THE deadline for completion of phasing out Badla financing from stock market has been set at August 26, 2005. As the deadline is approaching, heated debates are taking place on how leveraged speculation would be sustained after Badla. Given that trading volumes in our market are predominantly speculative, a lot is at stake, including brokerage income. The key question underlying the controversy about Badla phase-out is this: is it going to be margin trading or derivatives like single stock futures that are going to replace Badla?
Here we take the position that it would be single stock futures, already traded at KSE, and other derivative products like index futures, which are to be introduced, that are going to sustain speculative volumes after Badla with only a limited role for margin trading. Let’s look at the supporting arguments and the international experience.
First, trading in futures does not require financing; you only have to maintain a deposit against outstanding positions with your broker, which is negotiated between the two of you. Margin trading can only be executed after you have secured financing for shares to be purchased in the regular (or T+3) market. This financing would have to be arranged in a fragmented market of banks, brokers, and their clients on counter party risk basis. Lenders would have to carefully evaluate expected return from the financing, risk profile of securities to be purchased, securities deposited as initial margin, and the borrowers.
This is unlike Badla in which (i) funds are traded just like shares so that billions of rupees can be channelled to speculators through a single trading terminal, (ii) both the speculative trades and the financing have the protection of KSE’s risk management system thus lenders do not have to evaluate credit risk of borrowers. Due to fragmented nature of margin financing and counter party default risk, its size is bound to be much smaller than Badla thus driving speculators to futures.
Second, futures are better able to meet market needs than margin trading (i) futures are used for speculation, hedging, and arbitrage whereas margin trading can only be used for speculation, (ii) futures allow you to exit or roll over a position without ever having to take delivery of underlying shares whereas in margin trading you would necessarily have to take delivery of shares purchased, (iii) futures allow you to go both long and short with equal ease whereas in margin trading, you can only go long because securities borrowing and lending is not a part of margin trading, (iv) futures give you a higher degree of leverage as your deposit with your broker can be as low as 10 per cent whereas in margin trading you would have to bring at least 30 per cent of your own money to avail the facility, (v) futures require limited documentation and that too only at the broker level whereas margin trading would require more documentation at the level of both broker and financier bank, (vi) futures are being traded at the KSE since 2001 whereas issues related to implementation of margin trading are still being resolved.
There is evidence from the recent past to substantiate these arguments. On March 16, 2005, when the bull rally was at its peak, value of Badla in the then 12 eligible securities was Rs28 billion whereas open interest in futures in these 12 securities was a close second at Rs25 billion. One security, PPL, which was ineligible in Badla but eligible in stock futures, had an open interest of about Rs9 billion. Total open interest in futures was at Rs43 billion, higher than Badla value has ever been. Once in March, turnover in futures has also exceeded the turnover in the regular market. Add to this that futures have attracted so much activity even though their margining regime has always been far more stringent than that of Badla.
Had they been competing with Badla on a level playing field, their activity level would have been much higher. It would be logical to say that margin trading would only have a chance of success in those securities on which futures are not available but there is still a strong demand for speculation. Concentration of market capitalization and trading in securities eligible for stock futures suggests that there would be very few such securities left for margin trading.
Let’s now turn to the Indian experience with Badla, derivatives and margin trading. The Indian experience is most relevant for us because capital markets of the two countries have had many things in common, including Badla. Due to recurring market scandals and large defaults related to Badla, Securities and Exchange Board of India (SEBI) tried for years to eliminate it. Finally it was in July 2001 that SEBI successfully banned Badla with the introduction of rolling settlement cycle and derivatives. In a recently published paper, “An overview of the Securities Markets in India”, M. S. Sahoo, chief general manager of SEBI, has compiled very useful statistics that help us address the issue at hand.
According to this paper, the combined turnover velocity for all Indian stock exchanges, as measured by the ratio of traded value in regular market and market cap, fell from 448 per cent in FY2001 to 121, 133 and 118 per cent in the following three years after the ban on Badla. However, this loss in the regular market was more than offset by the growth in the equity based derivatives (stock futures, index futures, and options) and other factors as the annual cumulative traded value at all Indian exchanges for all segments in FY2004 is 54 per cent more than that in FY2001.
Derivatives have grown tremendously at the National Stock Exchange of India (NSEI), which is India’s dominant exchange. At the NSEI, stock futures account for more than three-fifth of the derivatives traded value. They have been such an astounding success that NSEI has become the largest market for stock futures in the world, in terms of notional traded value. Interestingly, this success of single stock futures has often been attributed because of similarities in futures and Badla mechanism. While derivatives have grown so tremendously in India, margin trading is yet to make its presence felt.
This is shown by a report dated December 2004 by the Secondary Market Advisory Committee to SEBI. According to this report, the present day margin trading facility commenced in April, 2004, that is almost three years after banning of Badla. Less than one per cent of brokers at NSEI are providing margin trading facility and traded value accounted for by margin trading is insignificant compared to total traded value in the regular market. To promote margin trading, SEBI has recently amended its regulatory framework.
Based on these arguments, evidence, and the Indian experience, we may say that it is going to be derivatives, particularly stock futures, which are going to fulfil the demand for leveraged speculation after Badla with only a limited role for margin trading. These days activity is subdued in futures because after the March crisis, we have quickly moved from a liberal to a conservative regulatory regime. However, this situation is going to persist only as long as ambiguities about final design and implementation of futures regulations remain.
Soon we are going to have a thriving futures market, its turnover would be greater than that of regular market and its open interest would be greater than the value of Badla, had it continued. The speculative volumes and brokerage commissions would be secured and the controversies on what is going to replace Badla would get phased out like Badla itself.
