SEBI slams down on F&O manipulation-II: NSE and BSE as the first line of regulation stand exposed
Some operator-driven stocks in the F&O segment have crashed in response to SEBI’s decision to change the norms. Why had NSE added a bunch of dubious stocks to the F&O list that was open to manipulation and why is BSE silent about manipulation in hundreds of obscure companies? The answer is simple: Bourses are out and out profit-making entities and cannot be relied upon to act as the first line of regulators
The day after the market regulator Securities and Exchange Board of India (SEBI) changed the criteria for choosing stocks that would be eligible for the Futures & Options (F&O) segment, some of the obviously shady companies fell sharply. If this was not enough of a severe indictment of the quality stocks that trades in the NSE’s F&O segment, today some the other dubious F&O stocks crashed. Apparently, large positions in these shady scrips belong to the promoters of these companies themselves and brokers close to them and were pledged with financiers to raise money. SEBI’s moves and recent the market weakness ensured that there were pressures on the financiers who had funded these positions. They have resorted to firesale of pledged shares to recover their cash. Situations like these were inevitable ever since NSE expanded its F&O portfolio with a long list of companies whose business is puffed up and the stocks are run and down by operators and promoters.
It has all been an open secret. Indeed, more than two years ago, one of our Chennai-based readers, Shaym Shekhar, went to the extent of writing a detailed letter to the National Stock Exchange (NSE) which Moneylife forwarded to the Exchange, SEBI chairman and the finance ministry's capital market division. The points raised by him and the flimsy responses of NSE and its joint venture with CRISIL, India Index Services & Products (IISL) were as follows:
1. The Nifty includes a holding company (Reliance Industries) and a subsidiary company (Reliance Petroleum) in which it has controlling interest. What is the logic behind this duplicative representation? The same question holds for Reliance Infrastructure and Reliance Power.
NSE’s response: The top 50 companies listed on the NSE that satisfy the criteria related to market capitalisation, liquidity (impact cost), floating stock and minimum listing criteria are considered for inclusion in the index.
2. When an analyst computes the PEs of an index, earnings of an index’s constituent companies are material to its EPS. Why include Reliance Power and Reliance Petroleum in the Nifty long before they have started commercial production? What is the rationale for giving a company index representation when it has no earnings history?
IISL’s response: Currently, companies are reviewed based on market capitalisation, liquidity (impact cost), floating stock and minimum listing criteria. Profitability is not a current criterion. In case, one was to introduce profitability as a criterion, all companies with long gestation periods (infrastructure, telecom, etc) would not be eligible for inclusion in the index. In such a case, the resultant index would not be truly representative of the underlying market.
3. A company’s price discovery starts when it makes an IPO. The price discovery process would be effective only after a reasonable period. Why did we include a company like DLF within months of listing? DLF’s dominant revenues were from inter se transactions with its own subsidiary or related parties. Had NSE assessed corporate governance at DLF before DLF was brought into its index? How do you justify including DLF in the Nifty with not even a few quarterly results to judge performance or corporate governance? The serious litigation that DLF had with its minority shareholders just months before the IPO and the covertly managed earlier de-listing process reflected abject lack of corporate governance. DLF made hurried out-of-court settlements with the litigant shareholders to raise capital and get re-listed. Were these factors duly considered before giving DLF a presence in the index?
IISL’s response: A company which comes out with an IPO will be eligible for inclusion in the index if it fulfils the normal eligibility criteria like impact cost, market capitalisation and floating stock for a three-month period. This three-month period is reckoned from a cut-off date which is at the end of every quarter. So, typically, an IPO stock will become eligible for inclusion, if it meets all other criteria invariably for a period exceeding three months. Factors related to litigation, etc, are subjective in nature and are not considered while reviewing the index constituents.
4. Reliance Power crashed within minutes on the listing day. Institutional shareholders dumped the stock that day implying that they had been duped on valuation. Yet, NSE included it in the Nifty within months of listing. Implicitly, you made every Nifty index fund buy the stock, which they had chosen to dump months ago. Were you not interfering with the price discovery and forcing investors to buy an out-of-favour stock by giving it index representation?
IISL’s response: The stock from the replacement pool with the highest market capitalisation that satisfies other criteria (mentioned above) are considered or inclusion. Factors related to valuation (correlation between issue price and market price post-listing) are not considered for inclusion in the index. Market capitalisation (and not issue price-related data) is internationally considered as one of the eligibility criteria for inclusion of constituents in the index.
5. NSE included several scrips in the F&O segment like Educomp Systems, Lanco Infra, HDIL, Sobha Developers, AIA and Rajesh Exports, to name a few. These scrips were thinly traded even in the cash segment before they were brought into the F&O. The valuations went up several-fold after that. What is your method of evaluating a company before you include it in F&O? What is your response to my accusation that the futures segment was used to rig the stock prices in several mid-cap companies in 2007-08?
NSE’s response: SEBI prescribes the following criteria for selection of securities for derivatives contracts:
A. The stock should be out of the top 500 in terms of market capitalisation and average daily traded value in the previous six months on a rolling basis.
B. The stock’s median quarter sigma order size over the last six months shall be at least Rs1 lakh. The MWPL (market-wide position limits) of the stock should be at least Rs50 crore. For the above purpose, the MWPL shall be equal to 20% of the non-promoter holding in the stock.
However, as required by SEBI, an application is made for introduction of derivatives contracts using the following more stringent criteria. The stock should be out of the top 500 in terms of market capitalisation and average daily traded value in the previous six months on a rolling basis; the stock’s median quarter sigma order size over the last six months shall be at least Rs5 lakh; the MWPL of the stock should be at least Rs100 crore. Securities, which do not meet the following criteria for consecutive three months, are excluded from derivative list: The stock's median quarter sigma order size is at least Rs1 lakh, while the MWPL of the stock is at least Rs45 crore.
A few years ago, NSE decided to dump as many as 50 scrips from the F&O list. We wrote at that time, “NSE does not say whether it was a mistake to have included them.” It also decided to modify the criteria for selecting the stocks for F&O. The NSE formula was a mumbo-jumbo which allowed it to include poor-quality stocks and those with minimal volumes in F&O for creating higher trading turnover.
As is clear, in practice, all this while, it was NSE which has been deciding which stocks to include in the list. What was the idea? More and more scrips in F&O and that too the scrips that market operators want, meant higher traded volumes which in turn meant higher revenues for the NSE. NSE, remember is a for-profit entity, where a large number of top institutional investors have invested their money. Since cash market volumes are flagging, the NSE management had to create volumes in the speculative segment to create revenue and profit growth like any other business. Everyone except the regulator could see it.
This was NSE’s game but don’t think that BSE is blameless. Thousands of poor quality stocks are listed in the BSE. They are often targets of massive manipulation as we have been writing for the past few years in Moneylife magazine. Stocks of companies with revenues or profits which have gone up multi-fold but BSE and SEBI pretend not to notice it. We intend to put out a longish research piece on this in the magazine soon.
It is intriguing that SEBI has stepped in to cut the F&O list by bringing in stricter criteria. What investors (the few who are left in the market) would like to know is, what will SEBI do about the fundamental issue here? The bourses are for-profit entities where top managers are paid globally competitive compensation. If they are left alone, they can stoop to any level to push their key sources of revenues—traded volumes and listing fees. SEBI’s regulatory action on F&O is laudable but skirts this fundamental rot within the system.