In the early 1990s, the Indian stock market was plagued by numerous problems: lack of a legal regulator, weak governance of exchanges, virtually non-existent risk management systems, reliance on paper-intensive manual systems, lack of a truly national market, lack of derivatives markets and near absence of institutional investors and intermediaries.
The stock markets blocked any attempt at reform, and the GS Patel Committee voiced the view of many when it wrote: “With the opening of our economy and the coercion of the ensuing conditions, our stock markets owe a duty to themselves and to the nation. to adapt and adapt to the changing times, do their best to eliminate at the earliest their flaws and imperfections that have become a dominant theme of national and international importance, subordinate their interests to those of the investors and the economy and their full cooperation with the regulators, rather than confronting them even with minor matters and giving the impression that they are trying to hinder and slow down the reform process in the stock exchanges.”
Carry forward, purse way
Boys selling share transfers in Dalal Street in what was then Bombay in 1995
The badla or carry forward system became the central issue in this conflict, as it was the most visible symptom of all that was wrong with the markets. It was a leveraged product (with some resemblance to single-stock futures with a two-week maturity), and in the absence of adequate margins or risk management, it often yielded undesirable results.
However, badla was only the visible tip of the iceberg, and real progress would not be possible without shattering the entire iceberg. With all its flaws eg. badla was the only mechanism for hedging, short selling and leverage in a non-derivatives market. likewise, badla provided a solution to the worst inefficiencies of the paper-based settlement system. At a time when it took buyers several weeks, if not months to get the share certificate in their name, badla allowed them to sell these shares before receiving those depositary receipts. The critical issue of optimal sequencing was whether to: create a futures and options market; introduce paperless settlement (dematerialization); and then abolish badla.
Optimal order of reforms was largely ignored on both sides of the debate. The old guard in the stockbrokers community didn’t want reform, thinking that if they stalled long enough, the reform momentum would fade and substantial change could be avoided. For zealous reformers, on the other hand, badla, which was the visible tip of the iceberg, was the obvious target to attack. It was thought that the abolition of badla would break the entrenched opposition and allow for later reforms.
When SEBI banned badla
In this context, the Securities and Exchange Board of India (SEBI) banned in December 1993: badla (the ban came into full effect in March 1994). The result was a sharp drop in liquidity with adverse effects on market efficiency and volatility. A year later, SEBI, headed by a new chairman, appointed the GS Patel Committee to review the case. Based on the recommendations of this committee, badla trade was revived in a modified form in January 1996 badla demanded automated software to calculate margins (for effective risk management) and electronic trading systems (for greater transparency). So within two years of his death, badla came back to life like a phoenix, and it would take another five years to kill him again.
During these five years, the Indian stock market has changed beyond recognition. The nationwide electronic market created by the National Stock Exchange (NSE) came to dominate the market. Paper share certificates were replaced by electronic entries in the newly established depots. Futures and options started trading on the stock index, followed by options on individual stocks. The bursting of the dotcom bubble led to the failure and demise of the Calcutta Stock Exchange. In the wake of this, the 15-day settlement period was replaced by rolling settlement, with all trades settled three days later.
Along with the introduction of rolling settlement in July 2001, amended badla was also banned, but the phoenix was reborn as single-stock futures four months later, becoming the largest equity derivatives market in India. It wasn’t until mid-2020 that single stock options caught up with single stock futures, and we could say that badla was eventually buried.
The Sensex crossed the 60,000 . level for the first time in September 2021
The modernization of the stock market in the 1990s was one of the great success stories of economic reform. The stock market became a source of venture capital for companies and an attractive location for investors. the abolition of badla was only a small part of this momentous institutional and technological transformation. Looking back a generation later, badla controversy seems like a lot of fuss over nothing.
The author is a professor at the Indian Institute of Management Ahmedabad
August 14, 2022