whether relative price levels of different shares are rationally determined. If we accept this line of reasoning, we will have to agree that it is difficult to state if the market has priced itself correctly when the Sensex is around 10,000 or the Nifty around 3,000. Nobody can say correctly whether the market has some more potential left to go up further or whether the Sensex will cross 12,000 by the end of 2006. If somebody predicts that market has overpriced itself and the Sensex will fall below 8,000 over the next few months, there is valid justification to disbelieve it.

My next proposition is that markets are deeply influenced by sentiments and herd mentality rather than logic. When a large number of players expect that the market is likely to fall, all or most of them will make attempts to exit as hastily as possible. Often, there is an attempt to exit hastily and the situation is similar to that of a stampede which often results in avoidable suffering and loss. Each market player plans to exit as early as possible so that he exits when the prices have not fallen too much. When a large number of market players hasten to exit, prices fall fast and steeply. Another interesting feature of market behaviour is that the responses of market players to certain developments are often disproportionate and excessive. In a relatively depressed market even a minor piece of bad news leads to a large fall in prices. Because of the herd instinct of the market players, price movements often tend to get exaggerated. My suggestion is not to treat market as a rational organism.

One more aspect which most of the investors should keep in mind is as follows. Most of the time, markets are influenced, although in varying proportions, by market players who tend to profit from the mistakes of uninitiated and gullible investors. A large number of investors who buy/sell on the basis of half-baked reports/studies tend to be big losers. Every boom sooner or later flattens out and a large number of investors who hold on to their investments with a greed to profit from much higher prices end up as big losers. Most of such investors may not return to the market in the next boom. But like moths in every rainy season, a new generation of moths gets attracted to the markets. Hence the cycles of boom and burst recur. Investors who do not have the stomach to digest losses from market collapses or do not have the expertise to tread carefully to protect themselves from the furies of bulls and bears should not enter the wonderland of equity markets.



[Adapted from the text of the Seth Shantaram Mangesh Kulkarni Lecture delivered in Mumbai on December 3, 2005.]

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