THE ECONOMIC TIMES

EDITORIAL

The significant date of May 17, 2004 and its neighbours stand out for creating history. May 17 saw a meltdown of the Nifty stock index by a good 13% from the opening to the closing.

The figure was higher if you take the intra-day high and low. The precipitous fall resulted in the first market-wide halt in the market . The Nifty index and sensex fell around 15% from May 1 to June 1.

It was also a period of extreme pessimism amongst investors , both small and institutional. The event which gave rise to the dramatic effects in the capital markets was the political turnout, which middle class India and foreign investors goaded by off the mark exit pollsters had not expected. A Congress victory with Left support was not something even the Congress had thought possible, leave alone investors.

The new government was quite livid with ‘operators’, a bugbear used for presuming there was a cartel of people who had a vested interest in manipulating the market and who caused the huge fall in values at great profit to themselves.

This is a favourite theory of people who believe in the conspiracy theory of a cartel working to discredit the new government. So was this a cartel? Is the conspiracy theory valid? Given the fact that four mysterious entities have been issued summons to explain why they sold heavily on the fateful date of May 17, one would believe the conspiracy theorists abound in the finance ministry. It being no secret that Sebi was goaded into initiating an investigation.

In the financial world, particularly the academic world of finance, one often hears of the phrase ‘efficient market’ or the ‘efficient capital market hypothesis’ (ECMH). The theory argues that markets are efficient and that information efficiently translates into the price. Prices already incorporate past events and they also incorporate expectations of the future, according to the theory.

In analysing the 17th and the dates following it, it is important to understand that if it is presumed that markets are efficient, then it means that the event risk was translated into a steep decline in price.

In other words, the pessimism was stark and the starkness translated into a price collapse. If one presumes the markets are efficient, then the conspiracy theory falls. You cannot scold a child not to be scared of the dark even if there is nothing dangerous. If you try to punish a child for the same, then it is perverse.

Even assuming that the markets are not efficient and prone to manipulation, then one must understand what it means to manipulate the markets – before one draws a final judgement that there was manipulation.

This is where an understanding of the legal aspect of manipulation becomes important. Manipulation is the intentional interference with the free forces of demand and supply. Put in other words, excess supply or excess demand, though they affect prices, do not create manipulation. If one looks at the law on manipulation as has developed in India, we have some sophisticated understanding by the SAT in Shankar Sharma’s case.

Unfortunately, such sophistication has not been adopted by either the market or by the regulator.

Manipulation turns completely on the intent of the person alleged to have manipulated. If one reads the rule against manipulation under Sebi’s regulations, two words keep getting repeated throughout the regulation.

One is ‘intent’ and the other is ‘device’ and its synonyms like ‘misleading’, ‘artificially’ etc. In the US, manipulation springs out of the anti-fraud rule – there being no specific prohibition against manipulation. However, US courts have consistently held for the last four decades that manipulation must necessarily involve intent to deceive. Mere knowledge that price would fall is not sufficient to constitute manipulation.

I wrote a piece analysing the 1987 crash, after 10 years of the crash, with Brandon Becker, former director of the division of market regulations of the SEC, who was with the SEC when the US markets fell by 23% in one day. And unlike our election concerns, there was no trigger event which precipitated such a large fall.

Despite a lack of a trigger, the regulator and a presidential task force set down to analysing the problems which could have precipitated the fall. There was no witch-hunt against people as we in India are getting used to.

By contrast, a systematic analysis was done looking at issues such as the role of margins, circuit breakers, capital requirements, clearance and settlement, automation and program trading.

By contrast, anyone who involuntarily reduces prices in India, whether genuinely believing a problem is around the horizon or not, is a villain and must be sent to jail. In hindsight, such reasons may not seem correct and the reasons could be plain wrong, but that does not make the decision criminal.

Such action reflects poorly on our political process which seems to target people who were pessimistic instead of crooked. And the reason the pessimism is sought to be penalised is because it hurt the image of the newly formed government. If at all, there was a problem, the same investors have taken the market to historic highs now. Why aren’t people being investigated in an upwardly mobile market?

The raison d’etre of the stock market is the existence of two people with differing views. If one person didn’t think Reliance was overpriced and the other that it was underpriced, there would be no trade in Reliance.

On the happening of a significant event as happened on the 17th, it is impossible to blame ‘market operators’ for the collapse of the market. Unnecessary victimisation of those who sold on that day must stop.

The finance ministry should give the entire investigation a quite burial. It should instead rest on the laurels the same market has awarded them with repeated new highs of the sensex. Anything else would be a travesty of law and justice.

The author is advocate with P. H. Parekh & Co and currently visiting faculty IIM, Ahmedabad.