Risks & business are Interlinked - the trade off between the risk and the return

Risk is what an individual or an organization or a system encounters in the form of an outcome of an action,different from the aspired and anticipated one. While risk need not necessarily lead to an adverse result, it has the potential of throwing up surprises, not necessarily pleasant always. No doubt, no risk means no business. Much more so, in the case of capital markets, primary or secondary. In secondary market, not only shares and securities are traded; in the process, RISKs and RETURNs are also traded; and, there is a trade off between the risk and the return. Risk taking is essential to an active market and legitimate risk taking should not be unnecessarily or unduly stifled. Regulators cannot be expected to prevent nor can it prevent absolutely failure of market intermedia ries but the risk of failure can be and ought to be minimized. And, the Regulator should seek to mitigate the impact of any failure, if and when it occurs. For this purpose, what is required is effective Risk Management system, continually monitored and up graded as warranted. The size and complexity of the market will dictate the imperative the kind and the level of sophistication of the system.

We have:

1. 23 stock exchanges, with 15 subsidiaries,

2. 10000 brokers,

3. 13682 sub brokers

4. 9644 listed companies,

5. 2 depositories,

6. 411 DPs,

7. 3441 companies under compulsory DMat

8. 123 merchant bankers,

9. 46 underwriters,

10. 27 Debenture trustees,

11. 58 portfolio managers,

12. 91 R&T agents,

13. 66 Bankers to issues,

14. 4 credit rating agencies,

15. 7 foreign VCFs,

16. 43 domestic VCFs,

17. 37 MFs-384schemes-AUM:Rs.1.12trillion,

18. 511 FIIs-1406 subaccounts – cum inv:$18bn.

One could appreciate how essential it is to have an adequate and effective risk management system to protect the integrity of the Indian market and how difficult it would be to implement it. Nevertheless, it is a matter of comfort that, commensurate with this size and complexity, Risk management system has already been firmly in place and is successfully operational.

Transparent, vibrant and efficient secondary market is necessary to provide avenue for deployment of savings and also to prop up the primary market, to mobilize savings for investments needed for capital formation and economic growth. A number of risk containment measures have been put in place to render the secondary market, fair and efficient.

1. Screen based trading: The trading system has become on-line, fully automated, screen-based. Open outcry is now outmoded and virtually discarded. Manual trading has yielded place to terminal trading. It has brought about efficiency and transparency. It has cut down the cost, time and risk involved. A large number of participants, irrespective of their location, now trade with one another anonymously and simultaneously, providing equal access to every player, with orders, big or small, thus improving the depth and liquidity of the market. The system provides perfect audit trail, facilitating dispute resolution. Given the size and complexity of the country, that we could click the system and stabilize it so successfully is, by no means, a mean achievement.

2. Dematerialisation: A cent percent dematerialization-trading dream, too, has virtually materialized. Today, the investing public has been saved from the risk of loss in transit or in custody, misplacement or mutilation, theft or destruction, bad delivery or delayed delivery, forgery or duplicity, and also from irritating headaches of intimation of change of address, watching the receipt of bonus or rights shares, etc. Both NSDL and CDSL have interconnectivity and ten stock exchanges, accounting for 99% of the turnover have established connectivity with either of the two depositories.

3. Settlement Cycle: Gone are the days when the seller had to wait for weeks and perhaps a month for settlement. Not long ago, the trading cycle used to be as long as 14 days for specified scrips and even 30 days for other scrips and settlement took another fortnight! Certain developments in the intervening period between the trade and settlement, could tempt the parties to roll back their promises, leading to defaults, disputes and, in short, settlement risks. This risk has been considerably minimized by introduction of compulsory rolling settlement and contraction of the trading cycle. Rolling settlement on T+5 basis, was made compulsory, initially, for 200 actively traded scrips on BSE and NSE, reducing the trading cycle to one day and settlement period to 6 days; this was extended to cover all the scrips in December 2001. Within a little over two years we moved to T+3 in April 2002 and then to T+2 by April 2003. The transition has been so smooth and successful that it has received world wide acclamation. We should now look forward to a day when the settlement would be on T+1 basis or even Real Time Basis.

4. Prudential limits: The comprehensive risk management system now in place, which is continually monitored and upgraded, covers capital adequacy, margining, exposure and turnover limits, on-line position monitoring and automatic disablement. Minimum capital requirements have been stipulated at broker levels. Exposure limits, in terms of intra day gross turnover and cumulative net outstanding position in securities at any point of time, are linked to certain number of times the base capital and free base capital respectively. There are daily margin, mark to market margin and volatility margin. All the scrips attract 99 percent Value at Risk based margin. The trading and margin positions are monitored on real time basis and any failure to make good the margin requirement will result in automatic disablement of the terminal of the member.

5. Central Counterparty: While the stock exchanges provide the platform to its trading members, there is a central counterparty in the form of Clearing Corporation which interposes between the counterparties to trades and ensures that the members meet their obligations. Besides, counterparty guaranties in the form of Trade Guaranty Fund and Settlement Guarantee Fund are available to honor the obligations of the member in the event of default.

6. Circuit breaker: An index based marketwise circuit breaker system is also operative to curb unhealthy volatility. These circuit breakers applies at three stages of the index movement, either way, at 10,15 and 20 percent, will bring about a coordinated trading halt in the market nationwide, the moment the index level is pierced.

7. Cash and Derivatives: Deferral products like carry forward, which encouraged leveraged trading by postponing settlement stand banned; Thus, the cash market has been isolated from derivatives. The introduction of the derivatives in the market and the gradual enlargement of the basket of products comprising Index Options, Index Futures, Stock Options and Stock Futures, has enhanced the liquidity, efficacy of the market and also provided hedging opportunities, besides tempering volatility in the cash market. The Risk management system which includes VAR based margining, on line monitoring of margin and automatic terminal disablement features is on par with any international standards. In fact, on- line monitoring of margin and automatic disablement of terminals place the Indian Market a step ahead of other Global markets.

8. Central Listing Authority: With a view to harmonizing the listing requirements across the various stock exchanges and centralizing the listing powers in one single authority, an independent body viz. Central Listing Authority has been conceived and has come into being.

9. Structural issues: The structural issues have also been addressed. The corporate governance standards of the Stock Exchanges have been sought to be refined, though they themselves are Self Regulatory Organisations. Like charity, the propriety too, should begin at home. In order to eliminate conflict of interest situation and ensure alignment of investors’ interest with the Exchanges, the process of demutualization and corporatisation of stock exchange has already been initiated. Almost all the stock exchanges have submitted their plans. These are under process. In the changing competitive environment, survival will call for adaptation. According to Charles Darwin, it is not the strongest of the species that survive or the most intelligent, but it is the one most responsive to change. This Darwin’s theory is very relevant in today’s context. The Regional Stock Exchanges would need to be responsive to the change and be alive to the reality. Pragmatism would demand creative destruction. The coming years will, hopefully, witness structural consolidation.

10. Corporate Governance: The corporate governance standard is a crucial factor for ensuring investors confidence. While the Company Law would take care of the basic requirement of the form of corporate governance structure, SEBI is concerned with the corporate governance practices on on-going basis. SEBI constituted a new committee on corporate governance under the Chairmanship of Narayana Murthy to look into existing corporate governance practices and suggest improvement wherever necessary. Based on this report, revised corporate governance standards have been finalised. Disclosures on corporate governance standard observation would form part of the listing agreement requirement. Simultaneously, SEBI encouraged the credit rating agencies- ICRA and CRISIL, to evolve a suitable corporate governance index as a measure of wealth creation by the corporates. Some of the companies have been rated against this index. It is our belief that the economic compulsions would increasingly induce the companies to go in for the corporate governance rating. Corporate governance is essentially ethics-based. No amount of legislation or regulation will serve the purpose fully, unless there is an attitudinal change on the part of the management of the corporate.

11. Regulations: In the dynamic conditions of the market, the regulation cannot remain static. As a measure of regulatory dynamism, various guidelines concerning intermediaries, listed entities, and trade practices have been reviewed and suitably modified. Such a review would be a continual process, to address the risks of under or over regulation. Code of Conduct for various intermediaries have also been finalised and would be in their hands shortly.

12. Disclosures: Over the years, several initiatives have been taken to improve the operational efficiency and transparency in equity market and to provide investors with the security issues of high quality and to enable entities to raise resources in cost effective manner. The disclosures prescribed for new issues in India are comparable, in terms of contents and stringency, to those obtaining in most of the advanced markets. Entry norms and track record criteria have also been attuned to ensure the quality of new issues and to protect the investors. The continual disclosure requirements for listed companies are also at par with any international standards. These relate to publication of annual audited results and quarterly results in prescribed format and time frame, consolidated results, segmental reporting, cash flow, auditors qualifications and their impact quantification, and disclosures of certain transactions. To enable electronic filing of information, Electronic Data Information Filing System has been set up in association with National Informatics Center.

The market is dynamic and human mind ingenious. Certain risks would, therefore, keep on popping up, in the day to day operations e.g. the behavioural risks – misconduct, manipulation, malpractices, fraud and unfair trade practices – which would undermine the market integrity, erode into investor confidence and jeopardize the interest of hapless retail investors. These should be the areas of concern for the investors and the Regulators. Normally, once bitten, one is twice shy. The Indian investors have been bitten twice in the recent past. To pre-empt any further biting, therefore, the intensity of shyness must necessarily be high. As a regulator, SEBI keeps a constant watch to spot any unusual movement or activities for possible prompt action. There are a few known kinds of meddling with the market integrity:

1. Dabba trading,

2. Circular Trading

3. Insider Trading

4. Front running

5. Pump and Dump

6. Corners and Squeezes

7. Capping and Pegging

It has been brought to the notice of SEBI that authorised trading terminals, in some places, give illegitimate birth to unauthorised dabbas! Based on informational tips, SEBI has clamped down on such trading joints in a few places. Due to regulatory jurisdictional problems, the State Governments have been requested to help in curbing these activities.

A constant watch is kept to spot and stop other kinds of manipulations and malpractices. Plans are underway to institute a front line integrated electronic market surveillance system. Meanwhile, the current surveillance systems of Stock Exchanges and SEBI generate certain alerts and SEBI itself keeps an alert to spot any unusual movements or activities for pre-emptive or punitive action to protect the integrity of the market.

To sum up, a number of measures - on line screen based trading, cent percent dematerialized trading, shortening of settlement cycle from T+5 to T+2, risk mitigating prudential norms of capital adequacy and exposure limits, value at risk based margining, realtime monitoring of positions and margins, automatic disablement of the terminals, a central counterparty, and trade/ settlement guarantee fund, index based market wide circuit breakers, segregation of cash and derivative markets, enhancement of Governance standards among corporates and stock exchanges, continual disclosure requirements, registration and regulation of intermediaries - are already in place to manage and mitigate the risks in Securities Market. Nonetheless, if one relaxes with the comfort of a feeling that the Securities Market is now absolutely risk free, he runs the risk of deluding himself. The market is large and still it has the potential to grow. While the growth should be nourished, the attendant risks need to be contained. In other words, the path to growth needs to be paved by clearing risky pebbles, if any.

All available tools - Regulations, guidelines, surveillance, inspections and investigations are applied to deal with market misconduct and enforce action against market manipulators. Still, there is no denying the fact that some manipulators will keep on playing. Invariably, while manipulators play, the retail investors fall a prey. Often, there is a fatal attraction to hypes and greed. On its part, SEBI has started conducting Investor Awareness Programmes at various places across the country in collaboration with different agencies. But it is for the retail investors to be diligent enough not to be led by some invisible hands via garden path to prickly desert.