• PAGE ONE
• INDEX
• HOME

Rolling into a new era

R. H. Patil

THE equity market is not going to be the same after the T+5 rolling settlement begins on July 2. The first major noticeable change will be the sharp decline in the inter-exchange arbitrage. Under the present trading arrangements where all the stock excha nges are trading under the account period modes, there is considerable scope for intra-week speculation. It is possible to take a large exposure in any of the scrips, depending on the different levels of leverage/exposure that the stock exchanges offer t o their brokers.

Brokers, in turn, allow their clients to take positions in different stocks if they are sure that the latter will bring in securities or cash to complete the settlement and if the clients do not decide to square their open positions. Since different exch anges followed different account period cycles, the clients or the brokers did not have to close their positions by transferring them to another exchange.

For example, the NSE follows a trading cycle from Wednesday to Tuesday. Those trading on this exchange could transfer their position to, say, the BSE, before the close of Tuesday and create a buy position on the BSE. This transfer of open positions can g o on indefinitely from one exchange to the other as long as they are willing to pay the margins of different exchanges. Since they receive the margin amount from the exchange where they close their position, they could use this money to pay the margin of another exchange where they transfer their position. A halt to this inter-exchange transfer of positions is bound to reduce substantially aggregate trading volume of all the exchanges. But the really important question is if the rolling settlement will lead to decline in liquidity.

A fear psychosis is being created by some vested interests that the liquidity on the stock exchanges will decline with rolling settlements. Their main intention is to see that the badla, which has so far been the major cause of the stock exchange crises, is not discontinued. Badla has served as a good tool for market manipulation and front running. To be fair, one cannot rule out the possibility of liquidity levels declining temporarily in the immediate future. However, this impact will be felt mainly b y the exchanges, which merely serve as temporary parking grounds in the merry-go-round game of transferring open positions from one exchange to the other.

One exchange which has so far served as the major parking place of positions is the CSE. If the press reports are to be believed, the parking was done officially at the CSE and the unofficial market run by several of its powerful brokers. It is also repo rted that the unofficial market was several times bigger than the official one. This meant that the players did not have to worry about the margin payments or the exposure limits. Merely because this inter-exchange arbitrage will substantially vanish on account of the rolling settlements does not mean that liquidity for the investors will diminish. Liquidity will continue to be available at least at the two exchanges at Mumbai. Both the NSE and the BSE now have nationwide reach and investors in more tha n 400 cities and towns, including the places at the current regional exchanges, have good access to them.

Another equally important aspect of the problem that should be noted is that rolling settlement will eventually increase liquidity. When the NSE first introduced the weekly trading cycle, the BSE used to follow the fortnightly cycle. It was being argued at that time that the NSE will remain a small exchange, as it cannot hope to generate the level of liquidity that the BSE was able to command. The second argument put forth on why the NSE will remain an exchange of no consequence was that the bourse had decided not to introduce the type of badla the BSE had at that time. But the developments, as they unfolded later, proved that both these arguments were incorrect. The NSE became the largest stock exchange in about a year's time surpassing the BSE's vol ume. How can one explain these developments in rational terms?

In the last 10 years or so, a lot of research in the area of market microstructure has been done, which also identifies the factor that influences market liquidity. Liquidity created through artificial means such as the carry-forward mechanism only helps the speculators manipulate the market. In any case, the carry-forward mechanism alone cannot create liquidity unless the stocks covered by it have large market capitalisation and sufficient investor interest on account of their intrinsic soundness or fu ture earning prospects. The major lacuna of the carry-forward system is that it creates excessive liquidity in stocks, which are already liquid.

Second, the carry-forward market diverts attention of the market players to a limited number of stocks and the other stocks become illiquid. The number of daily stocks traded on the BSE declined after the carry-forward mechanism was reintroduced in 1996. The carry-forward facility has made investors forget the basic principle of investment _ value investing. Most investors have forgotten that there are a number of good stocks outside the carry-forward list, which deserve attention and need nurturing fro m the long-term potential profitability angle.

All the markets that have shifted to rolling settlement have witnessed spurt in liquidity after a couple of months trading. Once the players understand the nuances of the new system, they feel quite comfortable with it. Instead of intra-week speculation, they learn the tricks of intra-day speculation. But the most important comforting aspect of the rolling settlement is that the market safety improves significantly.

Since the time gap between the day on which the trade takes place and that on which it gets settled becomes shorter in the rolling settlement, the possibility of the market undergoing sudden shifts or upheavals during that period is relatively less, or i f it happens its intensity is likely to be lower. This is one of the most important reasons why in the developed capital markets feverish preparations are going on to shift from T+3 system to T+2 system. These developed markets are eventually keen to shi ft to T+1 system so that trade funds required for paying margins come down substantially, apart from the fact that volatility will decline under a much shorter rolling settlement systems.

(The author is former Chairman of the NSE.)