At the beginning of the 1990s, the Indian stock market was plagued with a host of problems: lack of a statutory regulator, weak governance of exchanges, practically non-existent risk management systems, dependence on paper-intensive manual systems, absence of a true national market, lack of derivative markets, and virtual absence of institutional investors and intermediaries.
The stock exchanges blocked any attempt at reform, and the GS Patel Committee articulated the view of many when it wrote: “With the opening of our economy and compulsion of circumstances resulting therefrom, our stock exchanges owe a duty to themselves and to the nation to adjust and adapt themselves to the changing times, try their best to remove, at the earliest, their infirmities and imperfections which have become a dominant theme of national and international concern, subordinate their interests to that of the investors and the economy and extend their full cooperation to the regulatory authorities, instead of confronting them on even minor matters and giving the impression that they try to obstruct and delay the reform process in the stock exchanges.”
Carry forward, stock market way
The badla or carry forward system became the central issue in this conflict as it was the most visible symptom of all that was wrong with the markets. It was a leveraged product (with some similarity to single stock futures with a two-week maturity), and in the absence of adequate margins or risk management, it often produced undesirable outcomes.
However, badla was only the visible tip of the iceberg, and true progress would not be possible without shattering the entire iceberg. For example, with all its faults, badla was the only mechanism for hedging, for short selling and for leverage in a market without derivatives. Similarly, badla provided a work around for the worst inefficiencies of the paper-based settlement system. In an era when it took the buyers several weeks, if not months, to get the share certificate transferred to their names, badla allowed them to sell these shares before receiving those certificates. The critical issue of optimal sequencing was whether one should: create a futures and options market; introduce paperless settlement (dematerialisation); and then abolish badla.
Optimal sequencing of reforms was largely ignored on both sides of the debate. The old guard in the stock broker community did not want any reform thinking that if they stalled long enough, the reform momentum might dissipate, and substantive changes could be avoided. For zealous reformers on the other hand, badla, being the visible tip of the iceberg, was the obvious target to attack. It was thought that abolition of badla would break the entrenched opposition, and make subsequent reforms possible.
When SEBI banned badla
It was in this context that in December 1993, the Securities and Exchange Board of India (SEBI) banned badla (the ban took full effect in March 1994). The result was a sharp decline in liquidity with adverse impacts on market efficiency and volatility. A year later, SEBI, under a new Chairman, appointed the GS Patel Committee to review the matter. Based on the recommendations of this Committee, badla trading was revived in a modified form in January 1996. The reformed badla imposed the requirement for automated software to compute margins (for effective risk containment) and electronic trading systems (for greater transparency). Thus within two years of its death, badla came back to life like a phoenix, and it would take another five years to kill it again.
During these five years, the Indian stock market was changed beyond recognition. The nationwide electronic market created by the National Stock Exchange (NSE) came to dominate the market. Paper share certificates were replaced by electronic book entries in the newly created depositories. Futures and options started trading on the stock market index, followed by options on individual stocks. The bursting of the dotcom bubble led to the failure and demise of the the Calcutta Stock Exchange. In the wake of this, the 15-day settlement period was replaced by rolling settlement where all trades settled three days later.
Along with the introduction of rolling settlement in July 2001, modified badla was also banned, but the phoenix was reborn as single-stock futures four months later and went on to become the largest equity derivative market in India. It was only in mid-2020 that single-stock options overtook single-stock futures, and we could say that badla was finally buried.
The modernisation of the stock market in the 1990s was one of the great success stories of the economic reforms. The stock market became a source of risk capital for businesses and an attractive venue for investors. The abolition of badla was only one tiny piece of this momentous institutional and technological transformation. Looking back a generation later, the badla controversy looks like much ado about nothing.
The author is Professor at the Indian Institute of Management Ahmedabad