How Sebi's License Raj Is Spreading Chaos In Stock Markets

License Raj was a system between the 1950s and 1980s when incumbent governments in India maintained a tight leash over businesses through excessive and arduous regulations. Businessmen were burdened with 'severe' licensing norms and a barrage of conditions to fulfill. Tough conditions usually coerced businesses into violating some or other rule, thereby attracting red tape. Market regulator SEBI under incumbent chief Madhabi Puri Buch is presiding over an exceedingly tight regime that closely resembles the 'Licence Raj' - a key catalyst for the recent market crash.

Sebi's 'License Raj' like policy was at full display when a recent circular restricted Mutual Funds (MFs), India's largest category of investors, from buying or selling aggressively in the stock markets. For the past few years, India's MFs had emerged as a counterforce to foreign portfolio investor (FPI) flows and stood as a bulwark to support the markets when FPIs were seen exiting in droves. That bulwark was fractured by a SEBI circular, which has heightened the fear of red tape in the MF industry. Sebi's new dictat simply seeks a rigid conformity to SOP (Standard Operating Procedures), like the bureaucratic tightrope, which has the potential to hinder action or decision in buying and selling of stocks. In a nutshell, the fear psychosis created by a recent circular is dissuading MFs from buying aggressively even in falling markets.

In August, Sebi announced that MFs will be covered under the ambit of Prohibition of Insider Trading norms - not that they were not covered earlier but this time the regulator just got more draconian with rules that dictat how the MFs will trade. Sebi told MF self-regulatory body Association of Mutual Funds of India (AMFI) to prescribe in two weeks, detailed norms for 'Standard Practice on Institutional Mechanisms for Identification and Deterrence of Market Abuse," which would be effective 2 November.

Already, Sebi's earlier move on margin-related rules had vitiated the market sentiment and when AMFI prescribed SOP came into effect, it spread further chaos leading to benchmark indices and stock falling daily without any cushion of buying support from MFs. This, is even when other global markets are largely stable and the U.S. markets are touching new all-time high levels. In terms of price to earnings, Nifty and Sensex PE are lower than the US and many other markets.

What Did Sebi & AMFI Do To Make MFs Nervous?
As per prescribed SOP, to detect suspicious trading activity, MFs must generate three-tier alerts weekly and report them. The first tier is based on participation volume and volume-weighted average price (VWAP) for large, mid-cap and small-cap stocks. The second tier is considered price movements during deal execution, block trades and scrip volumes traded within an hour before the AMC’s trade. All suspicious alerts will be investigated further and the fund manager or the dealers will be sent on leave till they come clean - fear of red tape.

Consider this: VWAP is a technical indicator that determines the average price of a security based on price and trading volume. VWAP can be for any duration or for the entire day. Since the duration of VWAP is not specified in the recent SOP, traders consider VWAP based on trading activity during the entire day.

On any given day, a large MF trader may punch 30 to 100 buy/sell orders. But now, if their orders are too far away from the VWAP, then the MF dealer fears getting caught in the web of front running or red tape and hence they would consider buying and selling mainly in the last 60 minutes or 30 minutes of the trading session, just to stay closer to the VWAP of the day.

In case, if any trader had punched trades that were pending, he/she would fear frequently changing prices to buy at lower levels in falling markets, since that would attract the risk of moving away from the VWAP. This makes the SOP and Sebi's circular too draconian - License Raj.

Why? As per the prescribed SOP, a matrix of VWAP deviation (premium/discount) and market participation can generate "Alerts" at trade TRADE LEVEL, which can be considered potentially for "Suspicious Activity." Practically, since an average trader at domestic AMC does 30 to 100 trades a day, market considerations can create temporary mismatches with the huge sell orders of FPIs, especially during the first 90 minutes and the last 90 minutes, when maximum volume and trades are matched.

Illustration: If FPIs decide to sell a large quantity of any stock in the morning, which is 70 per cent of the volumes in a counter and even if an Indian MF wants to buy the same, they have to compulsorily buy throughout the day and at limited percentage of volumes, so that they don't breach the percentage volumes or VWAP benchmark or risk attract surveillance of suspicious activity.

Already, the universe for the mutual funds to invest was limited by SEBI in 2019, when it re-classified stocks into large, mid and small-cap stocks. MFs are not allowed to invest in stocks outside this list. The recent circular adds further restrictions on MFs to operate thereby diluting the promise of ease of doing business and generating returns for investors. In effect, this creates an unlevel playing field for the MFs, which would push investors away from them.

Such action may be against market integrity since it violates the price discovery mechanism. The MF industry players secretly say they feel helpless even as SIPs worth over Rs 25000 crore pour in each month. Soon when investors realised their investments were not generating enough returns, the would divert the money to other avenues and ditch the MFs.

Tight Regime On Margin Funding
Apart from the above-mentioned draconian rules, a regulatory circular in October expelled 1010 stocks, mostly in the small and mid-cap category, from the list of 'collaterals' acceptable as margin pledges for availing Margin Trading Facility (MTF) from clearing corporations.

This was another sudden shock for the stock markets. Till October, clearing corporations of exchanges were accepting 1730 stocks as pledges against margin for trading. But from November, the list was shortened to just around 700 stocks. Also, banks and NBFCs (non-banking finance companies) cannot accept stocks (not in the list) for giving loans or may give less money on higher pledges.

When the circular was introduced, markets were near their peak and the MTF book of stockbrokers stood at around Rs 73,500 crore. But the new rule in November led to panic selling as collateral positions were impacted, since most investors could not suddenly bring additional margin to fulfil the shortfall created by 1010 stocks turning useless for margin pledging or unable to generate leverage. The selling in these stocks also led to further market-wide collateral damage causing a rout in the small and mid-cap segment. In addition, the exchanges periodically put stocks under their graded surveillance measures and curb their circuit filters, which leads to selling in them.

In a nutshell, since all the events came in close succession in November, the overall game of demand and supply in small and mid-cap stocks was hugely disrupted by regulatory measures more than the fundamentals.

Election And Stock Markets
Any sharp downturn in stock markets closer to the elections can severely impact voter sentiments and turn them against the incumbent government.

In March just when the dates for the national election were announced, SEBI chief Buch made media statements with regard to "froth" in small and mid-cap stocks, "irrational exuberance, valuation parameters not supported by fundamentals" etc. Such statements from a regulator around election can vitiate the investment scenario as foreign investors turn cautious and also create a sense of despondency among domestic retail investors, who rue when the markets crash and small and mid-cap stocks see deeper pain.

This time too, when Sebi's MF-related draconian rule and the dictat on margin pledge came into effect, elections were around the corner in Maharashtra, the state with the largest stock market investor population in the country. Should we read more into the situation created by SEBI? It is a story I'll reserve for later.