[Economy 4 Newbie] SEBI & Stock Exchange (The Beginning)

This is the first article regarding how and why SEBI came to existence and how things were running in Stock markets in old times. The more about how they calculate SENSEX etc. will be dealt in upcoming articles later on.

As usual, my articles are politically and technically not 100% correct.

To understand this article better.--Make sure you read my previous article about Securities, Derivatives & Financial Market.

What is SEBI?

·       Securities and Exchange Board of India = SEBI

·       It regulates both the primary and secondary markets. (explained in my previous article)

·       It protects the interests of the investors in securities

·       It promotes the development of the securities market.

·       SEBI was established in 1988 but was given statutory powers in 1992, and started working effectively since 1993.

Why did the government create SEBI?

As you know that in India, the Government won’t do any major reform or action unless the things get messed up really bad. The same was the case why SEBI was given the power to control both primary and secondary market because they were in complete mess. So lets first see, what was the problems in primary and secondary markets before SEBI came in picture.

The problems in Primary market before SEBI came

·       primary market was extremely restrictive regulations on the issuers enforced by the Controller of Capital Issues (CCI)

Now lets assume I'm the big businessman.

·       Primary market is where i issue my security for the first time.

·       I can't fix the prices of my shares, as I like, because i've to follow the rules made by CCI.

·       but that dude always underprice my issues.

·       When I put my equity shares for the first time in Primary market = this is IPO (initial public offering)

·       but now as you know that I can't fix high prices for my IPO due to CCI dude.

·       so my IPO is very cheap.

·       so lots of people will send application to buy it because its cheap  (= over subscription) 

·       so i'll have to give the IPO shares via lottery only to a few people.

·       but those who get my cheap IPO via lottery will immediately go to secondary market and sell it at higher price.

·       = I lost money (that I could have made if CCI dude allowed me to sell my IPO @ higer price.)

·       and those lucky dudes who won the lottery made money without really doing anything.

·       As you can see, all this is not good for industrial Development.

The problems in secondary market before SEBI came

Secondary market = where you trade the securities that you purchased from primary market.

For general understanding-  the stock markets = secondary market = where you sell/buy shares.

So lets see the

problems of Stock markets before SEBI came

·       first organized stock exchange was established in 1875 in Bombay (now Mumbai)

·       there were almost 20 regional stock exchanges in 1992,

·       but  trading was concentrated in Bombay Stock Exchange and it enjoyed a monopoly

·       Users from outside Bombay found it extremely difficult to trade in BSE due to poor technology and high cost of telecommunications. (they didn’t have internet or cellphones with free incoming calls in 1992!)

·       BSE imposed a high entry barrier, so that competition among brokers was absent.

·       That’s why  services provided by the brokers were, thus, extremely inefficient and costly. (its same like Indian railway’s stinking toilets- you can’t complain because railway don’t have much competition.)

Specific problems in Share market before 1992

“open outcry” system

·       means trading used to take place in trading ring where non-brokers were not allowed in.

·       These traders will shout the prices like we've in vegetable markets.

·       There wasn't any mechanism to verify the prices at which trading actually took place.

·       So, brokers used to charge prices to the investors (buyers and sellers of securities) that were usually different from the actual prices

·       =brokers used to report higher than actual prices for buy orders and lower than actual prices for sell orders).

·       If investors (buyers or sellers) demanded a more accurate price, orders often got cancelled (for example, the broker could simply claim that such a favourable price was not obtained in the market).

The settlement system

·       payment of money and delivery of securities after trade by the brokers to both parties (buyer and seller of shares)

·       it favored the brokers and was to the disadvantage of the investors.

·       the settlement was “futures-style” and was on a fortnightly basis.

·       means that trading done during a fortnight would be settled at the end of the fortnight.

·       system of badla =enabled the brokers to carry forward their liability (of money or securities) to next settlement.

·       so, brokers could postpone settlement almost indefinitely, if the prices were not favorable to them.

·       This led to a high degree of risks. Large-scale problems arising out of failure to make payment or deliver shares, would lead to closure of BSE for days together,

·       this  used to recur at the rate of almost once every other year.

“bad delivery” of Shares

·       Even after you buy the shares and get the paper in your hands- you had to send the shares to the registrar of the company to register the ownership of that share in your name.

·       At this stage, the problem of bad delivery arose due to a number of problems

·       if the signature of the seller did not match with the one maintained with the registrar, the shares were sent back.

Reasons for inaccurate signature

·       The seller of the shares, who probably purchased the shares years back, might unwillingly sign in a different manner.

·       But in many cases, manipulations by unscrupulous operators were responsible.

·       counterfeit shares (wherein any signature were put by the counterfeiter),

·       Engineering bad deliveries by selling party’s brokers or by the companies themselves to delay settlement in order to support price manipulation.

·       The time lag between buying shares and getting it registered in the name of the buyer used to take anything between 1-3 months if everything was alright.

·       The time lag normally went up to six months on an average in case of bad delivery.

Anyways so above were the problems with primary + secondary market so Govt. made a law to give powers to SEBI to control them both. And so CCI was abolished.

NSE (National stock exchange) was established to end the monopoly of Bombay Stock Exchange.

NSE (National stock exchange)

·       NSE was a new exchange promoted and owned by public sector financial institutions (like IDBI, UTI, LIC, GIC, IFCI, etc.) and banks.

·       NSE is  professionally-managed (as opposed to the other exchanges that are managed by brokers or members still today)

You saw the problems of BSE ago, and to curb them,

NSE came with 4 innovations

Computerized trading

·       First, physical, floor-based, brokers-dominated trading outside the eyes of the investors was replaced by anonymous, computerized order matching system

·       where trading is done in front of the investors.

·       The order-matching system is characterized by strict price-time priority,

·       wherein an order is executed according to the price parameters set by the investors.

·       The OTCEI, which was set up in 1992, was the first computerised exchange in India.

·       NSE started operations in 1994 with electronic trading, while all other exchanges introduced electronic trading subsequently.

·       By March 31, 1999, all the 23 stock exchanges in the country had computerised on-line screen based trading.

Satellite communication

·       to spread the reach of the exchange to all over the country was attempted successfully, for the first time, by NSE.

·       This was in stark contrast to the other exchanges which till then had the reach limited to their cities of operation for over a century. 

Professional managers

·       the traditional exchanges were and still are managed by the member brokers.

·       This gave rise to many malpractices, a conflict of interest being the most important one. Since the brokers themselves were in charge of enforcement of rules and regulations, they never took a decision in favour of the investors that went against their interest.

·       This gave rise to a conflict of interest between the members as brokers and members as responsible for enforcement of rules and regulations.

·       NSE avoided this problem right from beginning because it was set up as a limited liability company with brokers as franchisees.

·       This led to a situation where brokers were not held responsible for enforcement of rules and regulations, and

·       those who were entrusted with enforcement (professional managers) were not brokers.

·       As a result, NSE’s staff is free of pressures from brokers and is better able to perform regulatory and enforcement functions.

Weekly settlement

·       If you buy shares from me, you’ve to give me the money in  1 week and I’ve to give you the shares in the same 1 week.

·       the traditional practice of fortnightly settlement cycle + system of  badla that allowed extension of even this fortnightly cycle was replaced by a strict weekly settlement cycle without badla. 

Result-BSE Is busted

·       Equity trading at NSE commenced in November 1994.

·       Within one year of operation, NSE surpassed the BSE in terms of turnover.

·       BSE was working since 1875, with monopoly now it had to face competition with N.S.E

·       So in March 1995, BSE also adopted similar innovation to keep up in the race.

All this, lead to 5 good things Stock markets

Improved Transparency:

Investors can see with their own eyes the prices that are currently being quoted in the market, and choose to trade or not. 

Anonymity= no cartels

·       The electronic trading platform makes trading completely anonymous.

·       Traditionally,  lack of anonymity in trading in the floor-based system

·       gave rise to cartels (of brokers) and made price manipulation easy. NSE

·       was a break from this tradition as well and removed much of the scope for

·       price manipulation. 

More brokers = competition =good for clients

·       NSE throws open the business of stock broking to all and everyone (subject to fulfillment of certain criteria).

·       In contrast, BSE restricted new entry into the brokerage business until NSE came into picture.

·       Now More than a thousand brokers entered the market with the NSE leading to steep increase in competition and the consequent fall in the brokerages* by a very substantial amount.

·       This led to a drastic fall in transaction costs.  (*the broker’s Commission)

No more bad delivery

Automation of the trading system eliminated all the problems associated with manual trading (e.g., bad delivery/ signature etc.)

Investors outside Mumbai can earn money

·       Investors from all over the country have got access to an exchange on same terms and conditions as investors within Mumbai for the first time.

·       Earlier, Bombay stock exchange was the pre-dominant one in the country,

·       but investors outside the city found it extremely difficult and costly to do business in the exchange. (no cellphones with free incoming!)

·       Thus, true to its name, NSE turned out to be the first national stock exchange.

·       This benefited the investors from outside Mumbai more than perhaps the investors within the city.

National Securities Clearing Corporation Limited (NSCCL)

·       It’s a subsidiary of N.S.E, to prevent the counter party risk. (established in August 1995)

·       counter-party risk means the risk that one of the two parties in a transaction may fail to honour their commitment to pay cash [buyer] or stock [seller] on the scheduled settlement date

·       For every trade (buy or sell) done on the NSE, NSCCL becomes the counter-party.

·       means, the seller sells the securities to the NSCCL, and the buyer buys from the

·       NSCCL.

·       Even if a brokerage firm fails to make payment (or deliver securities), NSCCL makes the payment (or deliver securities).

·       This has almost eliminated counter-party risk and contained the recurrence of payment crises that characterised Indian stock markets for almost a century. 

Demat account

·       You read above, how the ‘bad delivery of shares’ was engineering by the brokers.+ the menace of counterfeit shares. And the fear of theft of shares.

·       To curb this problem, SEBI came up with the novel idea that is ‘Dematerialization of share holding’

·       This means, you’ve to get a Demat account in the bank and

·       when you buy shares, you don’t get a ‘piece of paper’. That share gets automatically credited to your demat account.

·       In November 1996, the National Securities Depository Ltd. (NSDL), the first depository in India, was established For this purpose.

·       SEBI played an active role in gradual shifting from physical certificates to dematerialised holding by introducing a mandatory element in the process.

·       Currently almost cent percent trading and settlement are done in a dematerialised environment.

·       But things are not that safe and sweet, thanks to IPO scam-Demat Queen Roopal Panchal