Comments on three papers by L. C. Gupta

Transcription

1 Comments on three papers by L. C. Gupta Susan Thomas IGIDR, Bombay 20 January 2001 Page 1 of 16

2 1. The Indian badla system Page 2 of 16

3 Dr. Gupta s arguments Subtle issues of market design have consequences for resource allocation. Badla generated a sharp wedge between the liquidity of BSE s A group versus other shares. This difference has real effects through the liquidity premium, giving a lower cost of capital for the former. Volatility was lower without badla. It s revival (1996,1997) set the clock back on reforms by five years. Cash settled options are as bad as badla. There is a role for market making and OTCEI. Page 3 of 16

4 Sound market design My view: a sound securities market is obtained through 1. Anonymous trading on-exchange, 2. Rolling settlement, 3. Novation at clearing corporation, 4. Settlement at depository, 5. Access to margin trading and derivatives We think badla is on it s way out, but recall how reforms got rolled back last time. July and August will be crucial months: on process engineering, on RBI s policies for loans against shares, on SEBI s stance on stocklending, and on political economy. Page 4 of 16

5 Liquidity premium The top decile of firms at NSE (roughly 100 firms) have liquidityratios which are better than those seen on the top decile at NASDAQ (roughly 450 firms). Outside of the top decile, NASDAQ firms show liquidity ratios of roughly 100%. NSE firms show a precipitous dropoff. Theory and evidence suggest that poor liquidity does go along with low valuations, so there is problem for all but top-decile NSE firms. We do not know whether moving to rolling settlement will solve this problem we do not know how to solve the problem of how to increase liquidity for the smaller firms. Rolling settlement will help in price discovery for shares of all firms. Page 5 of 16

6 Cash-settled options Physical settlement incurs higher transactions costs Physical settlement has vulnerability to short squeezes. When the underlying price is unambiguously observed (Nifty, MI- BOR), cash-settled products are best. If the underlying price is unambiguous, then cash-settled options are just lower-cost settlement compared to physically-settled options, with no possibility of short squeezes. Page 6 of 16

7 Order matching versus market makers L. R. Glosten. Is the electronic open limit order book inevitable? Journal of Finance, 49:pages (1994): order matching dominates market making in simple theoretical settings. These models do not grapple with the enforcement difficulties found when anonymity is absent. These models ignore the cost differences between floors / humans versus computers. Empirical evidence: the whole world is moving away from market making. Even bond markets, bastions of OTC trading and market makers, are discovering the virtues of electronic trading. Page 7 of 16

8 2. Volatility of the Indian stock market Page 8 of 16

9 Dr. Gupta s arguments Investors are hurt by large price movements; therefore, the range in price movements should be a measure of the risk of their investment. Volatility is best measured as the ratio of highest price by lowest price over a period. The observed ratio of 2:1 over a year is unreasonably high. Volatility of the stock market causes poor performance of mutual funds. Volatility causes poor performance in the IPO market. Volatility has been higher in the Indian market due to practices like badla, different settlement cycles between exchanges and order driven systems. Page 9 of 16

10 What constitutes an unreasonable high/low ratio? Suppose stock returns follow the process r t = µ + ρr t 1 + ɛ t, ɛ t N(0, σ 2 ɛ) It turns out that the high/low ratio of 2 can come about with ρ = 0, σ = 2.6. Lower sigma values generate the high/low ratio of 2 if there is a slight positive ρ. A years-high to years-low ratio of 2 sounds large. A daily stock volatility of does not sound large. However, these are mutually consistent. Page 10 of 16

11 Volatility causes poor MF performance? The MF industry has grown tremendously to Rs in assets. Most MF assets in India feature active management. MFs fare better than banks i.t.o. lack of entry barriers, openness to foreign competitors, sanity of prudential regulation, lack of assured returns. We define MF performance as risk-adjusted returns. Net of the risk taken, did the MF add value? Broadly speaking, the evidence is that MFs haven t added value. The standard explanations offered are (a) market efficiency - which makes beating the market difficult net of trading costs and (b) agency conflicts - the employees of MFs don t always work for the interests of investors. It is not clear how higher or lower volatility would affect these reasons. Page 11 of 16

12 3. Page 12 of 16

13 Dr. Gupta s arguments Investors are staying away from the equity market. SEBI is perceived as maximising the utility of the intermediaries rather than that of the investors. Investors believe that SEBI s main goal is not to protect investors. Investors perceive an inability to enforce as the greatest weak spot in SEBI. SEBI should have greater focus on detecting and preventing manipulation of prices in the market. Page 13 of 16

14 Are investors shying away from the equity market? There has never been greater retail participation in the equity market. The fraction of trading volume accounted for by inst. investors is lower than it was in 1992, even though we have two new phenomena : the MF industry and FIIs. NSDL has 4 million accounts; NSE has 10,000 trading screens; both are dispersed all over India. These outcomes would not have arisen if individual investors were avoiding the equity market. Page 14 of 16

15 Reflection of political economy at SEBI In an ideal world, the regulator should speak for the interests of the economy. In the real world, focused constituencies with much to lose have strong incentives to influence regulatory policy. In the case of SEBI, brokerage firms and mutual funds have the most to lose, so they are seen the most in SEBI s corridors. Dr. Gupta s evidence about mistrust of SEBI by investors is consistent with these problems. Page 15 of 16

16 A fresh start at SEBI In 1988, SEBI was a new experiment in institution building. Today we need to start anew on the project of building SEBI. SEBI s mission statement is fundamentally sound (unlike RBI). The prime focus should be upon political economy and organisation design. Page 16 of 16