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Monday, March 26, 2007

Two decisions of the SEBI board

A recent SEBI board meeting appears to have made two important decisions: To have mandatory `grading' of IPOs by a credit rating agency [link, link], and to permit institutional investors to do short selling [link]. Financial Express had an edit on the former, see an edit in Economic Times, and today Business Standard has an edit on both issues:

The Sebi board has made progress on capital market regulation by permitting institutional investors to engage in short selling. The fundamental principle of financial markets is that diverse speculative views come together to generate price discovery. Some people believe a security will do well: they are able to borrow money and buy shares. If they are right, they will be able to sell the shares at a future date, repay the loan, and be left holding a profit. Such borrowing permits the expression of positive views on a security. In an exactly symmetric way, the financial markets must permit the expression of a negative view on a security. If a person believes a security will do badly, he should be able to borrow securities and sell them off. If he is right, he will be able to buy back the securities at a future date, repay the loan, and be left holding a profit. Such symmetric expression of views by optimists and pessimists is usually good for market efficiency. For liquid stocks, the presence of derivatives trading on individual stocks has already addressed the problem of giving a pessimist the means to express his views. But even here, stock lending is a fundamental requirement for achieving market efficiency on the derivatives market, by supporting arbitrage.

The important next step should be the construction of an effective system through which access to borrowed shares is ubiquitously available as supporting infrastructure for the stock market, while avoiding the difficulties of the badla system. It is to be presumed that the onus of this will now lie with the two main stock exchanges, the NSE and BSE. Sebi and the exchanges need to build common scalable infrastructure which works for all securities; it should be possible for users to borrow shares, government bonds, corporate bonds, gold ETFs, dematerialised warehouse receipts, etcall through a single scalable borrowing mechanism. This would harness economies of scale, and deliver the benefits of short selling on all these markets.

While the decision about short selling by institutions is on the right track, the Sebi board has made a mistake in introducing mandatory IPO grading by credit-rating agencies. In mature market economies, the credit ratings of bonds are optional in the hands of the issuer and grading IPOs is non-existent. In India, credit-rating agencies have been delivered a bonanza by the government by making both mandatory. In the case of credit rating, at least, a rating agency can work for a decade or two, and then there can be accountability in the eyes of the market because rating decisions can be compared against the default experience. In the case of IPO grading, this slow and remote accountability is absent. Fluctuations in stock prices take place for all kinds of reasons, and no rating agency can be held accountable if some companies do well and others do badly. More importantly, it is impossible to hold the rating agency accountable for the IPOs that it blocked. Sound thinking in financial sector policy requires the elimination of IPO grading, the elimination of mandatory credit ratings for bonds, and a requirement that each rating agency report quarterly statements about the performance of its credit ratings of the last five and ten years.


  1. Hi Ajay,
    nice to read yr blog.. good work.. i wanted to know couple of thing as i am a new blogger. how can i add a guest book in my blog. and how to track numbe of user. can u give some info on it..

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  4. Sir,

    I agree with on IPO grading with you.
    On FIs short selling too have raised vailed loopholes particular issues on securities lending , which is core of the matter. I feel the before allowing short selling Sir I feel the system should be in place properly.
    example for say share of Wipro, Tech Mahindra, etc where in the free float is very thin i feel poor retail investor who believe in first buy and then sell stragey will be left with high volatility in share price, the mechanism should also address issue which took place in May 2004 wherein the Forigen investor made huge intra day profits.....
    and secondly, there should be transperence in postion taken by FI such as at the end of the day such a bulk transcation takes place on short selling the exchange should disclose the facts of it....

    looking forward

  5. As always, this is two step backward and one forward. The market had been clamouring for short sales and sec borrowing and lending for a long time. Hope the scheme is good so that it takes off. I presume we are not going to have ALBM or 'badla' in a new format.

    What happended to physical settlement of derivatives? This has been long pending. If this happens the sec borrowing and lending market will take off like anything.

    As for IPO the CRAs have the expertise, techniques and models to do the same. SEBI chairman has said today that it will not address valuation. The what is it for. Will rating agencies decalree their methodology to public as to why they ahve rated a company as 1 r 5? In this scenario, I fail to see the need for the same. CRA can do credit only . This is the global model.

    It seems that SEBI chairmen have a penchant for using CRAs to addresstheir formal agenda. A former SEBI chairman floated the idea of Corp. Gov rating which faded once he retired. Do we see the same fate for IPO rating?!


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