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B. Venkatesh

SEBI's recent order to ban UBS Securities Asia from issuing participatory notes for one year brings to the fore the function of a regulator in the financial market. Business Line editorial (May 20) rightly argues that SEBI's decision to investigate UBS may be questionable but its ruling appears justified considering that the FII refused to co-operate with the investigation. The issue, however, goes beyond this order.

As a regulator, SEBI should be concerned with the orderly functioning of the financial markets. This means creating a market microstructure that enables asset price efficiency.

The regulator has to investigate painstakingly causes for extreme events and then move against the perpetrators. The investigation on the May 17, 2004 crash fails in this regard. There seems to be no official report that conclusively explains why the event occurred.

Yet, the UBS order states that "in view of the crash in the Indian securities market on May 17, 2004, SEBI examined the dealings in securities by various entities on May 17, 2004... ." Thus, SEBI seems to have placed the cart before the horse.

The problem is that such regulatory decisions can have a bearing on asset prices. As in the quantum-mechanics world where the observer of the experiment influences its result, so can the regulator influence asset prices by its actions.

UBS case: The SEBI order states that UBS incurred a Rs 17.54-crore loss on May 17, 2004 from sale of shares in the spot market, while it gained Rs 59.37 crore from its short futures position. This amount is small compared to the total market turnover.

The SEBI order, however, seems to argue that UBS was one of the reasons "for causing a cascading effect of depressing the spot and the futures market".

On May 17, 2005, the market microstructure collapsed. The NSE and the BSE saw unprecedented trading halts. The S&P CNX Nifty fell 29 per cent from that day's high. It is, indeed, SEBI's duty to investigate such an extreme event.

The correct procedure would be to find the cause for the decline. Perhaps, asset prices were inflated and reverting to the mean.

Or perhaps, the May 17, 2004 crash was just a herd reaction to the surprise "shock" events on the political front. Whatever the cause, one issue needs to be debated: Whether the decline was due to some flaw in the stock market machinery.

Upward bias: It seems that SEBI has a biased view on asset price formations. The regulator was not concerned when the Nifty index climbed 120 per cent between April 2003 and January 2004.

Of course, it is a fact that investors are comfortable when the market moves up, feverishly or with measured pace.

But, surely, it is not SEBI's responsibility to enable investors to generate profits from sustained up-move in asset prices.

In fact, the NSE 2004 Fact Book shows that the absolute percentage change on any given day on the upside is not significantly different from the downside. That means SEBI should investigate extreme up-moves in asset prices as well.

Market forces: It is time SEBI shed its bias. As a first step, this means lifting the ban on short sales and making stock-lending cheaper. The reason is that short-sellers act as a friction on continued up-moves in asset prices.

Perhaps, asset prices may not have moved as much in 2004 if there were no ban on short selling. Perhaps, the May 17 crash may not have been so severe.

The fact is that short selling enables traders to supply shares in the market when they perceive that an asset has wandered too far away from its perceived intrinsic value.

Banning short sales helps the long-only managers and traders to push up prices and create asset bubbles. Such bubbles will eventually lead to sharp declines in prices, with or without institutions such as UBS.

SEBI needs to seriously consider ironing out such market microstructure issues. It would then make sense to move against offenders who cause extreme events.

(Feedback can be sent to bvenky@thehindu.co.in)

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