Stock scam: Loopholes in trading mechanism

By K. T. Jagannathan

CHENNAI, APRIL 7. The big bull is behind the bars. The huge bear is pushed into oblivion. And as always happens, the small investor is the unsuspecting victim of the crossfire. As history revisits Indian bourses, one is not sure if anyone has learnt the lesson.

Successive finance ministers have gone miles to please the stock markets, nay the broker community. Most of them have rarely concealed their glee when the markets zoomed immediately after they presented their annual budgets. Depending on how the markets react, a budget is termed good, bad or ugly. Not surprisingly, the shenanigans of recalcitrant brokers are, more often than not, swept under the carpet.

The latest crisis engulfing the country's premier bourse has, more than anything else, brought the focus back on the role of the regulator - the Securities and Exchange Board of India. How did the market watchdog let it happen? Experts well versed with the market mechanics argue that the regulator has to share a substantial portion of the blame for the latest crisis. The crux of the problem lies in non-provision of a level field in the marketplace.

A short trek down memory lane will put things in perspective. Not long ago, the National Stock Exchange (NSE) went gone ahead and introduced automatic lending and borrowing mechanism (ALBM) without the initial approval by the regulator. It is a different matter, however, that the SEBI subsequently recognised the NSE move. The Bombay Stock Exchange later opted for a similar scheme called BLESS.

Privileged sources assert that the SEBI recognition for these schemes created an uneven turf, resulting in another stock scam within a decade.

Under these schemes, an approved lending institution supplies shares (deposited with it by various entities in demat form) for a specified period to help a short seller tide over the shortfall for a fee. Usually, the operation takes the form of a book entry. Let us say broker A buys scrip X from broker B. Though he may not have the scrip on hand, B goes to an approved lending institution and borrows the scrip after paying a marginal fee and manages to honour his sale commitment. Such approved institutions are usually depository agents. They are more than happy to earn some money on demat shares lying idle with them.

The ability of A to remain a successful bull depends on the inability of B to honour his sale commitment. Under the new system, however, B often reaches out to a lending institution to get access to the scrip he short sells. If B happens to be privy to the operations of A (through the misuse of exchange's surveillance system), he can use the legitimate lending institutions to beat down A.

In a situation like this, A builds up a huge position but is not in a position to pay. When this process gets repeated, he turns a defaulter. Unlike in a conventional system, there is no way of knowing the short and long positions in the new system. For, commitments are always shown to be honoured.

The story is not without its irony, though. Bulls like A may have deposited their demat scrips - of different firms - with the depositories which could also be approved share lending institutions. Bears like B go to these institutions. Thus, B might have used the demat scrips of A himself lying with the lending institution!

For the first time, a bear cartel has come under probe. If the new share lending mechanism has proved a contributing factor for such scams, the unfolding evidence suggesting that the former President of BSE who had not let go an opportunity to sermonise on corporate governance had misused the surveillance mechanism must make the regulator sit up and review the structure of the country's exchanges. Is it possible to tell the brokers just to confine themselves to trading and leave the administration of the bourses in the hands of professionals?

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Section  : Business
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