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April 7, 1997


Citibank : One-in-a-million Ad

Commentary/Harshad Mehta

Badla is financial terrorism

At a time when the Indian stock markets must quickly adopt international trading practices, the exchanges are clinging to the primitive badla system for dear life.

The badla, a kind of carry-forward system, is lopsided, favouring a very small group of businesspersons. Actually, I would stick my neck out to say there shouldn't be any place for something as blatantly anti-growth as badla.

Harsh? Here's the argument: The badla system rewards the person who creates supply. If you sell 100 shares of TISCO short, and that too without owning them, in most cases you will earn an interest income at the end of each fortnightly settlement. This interest income for the shorter is called the badla.

For decades this system of intra-stock market finance survived for a number of reasons: One, it was convenient. If you didn't have the money to take delivery of 100 TISCO shares, all you had to do was approach your broker and buy long, that is without paying any money.

In turn, the broker tapped into the existing network of financiers on the market circuit and almost immediately you had someone willing to fund your purchase of TISCO shares in exchange for the fortnightly interest payment or badla.

Two. Tradition perpetuated convenience. Instead of looking at alternative sources of funding, businesspersons on the market sought comfort in the existing system on the grounds that it was an Indianised formula, that the badla charged per scrip was open knowledge on the market. It was also self-correcting as a high badla deflated equities and vice-versa.

The virtues of the system have far outlived their purpose.

In 1969 Morarji Desai banned forward trading. Because the market was largely speculative then, Sir P Jeejeebhoy stepped in to provide an alternative. He said speculators are welcome to buy but their sauda, or deals, would be squared off on the last day of the settlement.

The next day, the same transaction would be re-entered and the cost of finance would be added to the price the next morning.

It was a different India in those days. Being big was a crime and making money evil. Not surprisingly, most investors were pessimistic.

If a stock jumped by Rs 5 within a month, they promptly sold short on the grounds that there was no way the optimism could be sustained!

The governments did not do anything to prove otherwise. But 1997 is different. There is hope of sharp growth and there is a glimmer in our eye that India will emerge as an Asian tiger.

If you overlook the last bear market, there is a broader consensus for optimism. Most people you speak to will insist that the next five years are going to be far better and more exciting than the last five.

Judge what we are doing by sticking to the badla system. We are giving those who sell short an incentive. We are saying that even though the national scenario is highly positive, we are pleased to offer anyone who is pessimistic about this country's fortunes the financial reward of an interest income each fortnight!

More laughably, we have elevated the short seller to the status of a financier. In this case even though he might not even be owning a single share or any money in the bank, he earns interest.

You will argue that the shorter takes a risk against a possible rise in the price of the stock and ought to be compensated for.

I tell you that the optimist (bull) does the same: against 10,000 variables which could send the market into a spin - plague in big Indian cities, another war in the Middle East, terrorism, the fall of the federal government, an Indo-Pakistani skirmish on the Siachen, Laloo Prasad Yadav and the chance that the next monsoon will blow over the Thar instead.

In fact, considering the odds that an optimist has to put up with, I am surprised that he has to actually pay for thinking that things will get better.

Let me give you an excellent example. If you had shorted TISCO at a price of around Rs 130 when the market was close to its low in 1993 - hypothetically the worst time to go short - you would have made a real big killing since.

Assuming even a rock-bottom badla rate of 15 per cent (simple interest), the buyer's costing would have gone to Rs 210 - at a time when TISCO is only Rs 160 on the markets.

Which means that despite having completely misread the market but having had the good sense to short at the worst possible time, the seller would still have made money on his transaction.

Meanwhile, the buyer would have lost money even though TISCO's profits have gone through the roof during the period. Irony. Look at what national harm has been caused in the process.

Despite corporate results having improved over the last three years, India's broad P/E has dropped and is lower than that of comparable nations.

Each time our national P/E has tried to improve, it has staggered and dropped. The fallout has been on India's industry. With P/E ratios quoting low, corporations have not been able to raise equity finance abroad.

Result: India has not been able to bring its cost of finance down to a level where it is comparable with some of the countries with which it competes. I am tempted to extrapolate the problem. If it becomes possible for international money managers to short at 36 per cent per annum, they will simply buy money at 6 per cent, take delivery of stock and sell in India without giving delivery.

It could well have happened in the case of VSNL if the stock was in the 'A' list. Fund managers the world over would have shorted the stock immediately on listing, making it difficult for the corporation to launch its Indian issue and mobilise resources.

I am going one step further: the badla system is antisocial. The bear is always on the lookout to drive fear into people and to achieve this he spreads stories of how the government is falling by day after tomorrow and how the petrol price hike is transpiring by the evening.

What amazes me is that nobody thinks this kind of financial terrorism is a crime. People call it opportunism. The community that insists that the badla system must continue in the interests of the bull market (ha!) are the brokers who, as intermediaries, make a small commission on the badla paid and earned. They are in the habit of shorting without owning the stocks and have made a regular income stream by creating supply. Then there is also the segment which has no money to buy stock.

The time has come to move over to futures and options. This is how it works: If I buy BPL at Rs 45 and want to limit my downside, I will enter into a contract for a year during which if the BPL price collapses, I have the option of selling to him at Rs 40.

I could enter into an upside contract as well. If the stock jumps then I could enjoy the option of buying more BPL stock at Rs 50. The crucial thing is the word 'option'.

It means that I have the freedom to decide whether I want to sell or buy. Because if at the end of the year the BPL stock is only Rs 42, I might not want to sell out at Rs 40. The contract permits me this leeway.

On the other hand, if I enter into the upside contract and the BPL stock stays put at Rs 45, I might not want to buy in at Rs 50. Great. The maximum that I can lose is Rs 5 (if the stock drops to Rs 40) plus the premium that I must pay the agency I am entering into contract with (writer).

On the upside, if the BPL stock jumps to Rs 150 in a year's time, all I have to do is to invoke the contract at a price of Rs 50 plus the premium, coolly collect another 100 (say) shares at Rs 50 a year from now and encash immediately with a clean gain of Rs 10,000.

This is only the cosmetic appeal of futures and options. What this system can trigger is an entire revolution in our financing of the stock market, making it possible for us to unleash the potential of portfolios left idle, create a liquid stock market, and raise the possibility of buying stocks at a cost not of 36 per cent per annum (the badla these days) but a third of this.

Then why isn't it happening ? Well, why would those earning 36 per cent off people like you and me want to create a system where their spreads vanish?

Next fortnight: The amazing world of futures and options.

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