A Sensex crash of 500 points in a matter of a few minutes, shows how hollow the Indian market is, as Moneylife has been pointing out for years now

Sometime just before 10 in the morning on Monday 20th June, on a simple rumour that India would restart talks on a tax treaty with tax haven Mauritius, stocks went on a freefall. At 10:00AM, the Sensex was at 17,737, a modest decline of 134 points from the close on Friday, 17th June (17,870). In the next three minutes, the index had plunged by another huge 170 points. Buying came in and the Sensex was up 80 points in the next minute or two and then suddenly a wave of fresh selling sent the Sensex crashing by 330 points in just 3 minutes of trading. The Sensex was down by 500 points from yesterday's close, literally in minutes-when a movement of 100 points has been hard to come by for days together.

The same has been the story during the rallies as well. On 13th April, the Sensex rallied by 626 points for no reason at all, within an overall trend of weakening stock prices, thanks to massive headwinds that the market and the economy are facing. From the next day again, the market started drooping.

What makes the market so bipolar? Well, it is indeed in the nature of the stock market to be volatile-sometimes without any reason. But there is another big reason for the Indian market to behave in such an extreme manner. It is the hollowness of the Indian market, which has become a play for options traders and institutional investors.

Moneylife has been pointing out that the Indian market is narrow, shallow, illiquid and concentrated in the hands of a few individuals located in a few centres-nearly 20 years after India embarked on financial liberalisation. We expected a spread of equity cult, but only a few thousand investors possibly trade on the cash market. The cash market volumes on the NSE (National Stock Exchange) and the BSE (Bombay Stock Exchange) have been dwindling rapidly, replaced by volumes in stock and index options.

The NSE records an average daily turnover of over Rs10,000 crore in the cash segment and over Rs80,000 crore in the futures and options (derivatives) segment, while the Bombay Stock Exchange (BSE) records a daily turnover of over Rs3,000 crore in the cash segment. While these numbers are much higher than what they were a decade ago, they are misleading. In the derivatives segment of the NSE, only a few lakh clients trade, of which 90% of trading is done by about 20,000. Indeed, according to the data presented by the minister of state for finance Namo Narain Meena, in response to a question in Parliament last year, only 2,188 investors accounted for 80% of derivatives turnover in the three-month period from April 2010 to June 2010. Just 537 investors accounted for 70% of trading; 223 investors accounted for 60% of trading—of which over half were proprietary brokerage firms. And a massive 50% of trading in NSE's derivatives trading turnover, the main pillar of the Indian stock market system, came from just 106 investors of which 58 were proprietary traders!

According to the D Swarup Committee report on investor awareness and protection, India has 80 lakh investors (who invest in debt and equity markets, either directly or through mutual funds and market-linked insurance plans). This official figure also represents a sharp decline from the two crore (20 million) investor population, claimed in investor surveys commissioned by SEBI (the Securities and Exchange Board of India) in the 1990s.

The fact is that the Indian market is extremely hollow—which does not seem obvious on a normal day. It is only when there is an external shock and prices decline precipitously that one realises that there are very few natural buyers or arbitrageurs and hedgers. Conversely, don't be surprised if one of these days we see an eye-popping 600-point rally. On that day, there would few natural sellers-or arbitrageurs and hedgers.

The biggest problem with the Indian market—and this is something
policymakers don't recognise—is that there are very few large long-term players.

Domestic institutions have not grown to stature that they can play shock absorbers to a sudden cascading decline. For a variety of reasons, neither mutual funds nor insurance companies have grown to a level that they can step in during a steep decline or sell when prices suddenly rally sharply. Policymakers hoped in the early 1990s that mutual funds would channel retail savings and emerge as large long-term players. In the early 2000s, it was hoped that the life insurance companies would come to play that role too. But both these businesses were allowed a free run with the kind of business practices which did not exactly serve the interests of retail investors. A regulatory backlash ensued, which first ensured that mutual funds were hobbled and then the insurance companies were hit hard. Suddenly, it seems that there are too many players with shaky business models in a floundering sector. We cannot see this changing soon and so we will remain in the grip of wild swings caused by a few large trades. Get used to many flash crashes and roaring rallies.