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B. Venkatesh

SEBI charging Mr Samir Arora, former Chief Investment Officer of Alliance Capital Mutual Fund (ACMF), with insider trading in Digital GlobalSoft raises the larger issue of policing the capital market. The SEBI order implicitly suggests that insider trading was evident only in Digital. But if one were to look at price trends in the last four months, dozens of stocks would fall under this category. Should not SEBI conduct an investigation into these stocks as well?

Efficient markets: Eugene Fama's seminal paper divided efficient market into three broad categories — weak form, semi-strong form and strong form. Suffice it to know that strong form efficient market is one where the stock price reflects all known information, both private and public.

Suppose a company is set to announce bonus shares. In a strong form efficient market, the stock will reflect both the bonus announcement and the bonus ratio. Why? Because no information is private, perhaps, due to high levels of reporting requirement.

Now, suppose a section knows that the company is likely to offer one-for-one bonus. The persons having this information may quietly buy the stock in the market. Many others may piggyback this trade. After a while, a large part of the market may get wind of the bonus ratio, though the company would not have made the announcement yet. That essentially sums up the current state of our stock market.

If this phenomenon happens with all stocks, how should we describe the market? It certainly does not fit into any of the classic Fama-style efficient market. Take Moser Baer. This company recently held a meeting to change its auditors, because the previous auditors refused to sign the financial statement. The meeting to decide on the appointment of new auditors was held at noon, but the stock touched the lower circuit filter in early morning trade.

How did the market get wind of the development? Moser Baer is but one instance of such interested trading. If SEBI wants to curb trading on private information, should it not take action against the "interested" parties in all these stocks? Why only Digital GlobalSoft?

Insider trading: The fact is that SEBI will find it very difficult to prove insider trading in all these cases. For one, it may be difficult to track down the "interested" parties. What if the shares passed a dozen hands before SEBI or the stock exchanges sniffed any wrongdoing in the stock concerned? Tracking the insider would then be difficult.

For another, the onus lies on SEBI to prove that the "interested" parties indulged in insider trading. And that is not an easy task. Even in developed markets, the ratio of proven insider trading cases to those filed for such offence is very low. If anything, the ratio will be lower in India, given our judicial system.

Under the circumstances, a surveillance system should be put in place that will warn the public of likely insider trading. One such filter could be change of more than 10 per cent in the stock price for, say, three consecutive days. At present, stocks are pushed to the upper or the lower circuit limit every day. Such unusual movement attracts more new uninformed investors wanting to profit from the momentum, which gives the traders the critical mass to push the stock further in the direction they want to. Since such price manipulation remains within the stock exchange-prescribed circuit filter limits, no action can be taken against the traders concerned. Placing filter rules based on unusual price movements can help the exchanges warn the public at large of possible insider trading. That will at least prevent uninformed investors from losses by trading in such stocks.

In short, stock exchanges and SEBI should take pre-emptive action instead of adopting systems that takes action after the event has occurred. SEBI, in particular, should not stop with its verdict on Mr Arora. It needs to extend this to all who have indulged in unethical practices in the market. Or else, the action against Mr Samir Arora will be inconsequential.

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