I took over as chairman of Securities and Exchange Board of India (Sebi) on 18 February 2008. The market had an upward run from 2005 onwards. The indexes had almost tripled. However, things started looking a little worrisome from the end of 2007. There was great uncertainty in the financial markets all over Europe and the US. Most people knew by then that things had gone wrong. Very few, perhaps no one, knew the way the problem would surface and what damage it would leave in its trail. Regulators were a worried lot. Some hoped that the storm would blow over without much damage. Some knew that the storm and the consequent damage was inevitable but hoped that somehow their jurisdictions would remain relatively unaffected.
We at Sebi were no different from the rest of the world. We did not know what events would unfold in the near future and derail the markets. We could do nothing to influence the events. The events were unfolding in the US and Europe. In such times, it is best to start examining the possible sources of risk and the robustness of the risk containment measures.
The most important risk the stock exchanges need to guard against is ‘settlement risk’. It is necessary but not enough for an exchange to be a platform where investors can trade in a fair manner. A trade is of no value if there is no reasonable certainty that it will be settled. In 1992, when Sebi was formed, the settlement mechanism in BSE and the other exchanges were broken. Brokers would trade for 15 days and settle the cumulated trades 15 days after that. In the meantime, a further trading for 15 days would have accumulated. As if this was not enough, frequently the settlement date would be further postponed! Broker defaults and investor losses were a regular feature every few years. The presence of paper share certificates and floor trading did not help matters.
Through years of painstaking efforts, Sebi had been able to bring order in the market. The exchanges had automated trading and depositories were in place. The exchanges had been pushed to create clearing corporations with sizeable guarantee funds at their disposal to ensure a smooth settlement even if a few brokers defaulted. The settlement cycles—elapsed time between a trade and its settlement—had been drastically reduced. Trades of a day would be settled in two working days. This left minimum risk in the market by way of open positions (traded but not settled). This risk was further sought to be contained through enforcement of margins on open positions. The proof of the pudding is in the eating. By 2008, the settlement process had worked without a hitch for almost a decade.
On 16 March 2008, JPMorgan Chase acquired Bear Stearns. This was no normal acquisition. The US regulators played an active role in this to avoid a default by Bear Stearns and the consequent chaos. Extraordinary times require extraordinary precaution. While the settlement process in the exchanges had worked smoothly for years, we at Sebi wanted to examine whether there were still some gaps that needed attention. We found that while the margin collection rule applied to non-institutional investors, institutional investors were exempt from paying margins. The assumption was that institutions would not fail to honour their settlement obligations. After some consultation we decided that this was not acceptable.
On 19 March, Sebi issued instructions that margin requirements would apply to institutional investors as well. It was to be applicable in two stages and would come into full force in June.
Hectic activity followed from the foreign institutional investors. Some said that we were trying to solve a problem that did not exist, some said that the market had started falling and this step was ill advised at such a time. In any case there was no evidence, they said, of an institution failing to fulfil its obligations in the market.
We even got a call from a foreign regulator early June suggesting to us that we reconsider our position. It was suggested that if we did not, funds may withdraw from the Indian market. Given the state of the market, it would result in a precipitous fall, it was argued. We were firm that we needed to maintain the integrity of our settlement process and protect investors in our market. A ‘fall in the market’ or ‘withdrawal by foreign investors’ were just diversionary threats to persuade us to change our position. We decided to remain firm, little realizing that a real life example was round the corner.
September 15, 2008 was a Monday. Lehman had declared bankruptcy over the weekend in the US. It was crucial for us to know the status of the Lehman entities which had traded in the Indian market. Were they in a position to legally fulfil their contracted obligations? Lehman India, when contacted by exchanges, said they had no idea. Lehman India could not verify anything with their US headquarters since it was the middle of the night there! This was an untenable situation. Sebi asked both the exchanges to close all Lehman positions and recover the losses, if any, from the margin money (that by then was being collected from institutional investors as well). In less than half an hour, the exchanges reported that Lehman positions had been reduced to zero and they had more than enough money to cover the losses. They in fact returned some excess margin money to Lehman. The settlement process in the Indian exchanges was now insulated from any fallout of Lehman bankruptcy.
Since that day, no one has argued that institutions need not pay margins since their trades do not pose a settlement risk. The Lehman bankruptcy triggered an extensive loss of confidence in the financial markets and the financial crisis followed. Its effect was felt in India as well. That discussion is for another day and another occasion.