## Sunday, July 22, 2012

### The two escape routes away from domestic formal-sector finance

Three problems afflict formal-sector finance in India today: capital controls, taxation, and financial policy. The most important financial products traded in the formal sector in India -- the stock market index (Nifty) and the exchange rate (the rupee) -- are under enormous pressure as a consequence.

One dimension, that has been emphasised in the existing discussions, is the flight to offshore markets. There is another: the trade goes off into underground markets. These come in two kinds. In the field of commodity futures, it appears that important price discovery and liquidity is found on unregulated markets. As an example, in Gujarat, the town of Bhabhar is famous for having a huge oilseeds and edible oil futures market. Babhar is a true market: it has liquidity and discovers the price.

A second mechanism is a class of market mechanisms which leech off the price discovery of a main market, do not really offer liquidity of their own, and let people achieve trades. In Indian parlance, these are called the dabba market'. Here is how it works:

1. The main market where Nifty trades is NSE. But if a customer goes there, he has to suffer the full burden of the securities transaction tax, the charge by the NSE member firm, etc.
2. The dabba operator (DO') sets himself up in business offering trading services in Nifty futures.
3. Many individuals place buy/sell trades with him. These are meticulously tracked; their profits and losses are calculated and money is exchanged w.r.t. each customer.
4. Through this, the DO is effectively accepting orders -- like an exchange -- and doing daily mark-to-market w.r.t. the customers.
5. On average, the sum total of trades by many customers adds up to zero. So the net exposure of the DO is roughly 0. If an exposure builds up, he might choose to lay off his risk on NSE.
6. The DO charges much less than the NSE member since he does not pay STT and his establishment costs are lower.
7. He is a big man in the community. He can break your bones. So you will not default on him. So he charges less margin. This is another attraction - but it means that some fraction of customers endup entangling with the underworld.
8. The DO will work with black money (i.e. cash). This is another attraction, compared with the all-cheques-and-PAN-numbers world of NSE. The short-term capital gains tax (or worse, ordinary business income treatment of winnings) is then avoided.
Bhavesh Shah, reporting from Ahmedabad in DNA, tells us that dabba trading has gotten bigger of late. He also points out that the DOs have been doing some system-building to make their business more efficient. Dabba trading is one response of economic agents to the problems of taxation and improper financial policy. It also happens to a varying degree with trading in India of international underlyings (e.g. crude oil or gold), where capital controls prevent locals from accessing the world market.

In summary, when India makes mistakes on three things -- capital controls, taxation and financial policy -- there are two kinds of responses on the part of onshore and offshore users of India-related financial markets. On one hand, users go off to overseas venues. On the other hand, users shift towards informality. In the limit, large scale mistakes on the three fronts will drive the bulk of customers away from the formal sector onshore market venues. RBI, the tax authorities and SEBI will then lord over an insignificant part of the market.

1. In my view, the true test of the informal (or underground) system is during high volatility days. It would be interesting to see the robustness of the DO system on the high sigma days like May 2009 (India elections) and May 2006 (an intra-day lower circuit - May 22nd 2006). These, in my view, may expose some potential credit risks / counterparty risks which, in the formal, exchange based system, is fairly limited.

The second issue that the regulators need to take cognizance of is the linkages between the participants of the underground sector and the formal financial (banking, NBFC) sector. I dont know if this is pertinent but, the overlaps in market participants in these two marketplaces places a second-order risk on the formal banking system. As an example - I feel that one of the areas where this overlap may come into play is in the case of collateralization of assets held in the formal markets for transactions in the underground markets. I am not sure if this is reflective of reality. But if this does happen, the market's sensitivity to high-volatility could potentially reach unfathomable levels.

From a stability perspective, it is important for the DO system to have sustainable risk-management practices similar to the formal system - but that would be asking for too much :)

2. Interesting. Reminds one of these: Bucket shops but I guess this is bigger than the small-time bucket shops, and maybe, more sophisticated.

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