Scams & Markets
The Indian markets have been witness to two major scams in their history which continue to haunt stakeholders in a big way. However, such scams have helped strengthen the system and alerted the regulatory environment. Yogesh Supekar discusses at length the major scams that impacted the Indian markets and how the regulatory system today is more vigilant and proactive than it was when the incidents took place
Even as global investors and various government agencies were focusing on steady economic recovery from the current pandemic, a little-known family office by the name of Archegos Capital Management sent shock waves across the global markets, leading to selling pressure in select stocks listed on the US bourses. It is estimated that close to USD 20 billion (Rs 1,40,000 crore) worth of shares of some of the large-cap Chinese companies were forcibly sold due to a margin call. This fire-sell led to the markets guessing about how the large banks may have been impacted due to these trades or positions and what could be the amount of losses faced by them.
Nomura Holdings was quick to inform that the losses for the banks related to Archegos Capital Management’s position could be to the tune of USD 2 billion. Converted into Indian currency, the figure is close to Rs 14,000 crore. Credit Suisse declared that the losses could be substantial enough and may be equal to the quarterly profits. The markets were surprised because this huge position was taken by a ‘nobody’ in the world of finance. After all, Archegos Capital Management is just a New York-based family office founded by an ex-hedge fund analyst, Bill Hwang. Often, we experience that such excessive trades or overleveraged trades by some greedy trader or investor surface now and then.
It is extremely difficult to identify when will such trades with heavy positions and excessive leverage increase the market risk for other market participants. In the case of Archegos Capital Management it was the use of ‘swaps’ which are nothing but derivatives instruments that can be traded over the counter without the requirement of public reporting. Usually, deeppocketed institutional investors indulge in such kind of trades. Swaps are popular amongst traders in the US because such instruments allow traders and investors to take huge positions without having to pay large sums of money upfront. The money used to take positions is often borrowed from banks.
When swaps are used one can take excessive leverage often not allowed to a regulated entity. No matter how difficult it is to forecast or predict a scam in a stock market, majority of the scams occur during a Bull Run when the stock prices are gaining momentum and when the interest rates are extremely low. With low interest rates, leverage is more affordable and the best part is that the financial system is loaded with lot of cash and hence traders may be willing to finance risky propositions. Also, the Bull Run makes it possible for market-makers and manipulators to dump large quantity of stocks in the market after rigging the prices higher as there is a huge appetite amongst the investing community for anything that has historically shown an upward price trajectory.
Scams that Hit Us
Securities fraud can be of various types. Essentially, securities fraud or investment fraud is a deceptive practice in the stock or commodity markets that lures investors to buy or sell securities based on rumours and false information which usually leads to heavy losses. Such manipulative practices are often in violation of securities’ laws. Some of the securities frauds include stock price manipulation, theft from investors, manipulating financial reports, front running and insider trading.
Accounting Fraud: Enron (2001)
Enron was a corporate giant and in 1995 was recognised as one of the most innovative businesses by Fortune. Enron is a perfect example of adopting fraudulent accounting practices and using accounting techniques to hide liabilities and inflating earnings and assets. Enron creatively used off-the book accounting practices and incorporated fake holdings, thus inflating the asset size in its balance-sheet. Enron utilised special purpose vehicles (SPV) to hide its huge debts from investors and creditors, thus misleading major stakeholders of the company. SPVs were also used to hide the toxic assets of the company.
The root of the scandal began by Enron’s misdeeds in the video rental chains business. Collaborating with a blockbuster to enter into the video-on-demand (VOD) market, Enron overstated its earnings, predicting the growth in VOD market. The company executed USD 350 billion in trades and spent significant amounts on broadband projects. By August 2001, the company was unable to recover costs as the dotcom bubble burst and investors who had bet on Enron lost huge sums of money, lured by the strength of its balance-sheet and earnings projection.
The CEO of the company used the mark-to-market (MTM) technique which is based on fair value rather than taking up actual value. MTM techniques are used to value financial assets and not actual businesses; however, the management of Enron used this technique to hide losses. The company kept adding on assets and also reported profits which were yet to be earned. The losses were never reported and the business transferred the assets to the off-the-books corporation. Such malpractices helped portray the business to be in a good financial shape which was in sharp contradiction to the reality on ground.
After being probed by the Securities and Exchange Commission on October 22, 2001, the management for the first time revealed that it had inflated its income levels by a total of USD 586 million, in November 2001. The company also admitted that it had been doing the same since 1997. Finally, on December 2, 2001, the company had to file for bankruptcy and the stock price ended flat at USD 0.26 per share. The crisis was so deep that shareholders of Enron lost an estimated value of USD 74 billion. Enron was a classic case of duping the regulator, investors and creditors alike by committing an accounting fraud.
Commodity Scam: Jignesh Shah (2013)
Jignesh Shah was a hero for all budding entrepreneurs in India who wanted to make it big in the world of finance. He was smart, aggressive and was the master of the game he played. He founded Multi Commodity Exchange (MCX) and Financial Technologies (India) Limited (FTIL). Shah is responsible for introducing several stocks exchanges, some of which are functional across various countries. National Spot Exchange Ltd. (NSEL) was established as a subsidiary of FTIL with the noble intention of weeding out the middlemen and intermediaries associated with farmers and the end buyers of farm products by facilitating an electronic platform to exchange the commodities. India’s first spot exchange, NSEL, showed lot of promise and raised hopes of reviving the rural economy through its transparent, demutualisation and hi-tech operations.
NSEL was also co-promoted by the National Agricultural Marketing Federation of India (NAFED) which aims to promote agricultural products and other commodities. All hopes were lost when it was discovered that NSEL was solely responsible for a financial fraud of Rs 5,600 crore. It came to light that NSEL was not able to pay back investors’ money who had invested in paired contracts that were sold as low-risk, highreturn contracts also guaranteeing fixed returns in excess of 15 per cent. Several investors parked money in the paired contracts without understanding the nature of the product. A majority of investors didn’t even know what a forward contract is.
Lured by high returns and low risk, investors took a liking for the paired forward contracts, only to realise that the whole operation of NSEL was fake and destined to fail someday. As per the prevailing norms, as directed by Forward Contracts Regulation Act, 1952, the contracts termed as ‘spot’ must be settled within T+11 days. In simple terms, the transfer of money and delivery of product must take place within 11 days from the initiation of the contract. NSEL violated the norms and started offering customised paired contracts of buying and selling of similar underlying on T+23 and even T+30 days. Such unique offerings were never heard of in the commodity markets and created an arbitrage opportunity for investors, leading to huge potential profits for investors and brokers.
This money spinning opportunity did not last long as participants realised that NSEL had no inventory to deliver the products after T+30 days or any other maturity it promised to deliver the products on. All the transactions happened just on the warehouse receipts (WR) without the actual commodity lying in the warehouse. By the time the regulators got in action investors were already duped to the tune of Rs 5,600 crore. NSEL was shut down completely on August 5, 2013 even as several arrests were made. The matter is still sub-judice and investors are yet to get their refund. This scam was an eye-opener for the regulators and the government when everyone realised that NSEL was not at all under supervision.
In short, the NSEL and could do whatever it pleased in terms of product offerings without any checks and balances. Yet again a loophole in the system was exploited by a greedy entrepreneur. How on earth could legally banned transactions be carried out in such wide proportions? The commodity markets were unregulated and the most ironical aspect of the NSEL scam is that NSEL was allowed to garner funds from investors for a financial product pitched as an excellent ‘investment opportunity’. After the fallout of the NSEL scam it was decided that the Forward Market Commission should be merged with SEBI. Such a merger will ensure that the commodity futures market is well-regulated.
Insider Trading: Raj Rajaratnam (US Markets) (2009)
Several Indians were perturbed to know that Rajat Gupta, a talented IIT graduate was accused of providing insider tips to a hedge fund manager. The allegations turned out to be true and Gupta was sentenced to two years in prison and had to pay a USD 5 million fine for sharing corporate secrets. But he was not the mastermind behind the insider trading activity; he was just one of the hired resources who could exchange insider information for a hefty sum of money. It was Raj Rajaratnam, a Sri Lankan who ran a hedge fund in New York, who devised this mechanism of beating the markets by using insider information. It is believed that Rajaratnam was able to book profits to the tune of USD 60 million using such a technique.
In October 2009, Rajaratnam was charged by the US Justice Department with 14 counts of securities fraud and conspiracy. Rajaratnam cultivated a network of executives, mostly with Asian nationality in companies such as Intel, IBM, Goldman Sachs, McKinsey, etc. He used to obtain insider information or material information not yet open to the public that would impact the stock prices. In return for such insider information, he used to reward these executives handsomely, at times running into several hundreds of thousands of US dollars. Rajaratnam used to obtain the quarterly results’ data before it was public and he also used to get insights into the the key decisions taken at board meetings.
He would then place huge bets running into millions of USD, thus leading to abnormal gains for his hedge fund – Galleon. He would also take huge short positions whenever the information was foreseen to have a negative impact on the stock prices. This insider crackdown was popular as it was perceived as one of the larger crackdowns in the history of corporate America. This case also involved several Southeast Asian Americans who had made a good career for themselves in the US. Ironically, the person who framed charges and led the investigations was an Indian American, Preet Bharara. The Galleon insider trading scam is a pure case of a failed attempt of using insider information to make abnormal profits consistently. Insider trading is illegal in the US and in India as well.
Ponzie Scheme: Bernei Madoff (2009)
Bernie Madoff is an American financier who is credited for having executed the largest ponzi (fraudulent investment scam) scheme in history, defrauding thousands of investors out of tens of billions of dollars over the course of at least 17 years, and possibly longer. Madoff was always behind achieving ‘long-lasting success’ and he eventually set up a business, Bernard L. Madoff Investment Securities LLC, one of the largest penny stock brokerage and wealth management firms. The computer trading software program developed by Madoff and his brother Peter Madoff attracted massive order flow and boosted the business by providing insights into market activity.
It was eventually adopted by the NASDAQ trading exchange and laid the foundation for much of the electronic trading systems that are in place now. Post gaining recognition, Bernie Madoff served as the chairman of NASDAQ in 1990 and further also served in 1991 and 1993. The question that puzzles many is that in spite of achieving great success and recognition, why was Madoff involved in the fraud ponzi scheme. Madoff’s ponzi scheme was operated through the wealth management arm of his firm. It was in fact a very simple and classic fraud. Madoff attracted investors by promising them high but not outlandish returns on their investments. But when the investors handed over the money, in reality Madoff just deposited it into his personal bank account at Chase Manhattan Bank and let it sit there.
When investors wished to take out their profits, he just lured in other investors and paid off the profits of previous investors with investments made by new investors. Madoff’s scheme was trusted by investors because of his own reputation and also because he started investing in blue chips using a collar strategy, also known as split-strike conversion. While it was evident that Madoff’s schemes were suspicious with red flags being put up since the early 2000s, it was in 2008 when the S & P 500 had crashed by around 39 per cent and the markets had witnessed a financial crisis that a wave of redemptions revealed Madoff’s fraud.
As the selling continued, Madoff was unable to keep up with a cascade of client redemption requests as investors to the tune of USD 7 billion wanted to cash out their investments. On December 10, 2008, he confessed to his sons who then alerted the authorities resulting in Madoff’s arrest on December 11, 2008. He pleaded guilty to 11 federal crimes and admitted to operating the largest private ponzi scheme in history. On June 29, 2009, he was sentenced to 150 years in prison with restitution of USD 170 billion. Madoff had said that his firm had liabilities of approximately USD 50 billion while prosecutors estimated the size of the fraud to be around USD 64.8 billion based on the amounts in the accounts of Madoff’s 4,800 clients as of November 30, 2008.
The Harshad Mehta Scam (1992)
The Indian equity market has had its own share of scams. Who can forget the likes of ill-famed ‘Big Bull’ Harshad Mehta and then Ketan Parekh who managed to deliver a bigger scam than Harshad Mehta in a matter of 10 years from Mehta’s scam being exposed? Harshad Mehta used to work as a broker before launching his own broking firm, ‘Grow More Research and Asset Management’ in 1984. During the early 1990s, postliberalisation there was tremendous pressure on the PSUs and private sector players, including banks, to increase the bottomline as the entry of foreign players and increased competition became overbearing. During the liberalisation era, banks had to maintain a fixed percentage in government fixed income securities with the Reserve Bank of India (RBI), also known as statutory liquidity ratio (SLR).
Banks were not able to optimise the returns on the cash they had. It then became a common practise for banks to loan their excess capital to other banks who could not maintain the desired SLR. This led to the birth of ‘ready forward deals’ (RFDs). RFDs implies a secured short-term loan from one bank to another against collateral i.e. government bonds. It was also a common and accepted practise to simply issue bank receipts (BR) instead of actually transferring the bonds. With the advent of BRs the actual securities i.e. government bonds weren’t transferred, but short-term buying and selling took place. Here is where Harshad Mehta came into the picture as a broker or intermediary. Banks use to issue the BRs in the name of the broker and then the broker could lend money to another bank.
Due to this modus operandi the original lending bank and borrowing bank would never know each other’s identity. Taking advantage of this process and using his influence as a successful equity player, Mehta would easily convince banks to issue cheques in his own name and then with this money he would buy and sell the BRs. Mehta use to deal with multiple banks in RFD deals while in normal cases there would be limited banks involved. That was his manipulation. Also, he managed to form an alliance with banking officials to create fake BRs with no collaterals. This allowed Mehta to raise multi-crore rupees without any collateral which he used to park in equity markets generating above average returns.
By cashing the cheques and using the funds to buy stocks, Mehta used to inflate the stock prices. One of his favourites was ACC Ltd. which he inflated from Rs 200 per share to Rs 9,000 per share in just three months. After inflating the stocks, he could easily dump them in the markets and repay the money owed to the bank or banks. In rare cases where he was not able to dump shares in the markets, Mehta would borrow from a different bank and repay the funds to the original lender, thus maintaining his cash flows without having to sell the stocks which he intended to manipulate the prices of. The fast-rising stock prices created an artificial bull market in India and got several investors across the nation jumping on to the bandwagon.
No one questioned the fundamentals and everyone simply chased the stock prices. Eventually, when the bubble burst, Mehta could not repay the money owed to banks and that is where he was exposed. After discovering the scam, which is known as the ‘1992 scam’ Mehta was sentenced to prison for nine years. It was reported at that time that the scam was worth Rs 5,000 crore, a huge amount at that time. It is difficult to imagine that a similar type of scam could happen in today’s environment with stricter regulations in place and increased vigilance in the system. The banking system also stands more alert today than it was during the early 1990s.
The Ketan Parekh Scam (2001)
Ketan Parekh’s scam was much bigger and is touted to be close to Rs 40,000 crore. After having worked as a trainee under Harshad Mehta, Parekh deployed the ‘pump and dump’ strategy while executing foul play by using circular trading methods. Instead of BRs, Parekh used pay orders. The stocks under his radar, famously known as K-10 stocks, were artificially inflated, coinciding with the dotcom bubble (1997-2001), and hence it was very difficult to identify any foul play. Parekh not only used to inflate the share prices but also provide these shares with inflated prices as collateral and borrow money illegally by bribing bank officers to invest further in the markets. The fraud was identified when the stock prices crashed owing to the dotcom bubble, leading to bankruptcy of Global Trust Bank and Madhavpura Mercantile Co-Operative Bank. These banks funded K-10 operations by obtaining any form of collateral or none from Parekh. It was the investigation by RBI into the transactions of these banks that helped expose the scam.
The Nick Leeson Scam (1995)
Nick Leeson is a former derivatives trader who in 1995 became notorious for bankrupting Barings Bank, the United Kingdom’s oldest merchant bank and one of the most prestigious banks in the country. Glorified as a ‘rogue trader’ back then, Leeson was involved in multiple unauthorised speculative trades that led to huge losses. Initially he was very successful in making speculative trades that reaped huge profits for Barings Bank. But after shifting to Singapore Leeson began making unauthorised trades, which were successful and contributed towards up to 10 per cent of the bank’s profits. Leeson was primarily trading futures on the Nikkei 225 Stock Average on behalf of his clients.
While he was expected to maintain a ‘cash neutral’ business, in reality he was actually using the bank’s money to make bets on the market in an attempt to recoup his trading losses. As a result of earning unlimited trust and freedom from his seniors and lack of surveillance, Leeson was able to hide the losses that he made from his bad trades in an error account or a secret account. In an attempt to recover the lost money, Leeson began taking risky positions and it was in late 1993 that the losses in the secret account that Leeson was maintaining exceeded British 23 million pounds. As per the data, by the end of 1994, the amount had increased to British 208 million pounds.
The final strike that busted open Nick Leeson’s fraudulent bubble leading to the bank’s bankruptcy was when on January 16, 1995, with the aim of ‘recovering’ his losses, Leeson placed a short straddle on Singapore Stock Exchange and on Nikkei Stock Exchange, betting that neither will go up nor down by a significant margin. But on the next day i.e. on January 17, 1995, an earthquake with an epicentre in Kobe, Japan caused a sharp plunge in the Asian markets with Nikkei dropping by 7 per cent in just one week. Leeson by then had taken a USD 7 billion value futures position in Japanese equities and interest rates, linked to the variation of Nikkei.
He was ‘long’ on Nikkei. To recoup and adjust his losses, Leeson bought more than 20 000 futures, each worth USD 1,80,000 in the next three days of the earthquake. Realising that his risky trades attempted to offset his losses had failed, Leeson fled from Singapore, Malaysia and Thailand before he was finally caught in Germany and was arrested upon landing. He was then extradited back to Singapore on March 2, 1995. While Leeson was sentenced to six and a half years in prison in Singapore, Leeson's losses accounted for British 827 million pounds, twice Barings Bank’s available trading capital, and after a failed bailout attempt the bank declared bankruptcy in February 1995.
Chronology of Events
1992
April 23: The Times of India reports that the State Bank of India has asked the Big Bull to square up Rs 500 crore of irregularities.
April 29-30: There is mayhem in the parliament. Finance Minister Manmohan Singh announces that the RBI will probe the scam. The government calls in the Central Bureau of Investigation (CBI).
April 30: The Indian Express reports that UCO Bank allowed Harshad Mehta’s companies to use Rs 50.37 crore by discounting its bills.
May 5: The RBI forms a committee headed by Deputy Governor R Janakiraman to probe the scam.
May 6: The Indian Express reports that the National Housing Bank, a wholly-owned subsidiary of the RBI, has given money to Harshad Mehta to help him square-up his outstanding with the State Bank of India.
May 9: M J Pherwani, Non-Executive Chairman of the National Housing Bank, quits. Two days later he leaves the chairmanship of the Maharashtra State Finance Corporation, the Stock Holding Corporation and Infrastructure Leasing and Financial Services.
May 10: Standard Chartered Bank learns about the securities’ gap in its books. UCO Bank Chairman K Margabanthu is asked to go on leave. May 11: The CBI, led by K Madhavan, starts investigations.
May 14: The CBI freezes Harshad Mehta’s bank accounts and seizes his assets.
May 21: M J Pherwani dies.
May 25: The RBI asks Bhupen Dahl to step down from the Bank of Karad.
May 27: High Court orders the liquidation of the Bank of Karad. The order sparks a run on the bank.
May 29: S P Sabapathy, Chairman of Bank of Madura, is dismissed by the RBI. There is a run on the State Bank of Saurashtra following rumours that it is stuck with false bank receipts.
May 30: First report of R Janakariman published. The CBI registers case against the State Bank of India officials after the committee report.
May 31-June 1: Niranjan Shah, an associate of Harshad Mehta, is raided by the Income Tax Department. He slips out of the country.
June 4: Harshad Mehta, his brother Ashwin Mehta and the deputy managing director of State Bank of India arrested along with others.
June 6: Special Court Ordinance promulgated.
June 20: The CBI files cases against Bhupen Dalal, J P Gandhi, Hiten Dalal, Abhay Narottam, T B Ruia and officials of Canbank Mutual and Canbank Financial Services. June 23: Bhupen Dalal, A D Narottam, Hiten Dalal and others are arrested.
June 29: Ashok Kumar of Canbank Financial Services is arrested.
June 30: The RBI bans Fairgrowth Financial Services from any transactions.
July 2: Notification of Bhupen Dalal,T B Ruia and J P Gandhi.
July 3-8: John Docherty takes over from P S Nat as CEo of Stanchart Bank. The bank sacks five employees – Arvind Lai, Jaideep Pathak, R K lyer, V R Srinivasan and V Srinivas. The second report of the Janakiraman Committee is published. Bhupen Dalal and others are further remanded to custody. UCO Bank Chairman K Margabanthu is sacked. The CBI registers two more cases against Harshad Mehra related to SBI Capital Markets and State Bank of Saurashtra.
July 9: P Chidambaram quits because his wife owned 25,000 shares in Fairgrowth Financial Services. The CBI registers a case against UCO Bank Chairman K Margabanthu. The government announces a probe by the Joint Parliamentary Committee.
July 13: The CBI files a FIR against Harshad Mehta and officials of the National Housing Bank and the SBI.
July 20: K Madhavan of the CBI seeks voluntary retirement. There are rumours that he was under pressure to suppress the probe.
July 21: V Krishnarnurthy resigns from the Planning Commission.
July 22: Bhupen Dalal and five others are granted bail. July 30: The CBI registers a case against Fairgrowth Financial Services and raids its offices.
August 6: The Joint Parliament Committee, consisting of 30 members, is set up.
August 7-10: The CBI files corruption charges against V Krishnamurthy and arrests him. His accounts and the Sanwa Bank account of K J Investments Ltd., run by his sons, are frozen.
August 26: The third Janakiraman report indicts the Bank of America, Citibank, C Mackertich, and Stewart and Co.
August 28: The office and residence of Ajay Kayan, a key broker for Citibank, are raided.
September 4: The Joint Parliament, Committee files a breach of privilege case against Minister of State for Finance Rameshwar Thakur for attempting to influence certain committee members.
September 7: The CBI arrests K Dharmapal, Managing Director of Fairgrowth Financial Services Ltd.
September 15: The Joint Parliamentary Committee hearings start.
September 21: R Lakshminarayan, Executive Director of Fairgrowth Financial Services, is arrested.
September 22: Harshad Mehta is released.
October 8: The Standard Chartered Bank sues Citibank in New York for Rs 115.69 crore.
October 14: The JPC hearing implicates Minister for Petroleum and Natural Gas B Shankaranand for having ordered the placement of funds to Canbank Financial Services, where his son was a director.
November 10: Attorney General G Ramaswamy quits over allegations that he had taken an overdraft of Rs 15 lakhs from the scam-tainted Stanchart Bank.
November 24: The CBI raids the office and residences of M C Nawalakha, Member (Finance) of the Oil and Natural Gas Commission.
November 25: The CBI registers a FIR against Nawalakha for diverting Oil and Natural Gas Commission funds to Harshad Mehta. Industrialist T B Ruia is arrested six months after the Stanchart Bank named him as one of the accused. He was left off by the court several years later.
November 27: Stanchart Bank files recovery claims against 16 banks and mutual funds amounting to approximately Rs 650 crore.
November 30: RBI Bank rejects Bank of America’s application for Vikram Talwar to continue as its India chief. Talwar quits India.
December 2: The RBI asks to remove Area Manager A S Thiyagarajan of the bank’s operations in three South Asian countries and the mastermind behind the bank’s Indian operations.
1993
June 16: Harshad Mehta claims to have paid a bribe of Rs 1 crore to Prime Minister P V Narasimha Rao.
October 26: First charge-sheet filed by CBI against Canfina.
December 21: JPC report presented in Lok Sabha.
Investor Protection Measures
The role of Securities and Exchange Board of India (SEBI) is very important in strengthening the overall financial system. The mandate of SEBI is to protect investors’ interest, promote the development of markets and regulate the securities market. With the grant of statutory powers to SEBI, the Indian markets have evolved into a market-oriented and disclosure-based regulatory regime from a highly controlled and merit-based regulatory regime. SEBI in alliance with the public exchanges has taken several steps to protect investors and strengthen the markets. These are highlighted below:
1. Investors Education and Awareness
A massive exercise carried out nationwide to spread awareness and investor education has helped lakhs of investors take informed decisions. This initiative is believed to be the best way to manage and tackle the problem of investors being defrauded by traders like Ketan Parekh and Harshad Mehta. Comments Praveen Dighe, a regular investor: “I have been attending investor awareness programmes for over a year now. I believe attending such programmes have shaped my thinking and approach when it comes to investing. Not all programmes provide great insights but the message is consistent across all sessions. This has steered me in the right direction. I am confident that no ‘big bull’ can trap me into buying any fundamentally poor stock at an exorbitantly high price.”
Right Reforms
Thanks to reforms put in place after the financial crisis more than a decade ago – The Volcker Rule, the Dodd Frank Act, BASEL III – the banking sector is in strong shape.
“I understand the valuations and parameters in a stock that should be looked at before investing. It is investors like me who are victimised to satisfy the greed of certain market participants. An investor awareness program provides basic information and has thus disciplined me into thinking that leverage is not good in the long run for equity investors. Another important lesson is the research required before investing. If a stock is flying without any underlying fundamental development, one should be cagey. Overall, I believe I have learnt how to survive in markets even if there are manipulative players in the markets, who in my view are no more existent,” he adds.
2. Disclosure
SEBI ensures that detailed information that is relevant to investors is available in the public domain. There is renewed focus on disclosure as SEBI has adopted a disclosure-based regulatory regime. It is required that the issuers and intermediaries disclose all relevant information about themselves.
3. Market Systems and Practices
SEBI has ensured that a system and proper practices are in place which can make transactions safe, whether through a screen-based trading system, dematerialisation of securities, T+2 rolling settlement, regulating intermediaries, etc. These are all steps taken to provide protection to investors in equity markets. The system is designed in such a manner that only fit and proper persons are allowed to operate in the market. There is an incentive for those intermediaries who comply while the miscreants are not left behind without appropriate punishment. In a recent communication, SEBI mentioned its displeasure with the corpus of Investor Protection Fund (IPF) being inadequate. It has asked both the public exchanges to increase the corpus significantly.
As of now, the corpus of IPF is extremely low when compared to the profits and earnings of the stock exchanges. It is feared by SEBI that refund to the investors may not be possible in case of broker defaults at the current level of cash in IPFs. It has also been identified that exchanges are delaying declaring the brokers as defaulters as the pay-out to investors can happen only when the broker has been declared a defaulter. No doubt there are issues and challenges, but we are heading in the right direction as vigilance increases with the rising complexity of markets and volumes. As of now, market systems are in place so that damages can be minimised. No market system or regulation can bring the manipulation to zero. However, a good regulation system can minimise the occurrences of such manipulations and most importantly, the impact can be smoothened for investors in case of any such manipulation.
Leverage
Leverage is using the borrowed money for trading in variable income assets.
4. Investor Grievances Redressal Systems
SEBI has put in place a facility wherein investors can complain against those intermediaries and companies not playing by the rules. Appropriate enforcement actions are taken against those found guilty. SCORES is one such initiative which facilitates investors to lodge complaints online with SEBI and view their status. Circuit filters, ASM (long-term or short-term), sending compulsory SMS to investors once stocks are sold and debited from the custodian account are just some of the measures taken to make the system more robust and less prone to manipulation. Every scam that has hit Indian markets has led to the market system becoming more robust and growth-oriented in a more durable fashion. It has led to the introduction of more checks and balances, improved risk management and alerted regulators of the various loopholes in the system. It is only natural that the system corrects once the loopholes are identified.
Conclusion
For any financial market to grow, it needs more participants, increased transparency and a regulator that knows how to balance the incentives and strict implementation of rules. If the regulator is too strict it will discourage risk-takers and once that happens there is a risk of the markets de-growing. At the same time, if the regulators take a hands-off approach, there is always a chance for foul players to cheat majority of the investors and garner profits for themselves. If we look at the Indian markets closely, one gets a feeling that it is a market where insider trading is rampant. However, such cases are getting far and fewer in nature as we progress in terms of transparency, corporate governance, technology, automation, disclosure, risk containment and reduction in transaction costs.
The scams that occurred in India have helped the markets improve in terms of its efficiency. Be it the Harshad Mehta or the Ketan Parekh scam, each has helped the regulator introduce tighter rules and stricter governance norms, thus helping strengthen the markets for ages to come. Each scam has driven the regulator to identify loopholes in the system and keep building up the efficiency with prompt action. The end result is that India is not only one of the best markets in among the developing markets but can also be compared with developed markets when it comes to transparency, technology and transaction costs. Not to forget here that the Indian equity market is the eighth-largest equity market in terms of market capitalisation.
There have been several scams in the developed world, be it Enron, GFC-related irregularities etc., which increased the market risk for investors. In India, the scams occurred in the transition period i.e. during the liberalisation era. India needed capital to fulfil its growth aspirations and hence the way markets were regulated had to change. However, during the phase of liberalisation some strict controls were retained and the scams could not spill over into other sectors. A point in case is the capital control regulation that helped Indian markets escape contagion from the 1997 East Asia crisis. India has always had stricter regulations compared to its emerging market peers and that has augured well for the development of its capital markets.
The road ahead for India would be more participation, depth in financial instruments and financial innovation. Without financial innovation retail participation and the participation of small firms and start-ups may not increase and without participation from these players it is very difficult for the markets to grow. For regulators to do their jobs proactively and put into place new regulations to help protect investors’ interest, it is paramount that regulators have a better understanding of how the markets currently operate. For regulators it is not an easy task as several traders and trading platforms may be reluctant to provide access of data from trading accounts and high-frequency traders may not want others to know how they operate.
High-frequency traders thrive and survive with a superior market-beating strategy and sharing such critical information may quickly reduce the profitability of traders. Hence, secrecy is the key to such high-frequency trading and this is where the risks for the market may emerge in the future. Secret trading strategies with high volumes or positions is a grey area where even regulators may not have a deeper understanding of how the trading works – and this could be a breeding ground for future scams in the Indian markets. The problem for regulators while monitoring and regulating high-frequency traders is that the public stock exchanges stand to benefit from ‘lot of order traffic’ which comes from such traders.
Public stock exchanges may stand to lose from anything that hurts the high-frequency trading firms. Thus, it becomes extremely complicated to figure out the exact nature of manipulation and optimal strategies used by technology- savvy high-frequency traders which may make the system vulnerable. The aim of any regulator is to achieve international best practices while encouraging market integrity through a rule-based system. One hopes that as the size of the market in terms of capitalisation increases over the period of time, vigilance also improves while the regulator keeps encouraging risk-takers just enough to keep the markets healthy. Sophisticated pragmatic regulation with the help of deeper understanding of the market functioning and usage of the latest technology may ensure that no scams of the scale of Harshad Mehta or Ketan Parekh hit the Indian markets!