Can the Stock Exchanges Support the Envisaged Capital Growth?

8/10/2019 Can the Stock Exchanges Support the Envisaged Capital Growth?

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Can the Stock Exchanges Supportthe Envisaged Capital Growth?

R H Patil

The organization and management of thestock exchanges suffer from majorweaknesses and malpractices. Reformshave to be brought about urgently, if theyhave to support the envisaged growth inlisted capital from about Rs 6,000 crore in1985 to about Rs 90,000 crore by the turn ofthe century, argues Dr Patil.

Dr Patil has identified the reforms thathave to be made on a priority basis besides

providing, for comparative purposes, briefoutlines on the functioning of the stockexchanges in the US, UK, and Switzerland.

R H Pati] is Genera] Manager (Researchand Planning], Industrial DevelopmentBank of India, Bombay. His recent con-tribution to Vikalpa was on "Raising Funds

from the Capital Market: Challenges for thePrivate Sector," April-June 1986.

It is, perhaps, for the first time since Independencethat the health of the stock markets has receivedattention of the Prime Minister. In his budgetspeech, the Prime Minister stated:

For a healthy growth of capital markets, investors' rightsmust be fully protected. Trading malpractices must be pre-vented. Government have decided to set up a separateBoard for the regulation and orderly functioning of StockExchanges and the securities industry.

This is certainly one of the most importantpolicy statements of the government on the reformof stock exchanges in the country.

The subject of stock exchange reforms hasbeen receiving wide attention for quite some timein the press, public discussions, and academic in-stitutions. A major stimulus to these discussionswas provided by the comprehensive report of theHigh Powered Committee on Stock Exchange Re-forms headed by G S Patel, ex-chairman, UnitTrust of India. Another equally important reason

is that stock markets have become an importantchannel of investment for the common man in thelast three to four years. An unprecedented numberof investors has locked up its savings in shares anddebentures; any noticeable fall in prices erodesmarket value of its investments and the confidenceof an average investor is shaken. The suddenchange in market sentiments in February 1986when the two year up-trend in stock prices sud-denly halted has resulted in the realization that allis not well with the functioning of stock markets.An apprehension that prices would continue tofall if institutions do not extend their support to

markets has affected the perceptions of millions ofinvestors, many of whom entered the stock mar-kets only recently.

It is in the interest of investors as well as thecorporate units which raise funds on stock marketsthat the market functions in an orderly fashion.Through their prices, stock exchanges should reflectthe state of the health of the economy in generaland of the corporations whose securities are traded.


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Growth and Development ofStock Exchanges

Although India is one of the less developedcountries, its stock exchanges are more than 100years old. In 1850, the Companies Act which intro-duced the concept of limited liability was enacted,and the era of joint stock enterprise was ushered

into the country. The first organized stock

exchange was established in 1875 in Bombay. Thehistory of stock exchanges in India is characterizedby major upheavals till 1951 when planneddevelopment began.

At present there are 14 stock exchanges andthere are plans to open many more stock ex-changes in almost all important cities of thecountry. The pattern of development of stock

exchanges is shown in Table 1. From 538 stocks

Table 1: Development Pattern of Stock Exchanges


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valued at Rs 645 crore in 1961, the listing on theBombay Stock Exchange has increased to 2610stocks valued at Rs 20,378 crore at the end of 1985.

Over one-third of the public limited com-panies are now listed on the stock exchanges. Thelisted companies account for about 90 per cent ofthe total paid-up capital of over 14,000 public

limited companies in the private corporate sector.

Since stock exchange as an institution enablesthe corporate sector to mobilize funds from in-vestors, its growth is linked directly to the growthof the corporate sector. A wide network of finan-cial institutions, both at the national and statelevels, has grown to assist and promote industrialunits.

Composition of Listed Capital

The composition of listed capital on the stock ex-changes has changed significantly in this decade.The equity market dominated until the early1980s. During the mid-80s the rate of growth ofdebenture capital was much higher. Both equityand debenture markets have become equally im-

portant today. The structural and market-wise pat-tern of listed stock as of December 31, 1985, isgiven in Table 2.

The secondary markets of the country havewitnessed a major1 spurt during the post-Inde-pendence period. The number of companies andscrips listed have increased to four times the post-Independence level. Total reported annual turnover


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on all the stock exchanges is now around Rs 18,000crore, of which the Bombay Stock Exchange ac-counts for Rs 12,000 crore.

If the stock exchanges continue to grow at thesame rate as they have done in the last five years orso, the listed paid-up capital on the stock ex-changes would more than double to Rs 16,240

crore by 1990. By the end of the century theywould grow more than nine-fold to Rs 90,000crore. Impressive as they are, the figures indicatethe importance that stock exchanges would havein the national economy. Can the stock exchangessupport such growth? .

Prerequisites of Growth ofStock Exchanges

There are three sets of major factors that woulddetermine the future growth of stock exchanges.

The national economy and the corporate sectorhave to grow at a rapid rate. Government policieswould have to encourage people to invest in sec-urities. Finally, the organization and managementof stock exchanges should be able to support theenvisaged growth. Let us examine whether theseconditions are likely to be met.

Since 1980, the economy has grown at a ratehigher than the so-called Hindu rate of growth of3.5 per cent. All indicators suggest that the eco-nomy has moved on to a higher growth path andthere is promise of a growth rate higher than thatprojected in the Seventh Plan.

A number of policy changes, including thevarious liberalizations introduced by the govern-ment, have provided an incentive to invest in sec-urities. Thus, primafacie, there is a strong case toassume that the first two prerequisites will befulfilled.

Will the organization and management ofstock exchanges be able to support the envisagedgrowth in listed capital? Will stock exchangesfacilitate the structural changes that would ac-company the rapid growth of the organized capitalmarket?

Organization of Stock Exchanges

How are stock exchanges organized in free marketeconomies? There is no uniform pattern. The or-ganizational structures and operating rules of

Box 1

The United States Securities Exchange System

The United States economy has the largest grossnational product in the world. Yet, it does not haveas many stock exchanges as India currently has. In1966, the US had 14 registered national securitiesexchanges. Only nine are reported to be active to-

day. Excellent communication facilities and com-puterized linkages among the different securitiesmarkets have enabled the US to manage with asmall number of stock exchanges. Of its nine stockexchanges, the New York Stock Exchange (NYSE)is dominant, accounting for over 60 per cent of alltransactions.

In addition to organized stock exchanges, theUS has an Over-the-Counter (OTC) market whichis an electronic market place in which prices oftraded securities are updated almost on a minuteto minute basis and flashed on computer videoscreens. The OTC market is not "organized" in thesense that it does not have a "floor" on which com-

peting buyers and selle rs assemble at pre-determined hours to participate in an "auction"type of market. In the OTC market whenever a

broker receives an order for purchase/sale of a sec-urity he uses the computer terminal in his office toget quotations of the market makers who quote

bid/sell prices. The market makers are likewholesalers keeping a stock of securities all thetime and are willing to purchase/sell such sec-urities at their quoted prices. The brokers settletheir clients' orders by accepting the best bid/offer

price available in the market at that point of time.

New York Stock Exchange

NYSE is governed by a board of 23 directors ofwhom 20 are elected by the members of the Ex-change. These directors are grouped into two clas-ses, ten representing the public and ten NYSEmembers. The public representatives are ap-

pointed from a panel of names recommended by acommittee of NYSE members from among heads oflisted companies and representatives of financialinstitutions such as investment companies, trustcompanies, banks, and insurance companies. Theremaining three members of the Board are thechairman, the vice-chairman, and chief operatingofficer of the Exchange. They do not have personalfiduciary interest in the trading and can be ex-

pected to be as objective in their approach as any

of the ten public representatives. These 13 mem-bers without trading interests are primarily re-sponsible for the efficient functioning of NYSE.

NYSE has self-governance powers which ituses judiciously in choosing distinguished and in-dependent minded persons for its governing board.

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Market Surveillance

Market surveillance of NYSE may be regarded asone of the best in the world. The total staff of NYSEis more than 1000, of which well over 150 people

are continuously monitoring the functioning of themarket with their independent computer-linkedvideo screens. They keep continuous watch on theprice movement of all the scrips and are in closetouch with the specialists operating on the floor ofNYSE. The main job of the specialists is to ensurethat prices of scrips allotted to them by NYSE au-thorities do not behave in an erratic fashion. Thisthey do by quoting their own bid and offer prices.

Securities Exchange Commission

The Securities Exchange Commission (SEC) is anindependent, bipartisan, quasi-judicial body es-tablished by a statute for the purpose of administer-

ing Federal securities laws that seek to protect in-vestors' interests. It plays a major role in the effi-cient management of stock exchanges. SEC insistson full disclosure of all pertinent information byeveryone who intends to acquire over 5 per cent of acompany's securities. It controls trading practiceson the stock exchanges and in the OTC market. It isresponsible for establishing the general regulatorypattern and for promulgating rules and regulationsfor their implementation. There are many areaswhere the stock exchanges and SEC may indepen-dently investigate malpractices. For example, in-sider trading, market rigging, or market manipula-tion may be investigated independently by bothNYSE and SEC. The very presence of SEC, with its

watchdog activities, prompts the stock exchangeauthorities to remain alert all the time to ensure thatthe market operates smoothly.

SEC has a staff of about 2000 composed of lawgraduates, accountants, security analysts and ex-aminers, engineers, and other professionals. In thecourse of administering the provisions of the Sec-urities Act of 1933 and the Securities ExchangesAct of 1934, SEC investigates complaints or otherindications of violations of law such as fraud, in-sider trading, and market rigging or manipulations.It ensures that brokers and dealers adopt businesspractices that conform to the standards prescribedby law. It is empowered to suspend any member of

the stock exchange.SEC regulates all mutual funds which have to

be registered with it and prescribes general rules forinvestment of their funds. All those in the businessof investment advice and fund management have toget themselves registered with SEC and have toabide by the rules and regulations it prescribes.

stock exchanges in each country have evolved tomeet its national economic needs and ethos.Countries like ours that intend to accelerate the

pace of growth of the capital market can examinethe various models of stock exchanges and adoptfeatures suitable to our environment. Three im-

portant stock exchange models, viz. United States,United Kingdom, and Switzerland, are described

briefly in the adjoining columns.

Stock Exchanges in India:Major Weaknesses

On surveying the Indian scene, three major inade-

quacies of stock exchanges come to the fore:

weak organizational structure

non-professional, limited membership

domination by large member-brokers.

These weaknesses are discussed below.

Weak Organizational Structure

There are 14 stock exchanges established as as-sociated or limited liability companies. Each stockexchange is self-governed under the provisions ofthe Securities Contracts Regulation Act (SCRA).Rules and bye-laws of Indian stock exchanges haveto be approved by the government which has power(under the SCRA) to amend them suo motu.

Well over 75 per cent of the members of the

governing board of each of the stock exchanges areelected representatives of the members. The mem-

bers are individuals or partnership organizations.Government appoints three of its nominees on the

boards of stock exchanges. While the governmentcan issue guidelines on various matters, day-to-dayfunctioning of a stock exchange remains the re-sponsibility of its governing board, which is con-trolled by large member-brokers.

This is a weak organizational structure. Therules and bye-laws framed and approved by thegovernment are not implemented effectively sincethe governing bodies do not have the will to imple-ment them. The decisions taken by such governing

boards tend to subserve the interests of the power-ful members of stock exchanges.

Non-Professional Limited Membership

The stock exchanges have not been able to

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broadbase, professionalize, and increase member-ship in keeping with the rapid growth in volume andcomplexity of the business. Malpractices such asmarket rigging, insider trading, speculative build-up, default in commitments to clients, and neglectof investors' interests are common occurrences.

Domination by Large Member-Brokers

Large member-brokers dominate the weak ones inseveral ways. They get away with infringement ofimportant rules and bye-laws. They also use smallbrokers as conduits for malpractices. With thehelp of willing brokers, some of the highly re-sourceful speculators find it easy to destabilize theoperations of stock exchanges to serve their selfishinterests. Because the governing boards aredominated by the same large brokers, members failto honour their obligations to clients and otherbrokers. Occasionally the market closes. Pricesfluctuate widely. These are all detrimental to a

healthy and rapid growth of the capital market.

Unless these shortcomings are remedied, In-dian stock exchanges will prove unequal to thetask of sustaining the high growth in listed capitalenvisaged. What are the much needed reforms?

Priority Reforms

Government's concern for reforming stock ex-changes is reflected in its appointment of a highpowered committee under G S Patel's chairman-ship. The Committee has produced a voluminous

report and has made wide-ranging recommenda-tions covering model rules, regulations, and bye-laws of stock exchanges.

It is not possible to deal with the entire gamutof stock exchange reforms in a short article. What Ihave done is to indicate the key areas where re-forms are urgently needed.

Broadbase Governing Boardswith Non-Member Experts

Recognizing that success or failure of an institu-tion depends ultimately on the type of its manage-ment, the Committee has recommended majorchanges in the composition of governing boards ofstock exchanges.

The Patel Committee has suggested that thegovernment should appoint the chairman and the

Box 2

The UK Model of Stock Exchanges

In the United Kingdom, there were, prior to 1973,14 provincial stock exchanges, in addition to theLondon Stock Exchange (LSE). After March 1973,all the English provincial, the Scottish, and the

Irish Stock Exchanges were merged to form TheStock Exchange. All the members of these stockexchanges have access to the London floor just asthe London brokers have access to the floorslocated at Liverpool, Belfast, Birmingham, Dublin,Glasgow, and Manchester. Electronic linkagesamong all the floors of the stock exchanges havemade it possible for all the floors to function as asingle stock exchange of the country.

The stock exchanges in UK have functionedall along on the principle of self-governance. Thisis similar to the Indian system: the stock ex-changes formulate their own rules and regulations

and the governing body of a stock exchange iscomposed mainly of representatives of itsmembers.

The UK system is as efficacious in protectinginvestors' interests as the US system.As in US, UKhas also its own OTC market. Securities of othercountries are also listed and actively traded onLSE. However, the governing board is composeddifferently. The UK system also differs from theUS system in another way; there is no statutorilyestablished regulatory body to supervise the activ-ity of the stock exchanges.

Recently, some noticeable changes have beenintroduced in this field. A new law called the Fi-nancial Services Act received Royal consent in

November 1986. It is a complex act which replacesinvestor protection legislation and extends or con-solidates other pieces of legislation on insidertrading and listing of securities. Under the newAct, Self Regulatory Organizations (SROs), includ-ing the stock exchanges, will regulate themselves

based on certain rules and regulations. The Sec-urities Industries Board (SIB) (in some respectscomparable to the SEC in US) will oversee them.

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Securities Industries Board

SIB is not a statutory body, but will derive its au-

thority from the powers delegated to it by theTrade Secretary who has been empowered to ad-minister the new act. SIB will set standards for theSRO's own rules. The Office of the Fair Trade willwhet the rule book which will be sent to the TradeSecretary for approval. The Trade Secretary willthen request Parliament to delegate powers to SIB.Though it is not yet clear as to what powers will bedelegated to SIB, it appears from the current de-bate that SIB will not be as strong as SEC. SIBappears to be a compromise between the SEC typeof regulatory agency and the earlier system of self-regulation, a compromise reached to maintain aflexible policing framework. SIB will oversee the

operations of five SROs:

the International Stock Exchange of theUK and Ireland

Association of Futures and Brokers andDealers

Financial Intermediates, Managers, andBrokers Regulatory Association

Investment Managers Regulatory Organization

Life Assurance and Unit Trust RegulatoryOrganization

Each SRO is expected to frame its own rules andoperate under the supervision of SIB. Thus, it maybe noted that the UK system is making a transitionfrom the purely self-regulatory system to a par-tially self-regulatory system by accepting SIB asthe supervisory body. Such a system would be ap-propriate for a country like UK which has excelledin the working of a self-regulatory system. Self-regulation as a system can function efficiently pro-vided the parties who operate the system agree toabide by certain standards in their operations.Such a system would function efficiently only if

the security dealers possess a high degree ofintegrity.

chief executive of each stock exchange to be de-signated as managing director. This appointmentwould be based on a panel of three names of inde-pendent persons of eminence recommended to thegovernment by the governing body of the stock ex-change. The government is expected to choose oneof them for appointment as the managing director.Only one half of the remaining governing bodymembers (not exceeding 18) is to be elected fromamongst the members of the stock exchange. Theother half is to be appointed by the government torepresent various interests such as those of finan-cial institutions, banks, professional bodies like theInstitute of Chartered Accountants, Institute ofCompany Secretaries, Institute of Costs and WorksAccountants, investment specialists, institutes ofmanagement, and the Reserve Bank of India. Withsuch a composition, it is believed that stock ex-changes will be managed without fear or favour andthat indiscipline among members and their indif-ference to investors' interest can be tackled effec-tively. To strengthen the hands of the reconstitutedgoverning boards, the Patel Committee has recom-mended that governing boards be vested with ade-quate powers and authority to institute appropriatecivil or criminal proceedings against members andnon-members for breach of SCRA provisions, bye-laws, and rules and regulations.

The composition of the governing board as re-commended by the Patel Committee is somewhatsimilar to that of the New York Stock Exchange(NYSE) (Box l). NYSE has adopted it voluntarily; itwas not imposed by the government of the

United States. Since it is not possible to bring aboutthe desired changes with the concurrence of theexisting members of stock exchanges, the PatelCommittee has recommended suitable legislativechanges to accomplish them.

Increasing Membership

For a large country with 14 stock exchanges, thetotal number of brokers or members of stock ex-changes is only about 2,200. This is thoroughlyinadequate for a shareholder strength of 3 million

currently. The number of brokers has not in-creased with the rapidly growing volume of busi-ness mainly because exchanges are organized asexclusive clubs, and these clubs are interested inkeeping the number of members restricted for theirselfish purposes.

Any Indian citizen who has passed his secondary



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school certificate examination and who is 21 canbecome a member of a stock exchange by paying therequired security deposit and obtaining the mem-bership card of an existing member-broker. Al-though some of the newer stock exchanges havebeen liberal in admitting new members, admissionas a new member is dependent on such extraneousconsiderations as close family links with existingmembers. It has been observed that certain familygroups have cornered the membership of some ofthese stock exchanges and control their functioning.

Membership fee should be kept reasonableand admission of new members should be basedon qualification and experience relevant to thesecurities industry.

In the older stock exchanges which have notbeen admitting new members, the right of mem-bership (called membership badge on the BombayStock Exchange) can be bought. The current goingprice is stated to be in the range of Rs 7.5 lakh inBombay and New Delhi Stock Exchanges. Theprice for membership is continuously going up.The restrictive practices on membership have ledto an undesirable situation: there are a number ofinactive members. They continue to remain mem-bers with the sole intention of reaping speculative

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profits. They do not conduct securities business.For instance, the number of inactive members onthe Bombay Stock Exchange is reported to be 173out of a total membership of 504 (29 per cent). Theinactive members are significantly larger than theactive members on the Calcutta (60 per cent) andthe Ahmedabad Stock Exchanges (61 per cent).

The proportion of inactive members taking all thestock exchanges together is about 40 per cent.

Terminate Inactive Members

Admission to stock exchanges should be framed es-sentially on functional criteria: only those who areinterested in securities business should be allowedto become members. Once a member remains inac-tive for more than one year, his membership shouldbe automatically cancelled. Such rules can be intro-duced only if membership is not recognized as a

hereditary right or as an asset that can be sold. Themalpractices related to membership rights woulddisappear once the governing boards accept thebasic principles that membership size should varywith the volume of securities business and thatonly persons with requisite skills and resourcesshould be admitted as members.

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Admit Corporate Bodies andBanks as Members

At present, only individuals and partnership firmsare eligible to become members of stock ex-changes. In 1984, the government sought the opi-nion of the stock exchanges on the desirability of

admitting corporate bodies as members. It is re-ported that most of the stock exchanges opposed iton the ground that admission of limited com-panies would lead to concentration of business inthe hands of a few powerful members.

The stock exchanges, as they are constitutedtoday, do not have a high degree of concern forproviding more efficient services to their clients.

Several existing members are not acceptingnew clients because their resources are over-stretched. Surprisingly, these are the very samemembers who oppose the admission of new mem-

bers, whether proprietary, partnership, or corpo-rate bodies. Corporate bodies with strong financialand organizational base with qualified staff spreadover a wide network of offices have such resourcesand can guide and advise investors competently.Corporations and banks have to be allowed to be-come members.

Adapting the Swiss model (Box 3), we shouldencourage commercial banks to take up member-ship of stock exchanges. A vast number of in-vestors have much greater faith in commercialbanks than in the broker community. Banks enjoythe highest level of credibility with the investingpublic as well as with the brokers. Moreover, withtheir widespread branch network, banks will beable to widen the geographical spread of the busi-ness. Banks would be the best agencies for activiz-ing over-the-counter type of transactions all overthe country.

We should also encourage corporate members.For example, Merryll Lynch of the US operateswith thousands of their dealing staff spread overthe country.

Extend Membership to other Exchanges

As noted in the adjoining columns, the US and UKmarkets are getting more integrated. Two-wayflow of orders and deals are common among differ-ent stock exchanges.

The efficiency of spatially separated markets

is directly proportional to the speed with whichtransactions are completed and inversely to thecosts of such transactions. For a more efficient in-tegration of different stock exchanges, it is desir-able that the membership is not limited to only onestock exchange as it is at present. If an investorwants to purchase a security listed on some other

stock exchange, his broker should be in a positionto complete the transaction speedily, without ano-ther transaction with a member of the other stockexchange. This he can do if he is allowed to becomea member of all the prominent stock exchanges inthe country. Multiple membership of stock ex-changes should be permitted so that a nationalmarket develops for all listed securities. The pricedifferentials among different stock exchangeswould be reduced to the lowest. Our basic objectiveshould be to see that arbitrage transactions are notas profitable as they are today.

Trading Arrangements

Investors all over the world prefer assets that areliquid. Active secondary markets help in augment-ing the pool of savings in favour of the securitiesthat get listed on stock exchanges.

The main function of stock exchanges is toprovide active secondary markets that ensure li-quidity, transferability, and price stability to thelisted capital so that investors can easily buy andsell their holding of securities.

Trading arrangements have to contribute tothis function.

Excessive Speculation

To function efficiently, all markets, commodity andsecurities alike, need a class of dealers whose mainfunction is to even out day-to-day gaps in demandsand supplies. Such dealers emerge as sellers orpurchasers depending on the prices at which otherpurchasers and sellers are making bids and offersfor rearranging their investment portfolios. When

the dealers or market makers build large, speculativepositions in certain securities, the prices of suchsecurities may move up or down excessively. In reallife situations it is somewhat difficult to identifyclearly when excessive speculative build-ups havetaken place. To do so, one has to decide what level oftransactions constitutes an excessive or unwar-ranted build-up during a given period of time.



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Although there is excessive speculation onIndian stock exchanges, there was no quantitativeindicator for it. The Patel Committee has pro-vided a meaningful indicator. The Committeepoints out that about 90 per cent of the transac-tions taking place in specified shares are settledwithout actual deliveries of shares. They are con-

cluded merely through settlement of differences.Only 20 to 30 per cent of the remaining 10 percent of transactions are genuine deliveries infavour of investors. The rest are carry forward orbadla transactions. Thus, only about 2 to 3 percent of the reported transactions in specifiedshares result in actual purchases or sales by in-vestors. If we make suitable adjustments for trans-actions that are squared up daily and for thosethat are not reported to stock exchange au-thorities, the extent of excessive speculation be-comes clear.

Reasonable Speculation

All the same, a reasonable level of speculation,which does not destabilize markets, is necessary,provided it is based on:

indepth studies of balance sheets

demand and profitability prospects forthe company's products

careful study of the general economicconditions

intelligent anticipation of future events

shrewd analysis of market forces.

Such speculation helps in imparting a greaterdegree of liquidity to the markets especiallywhen large buy or sell orders from genuine in-vestors have to be executed without causing un-due fluctuations in market prices. Some specula-tion per se is, therefore, not harmful to orderlyfunctioning of markets.

As John Maynard Keynes put it:Speculators may do no harm as bubbles on a steadystream of enterprise. But the position is serious whenenterprise becomes the bubble on a whirlpool of specula-tion. When the capital development of a country becomesaby-product of the activities of a casino, the job is likelytn be ill-done.

Eliminate Kerb Trading

It should be made obligatory for those dealing insecurities to report all their transactions to stockexchange authorities. The present malpractice ofkerb trading, i.e. trading outside market hours ofstock exchanges and not reporting to the au-thorities, should be effectively curbed. Anymember indulging in this malpractice should bepunished with a fine if the offence is not of aserious character. But if the member makes ahabit of indulging in it regularly, he should beboth fined and suspended for a period of one ortwo weeks. If the member is not disciplined evenafter being punished, he should be de-registered.

Trading should be permitted only duringmarket hours so that it takes place under thesupervision of the authorities of the stock ex-changes which can ensure that it is fair and equit-able to all involved. At present, the stock ex-

change bye-laws and regulations permit tradingafter market hours, if it is conducted on the tele-phone between brokers. Increasingly transactionstake place at all hours all over the world madepossible by instantaneous communication links.

It is essential, however, that all transactionsare reported to stock exchanges so that the au-thorities have an opportunity to find out whetherany of the transactions are carried on withmalafide intentions.

Impose Trading Margins

India is one of the very few countries which hasnot adopted the standard practice of imposing re-gularly margins on all the trading that takes placeon stock exchanges. Hence, there is an opportun-ity to enter into transactions without shelling outeven small amounts of money. This poses a tempt-ation to indulge in overtrading resulting in marketdisruptions. As a result, some parties are unable tohonour their commitments fully on the settlementday. In the United States as well as in several othercountries all persons entering into securitiestransactions should have required funds to honour

their commitments when they are called upon todo so.

Margins are stipulated at a level which is ade-quate to safeguard the interests of the other partyentering into the transaction. In other words,when the price at which a purchaser enters into acommitment subsequently declines and, in case.

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the purchaser does not intend to take delivery, themargin amount provided by him should be enoughto square up the transaction at the lower price.Therefore, the margin amount should be equal toat least the likely difference between the purchaseprice and the actual price on the settlement date.

Under reasonably normal trading conditions

the level of margin should be around 10 to 15 percent of the price at which the purchaser enters intoa commitment. The level of margins may vary de-pending on market situation. If the stock exchangeauthorities feel that excessive speculative build upis taking place, not only should they step uppromptly the margins but should also ensure thatthere is accurate and complete reporting of alltransactions.

Curb Insider Trading

Insider trading is defined as "trading in securitiesbased on secret information about working of com-panies or any other relevant information of vitalimportance accessible only to a few persons onaccount of their key position in the company ortheir access to key persons working in the com-pany." Insider trading is rampant on Indian stockexchanges. The disclosure requirements aboutworking of listed companies are not as stringent asin some developed countries. It is only recentlythat the stock exchanges have made it obligatoryon the part of all the large listed companies to dis-close preliminary working results on a half-yearlybasis so that investors are kept well informed. Dis-closure requirements could be made quarterly. Iftrading is to be fair, all those who deal in securitiesshould have equal access to all the vital informa-tion. Since in India such a situation does not pre-vail, the general class of shareholders is at a greatdisadvantage vis-a-vis those who have easy accessto information.

In the United States, United Kingdom, andAustralia insider trading is a major punishable of-fence. Australian law is quite stringent in this re-gard: insider trading is a criminal offence punish-able with heavy fines and imprisonment. In the

United States, SEC recommended in 1983 imposi-tion of civil penalties, criminal proceedings, andtines up to three times the profits gained or lossesavoided (Box 1). In the United Kingdom also theCompanies Act was amended in 1981 to make in-sider trading a criminal offence (Box 2).

Unfortunately, there are no legal provisions at

the moment to punish those indulging in insidertrading. We must have stringent provisions simi-lar to those in other countries. Operations of thosein key corporate positions and of their brokersshould be closely monitored and wherever there isprima facie evidence about insider trading, the mat-ter should be thoroughly investigated by stock ex-change authorities. An apex body of stock exchangesshould keep close watch to ascertain whether stockexchanges are monitoring thoroughly the tradingmalpractices and whether they are taking effectivemeasures to curb insider trading.

Improve Market Surveillance

Apart from insider trading, there are a number ofother malpractices observed on Indian stock ex-changes. Excessive speculation, market manipula-tion, and price rigging are common features of the

day. Takeover attempts by "corporate raiders" arereported quite frequently. The present companylaw provisions empower the board of directors toreject transfer of shares to parties hostile to it:some takeover bids, therefore, do not succeed. Butin the interregnum, there is considerable anxietyamong non-management shareholders. The stockexchanges have accepted the code of ethics of theCity of London, according to which the price paidfor management takeover of shares should be of-fered to other shareholders willing to sell theirshares. In practice, it is difficult to implement thiscode. The recorded price in the management saleof shares does not disclose the true nature of thetransaction and hence the other shareholders areat a disadvantage.

Any attempt or intention of managementchangeover should be immediately reported to thestock exchange. Parties failing to do so should notbe allowed to take over management at a subse-quent stage. In other words, it should be ensuredthat the general class of shareholders is informedwell in advance of any possible move of corporateraiders.

It is useful to note the market surveillancesystem at NYSE. As noted in Box 1. well over 150people keep a continuous watch on the pricemovement of the scrips dealt on the floor of NYSEon a minute-to-minute basis on the video screensinstalled in their rooms. NYSE has evolved certainnormal price behaviour patterns for differentshares. The computer screens or video screensautomatically flash a message when a price moves

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out of the normal range. The person monitoringthe scrip asks the specialist on the floor of NYSEfor an explanation. If the explanation provided bythe specialist is not satisfactory, he immediatelycontacts the top management of the company con-cerned to find out whether any price sensitivedevelopments concerning the company'soperations are likely_ to have become known to

any person/ persons. The intention is also toknow whether any corporate raider is trying tocorner the shares. The brokers and thespecialists are obliged to name the party tryingto corner the shares. The information is flashedimmediately to all, including newspapers. Thesesurveillance measures effectively curb attempts atmarket rigging and price manipulation. Stockexchanges in India should evolve similarmeasures.

Stipulate and Enforce Brokers' Ratio of

Owned Funds to Aggregate Indebtedness

Member brokers should put in adequate funds oftheir own to support their continuous trading andfinancial commitments. The size of their (own)funds should bear some relation to the aggregatecommitments they make whether on their own oron behalf of their clients. If the commitments areexcessive and the market turns adverse, theywould not be able to honour their commitments.Hence stock exchanges should fix a limit on theaggregate indebtedness of a broker to ensure hissolvency and of the market.

NYSE does not allow aggregate indebtednessof a member to exceed ten times his net ownedcapital. It has defined aggregate indebtedness forthe purpose of this rule and has prescribed steps tobe taken when a member's indebtedness exceedsthe stipulated ratio.1India can examine this and

1 For the purpose of this rule, aggregate indebtedness is de

fined as "total money liabilities including borrowed funds,amounts payable against securities loaned and securitiesfailed to receive, the market value of securities borrowed to theextent to which no equivalent value is paid or credited,customers' and non-customers' account having short positionsin securities and equities in customers' and future accounts,and credit balances." Indebtedness, however, does not include

items such as liabilities adequately covered, credit balances inthe accounts of partners, and indebtedness for which adequatecollateral exists. A member's net capital is loosely defined asmember's liquid networth or owned funds. Whenever the ratioof indebtedness to owned funds rises above ten times, an earlywarning is issued to the member and the member is not permitted to expand his business further. If the member does notheed this warning and the ratio rises above 12 times, he isdirected to take suitable steps to reduce indebtedness. If themember disobeys the directive and the ratio rises above 15times, he is forced to go into liquidation.

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adopt such measures with appropriatemodifications.

Enable Limited Liability Membership

At present corporate bodies, with limited liabi-lity, cannot become members of Indian stock ex-

changes. One of the arguments put forth in notpermitting corporate bodies as members is thattheir directors' and shareholders' liability is bydefinition limited and hence it is difficult to pro-tect the interests of those parties who deal withsuch corporate bodies. Under the current arrange-ments, the liability of a member is unlimited. Allhis personal assets are available for meeting hiscommitments. However, in practice, dishonestmembers transfer all their personal assets in thenames of their relatives and friends when theyforesee the risk of a loss. As a result, the existingprovision of unlimited liability of members does

not serve the intended purpose when the mem-ber's firm goes into liquidation.

One way of solving this difficulty is to stipu-late a desirable exposure ratio taking the cue fromNYSE so that the member's overall exposure al-ways remains within reasonable limits. Such arule can be made applicable to all members, ir-respective of whether they are proprietary or part-nership firms or limited liability companies.

The provision for unlimited liability willhave to be done away with. Only if their liabilityis limited will professionals take up directorship

as salaried employees of corporate members ofstock exchanges.

Smoothen and Speed upTransfer of Shares

The present legal provisions governing transfer ofsecurities from buyers to sellers are cumbersomeand time consuming. The average time lag bet-ween the point of sale and the actual receipt ofshare certificates after they are registered in thename of the purchaser is reported to be three to

four months. In some cases where disputes arise,the transfer process takes more than six months.Such delays affect adversely the volume of trans-actions, float of shares, and the costs of trading.

Several suggestions have been put forward tosimplify and minimize the time lag. Some of theradical suggestions are to do away with the system

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of transfer forms and share certificates. Instead, apassbook system is suggested whereby the owner-ship of shares is indicated by suitable entries.

Section 108 of the Companies Act stipulatesthat transfer of shares from seller to purchaser isnot valid unless it is done through a dated transferform signed by the seller and the purchaser and

authenticated by witnesses. Under this system, theduly completed transfer form together with theshare certificates have to be lodged with the com-pany. The board of directors of the company has toformally approve the transfer of share certificatesin the name of the purchaser. The whole procedureis quite outdated. There are too many movementsof transfer forms and share certificates back andforth.

One suggestion is in favour of doing awaywith the dated transfer form so that difficultiesarising out of the closure of the members' register

and consequent invalidation of the transfer deedcould be avoided.2

An organization could be set up which couldhold custody of all share certificates on behalf ofinvestors and carry out the transfer of shares fromseller to purchaser based on the advice of sellerand duly approved by the concerned company'sboard of directors. Under this arrangement advicescould be issued in the form of cheques in favour ofthe purchaser and the purchaser in turn submitsthe advice to the corporation which would seekapproval of the company. This arrangement notonly avoids unnecessary movement of documentsbut also minimizes the time lag between the trans-fer of shares from seller to buyer. This could have asalutary effect of increasing the floating stock ofshares in the, market. Under the present system alarge number of shares which are under transfer ineffect get immobilized. The floating stock in themarket is considerably depleted. Since manage-ment holdings and institutional holdings of sharesare not available for sale except in large quantums,any reduction in the floating stock provides an op-portunity for the speculators to manipulate marketprices as they are sure that large deliveries wouldnot be forthcoming in the intervening period onaccount of limited floating stock.

All-India financial institutions have taken afirst step in this direction by indicating their de-sire to set up a Stock Holding Corporation of India.This body is to provide post-trade service facilitiesfor the institutions. Government has also indicatedits intention to permit private sector bodies to beset up on similar lines to obviate the difficultiesinvolved in the transfer of shares from sellers topurchasers.

Conclusion

Reforms that need urgent attention have beenpointed out. They have to be carried out expediti-ously in view of the galloping speed at which thecapital market has been growing. Failure to do somay render the capital market unhealthy and in-capable of sustained growth. We would be missingan opportunity of ensuring sound growth of thecapital market and the economy.

2The argument against such arrangement is that such a system

would encourage benami transactions as the documents couldmove from buyer to buyer as bearer bonds. But it must be statedthat even under the present system of dated transfer deeds

benami transactions can take place if shares are registered infictitious names.

Vol. 12, No.3, July-September 1987 43

Can the Stock Exchanges Support the Envisaged Capital Growth?

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