Business Line _ Opinion _ Badla and Single Stock Futures

7/29/2019 Business Line _ Opinion _ Badla and Single Stock Futures

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Badla and single stock futures

Neel Maitra

Single-stock futures have become increasingly popular.

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Even though badla remains irrevocably banned, Indian investors seem to favour derivative products which effectivelyresemble badla trades.

March 11, 2013:

In 1993, shortly after the discovery of the largest scam in the history of the Indian capital markets, the Securities andExchange Board of India (SEBI) banned the use of badla. The badla mechanism, which allowed trades to becarried forward without settlement, based on borrowed shares or cash, had already attracted criticism from suchdisparate sources as the International Finance Commission and the then-esteemed firm of Arthur Andersen.

An article which appeared in theEconomic and Political Weekly a few years after the ban, noted that SEBIsantipathy to badla extended to a reluctance to even use the term, preferring instead the euphemism carry forward.

In the aftermath of the ban, the Indian stock markets did not perform well. The Bombay Stock Exchange (BSE)reached a low of 3,250 points in February 1995 and badlas backers claimed that the ban had affected marketliquidity. By October 1995, SEBI had reversed its ban. Badla was back, albeit in regulated form, with a carry-forwardlimit of Rs 20 crore per broker, a ninety-day trading limit and 10 per cent margin on trades. Over the next five years,confronted with the popularity of badla trades amongst stock market participants, SEBI oscillated between banningand legalising badla until the introduction of the rolling settlement system allowed it to definitively ban badla in July2001.

single-stock futures

Despite SEBIs prolonged effort to alternately ban, legalise and regulate badla, some might suggest that badla mayhave had interesting, unintended long-term consequences for the development of the Indian derivatives market.Specifically, one might wonder whether the long history of badla trading played a role in determining the popularityof single-stock futures in the Indian derivatives market. Even though badla remains irrevocably banned, Indianinvestors seem to favour derivative products which effectively resemble badla trades.

A 2006 research paper by Asani Sarkar, published in The Oxford Companion to Economicsin India, found that themarket for equity-derivatives in India was flourishing. It noted, in particular, that unlike in many other countries,single-stock futures in India, which resemble badla mechanisms in some respects, were doing remarkably well. In asingle-stock futures contract, parties agree to exchange a specified number of equities in a company for a priceagreed upon today (the futures price or the strike price) with delivery scheduled for a specified future date.

The 2006 research paper thoughtfully observed that [o]ne reason for this success may be retail investors priorfamiliarity with badla trades which shared some features of derivative trading. This seems to suggest that thepopularity of single-stock futures might be the classic example of path-dependence; decisions limited by pastpractices, even where the underlying circumstances have changed.

A more recent study in 2010 by Ashutosh Vashishtha and Satish Kumar, published in theInternational ResearchJournal of Finance and Economics, confirmed that of the products traded in the Futures & Options segment of the

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National Stock Exchange (NSE), single-stock futures were the most popular in terms of volumes and numbers ofcontracts traded. Of course, one other reason for the popularity of single-stock futures is that they are simpleinstruments and are easily accessible to retail investors. But one might equally wonder whether the popularity ofsingle-stock futures has something to do with the fact that they resemble the badla trades popular amongst manymarket participants.

No neat theory

It is here that a set of odd facts seems to spoil this neat theory. Single-stock futures have proved to be far more

popular on the NSE than on the BSE. In the BSE, by contrast, index futures are more popular than single-stockfutures. Yet, following SEBIs ban on badla in 1993, it was the BSE that had lobbied hardest for badla to remain legal.In 2000, The Economisthad estimated that as many as 90 per cent of the trades on the BSE were badla trades. Ifthere was a market where traders should be trying to replicate badla mechanisms through single-stock futures, itshould have been the BSE. Yet, the BSE market participants of today showed a marked preference for index futuresover single-stock futures.

In late 1995, shortly after the BSE first succeeded in getting SEBI to reverse its ban on badla, the NSE approachedSEBI for permission to begin trading in index futures. Today, however, trading in index futures on the NSE remainsa distant second to trading in single-stock futures. One might wonder whether the BSE and the NSE swapped rolessome time over the last fifteen years.

One possible explanation for the remarkable popularity of single-stock futures is that they are relatively simpleinstruments that are accessible to the retail user. If that was all that there was to it, though, surely single-stockfutures would be equally popular on both the NSE and the BSE? A more accurate causal account might just be thatthe Sensex enjoys far greater recognition as an index than the Nifty, but even this fails to provide a completeexplanation. The Sensexs relative popularity might explain why the BSE has more index future trades than the NSE

but it does not necessarily explain why the BSE has more index future trades than single-stock future trades.

A third explanation might combine elements from the first and second ones. The Sensex is more popular than theNifty as an index, which explains why the BSE has more index future trades than the NSE. However, it could also beargued that the Sensex enjoys more recognition and is more closely tracked than any single scrip, including its ownconstituent scrips. One might venture this as a possible explanation as to why the BSE has more index future tradesthan single-stock future trades despite the fact that single-stock future trades share many of the features of the badlamechanisms that once ruled the BSE.

(The author is a corporate and securities lawyer in Washington DC.)

This article is by special arrangement with the Center for the Advanced Study of India, University ofPennsylvania

Keywords: India in Transition column, NSE, BSE, stock market, Badla, single stock futures, Securities and ExchangeBoard of India,badla ban

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