In 1993, shortly after the discovery of the largest scam in the history of the Indian capital markets, the Securities Exchange Board of India (SEBI) banned the use of badla. The badla mechanism, which allowed trades to be carried forward without settlement, based on borrowed shares or cash, had already attracted criticism from such disparate sources as the International Finance Commission and the then-esteemed firm of Arthur Andersen. An article which appeared in Economic and Political Weekly a few years after the ban, noted that SEBI’s antipathy 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 3250 points in February 1995 and badla’s backers claimed that the ban had affected market liquidity. By October 1995, SEBI had reversed its ban. Badla was back, albeit in regulated form, with a carry-forward limit of Rs. 20 crore per broker, a ninety-day trading limit and 10 percent margin on trades. Over the next five years, confronted with the popularity of badla trades amongst stock market participants, SEBI oscillated between banning and legalizing badla until the introduction of the rolling settlement system allowed it to definitively ban badla in July 2001.
Despite SEBI’s prolonged effort to alternately ban, legalize, and regulate badla, some might suggest that badla may have 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 popularity of single-stock futures in the Indian derivatives market. Even though badla remains irrevocably banned, Indian investors seem to favor derivative products which effectively resemble badla trades.
A 2006 research paper by Asani Sarkar, published in The Oxford Companion to Economics in India, found that the market 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 a single-stock futures contract, parties agree to exchange a specified number of equities in a company for a price agreed 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’ prior familiarity with badla trades which shared some features of derivative trading.” This seems to suggest that the popularity of single-stock futures might be the classic example of path-dependence; decisions limited by past practices, even where the underlying circumstances have changed.
A more recent study in 2010 by Ashutosh Vashishtha and Satish Kumar, published in the International Research Journal of Finance and Economics, confirmed that of the products traded in the Futures & Options segment of the National Stock Exchange (NSE), single-stock futures were the most popular in terms of volumes and numbers of contracts traded. Of course, one other reason for the popularity of single-stock futures is that they are simple instruments and are easily accessible to retail investors. But one might equally wonder whether the popularity of single-stock futures has something to do with the fact that they resemble the badla trades popular amongst many market participants.
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-stock futures. Yet, following SEBI’s ban on badla in 1993, it was the BSE that had lobbied hardest for badla to remain legal. In 2000, The Economist had estimated that as many as 90 percent of the trades on the BSE were badla trades. If there was a market where traders should be trying to replicate badla mechanisms through single-stock futures, it should have been the BSE. Yet, the BSE market participants of today showed a marked preference for index futures over single-stock futures.
In late 1995, shortly after the BSE first succeeded in getting SEBI to reverse its ban on badla, the NSE approached SEBI for permission to begin trading in index futures. Today, however, trading in index futures on the NSE remains a distant second to trading in single-stock futures. One might wonder whether the BSE and the NSE swapped roles sometime over the last fifteen years.
One possible explanation for the remarkable popularity of single-stock futures is that they are relatively simple instruments that are accessible to the retail user. If that was all that there was to it, though, surely single-stock futures would be equally popular on both the NSE and the BSE? A more accurate causal account might just be that the SENSEX enjoys far greater recognition as an index than the NIFTY, but even this fails to provide a complete explanation. The SENSEX’s 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 the NIFTY as an index, which explains why the BSE has more index future trades than the NSE. However, it could also be argued that the SENSEX enjoys more recognition and is more closely tracked than any single scrip, including its own constituent scrips. One might venture this as a possible explanation as to why the BSE has more index future trades than single-stock future trades despite the fact that single-stock future trades share many of the features of the badla mechanisms that once ruled the BSE.
Neel Maitra is a corporate and securities lawyer in Washington DC.
India in Transition (IiT) is published by the Center for the Advanced Study of India (CASI) of the University of Pennsylvania and partially funded by the Nand and Jeet Khemka Foundation. All viewpoints, positions, and conclusions expressed in IiT are solely those of the author(s) and not specifically those of CASI and the Khemka Foundation.
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