Can the Stock Exchanges Support

the Envisaged Capital Growth?

R H Patil

It is, perhaps, for the first time since Independence

that the health of the stock markets has received
attention of the Prime Minister. In his budget
speech, the Prime Minister stated:

The organization and management of the

stock exchanges suffer from major
weaknesses and malpractices. Reforms
have to be brought about urgently, if they
have to support the envisaged growth in
listed capital from about Rs 6,000 crore in
1985 to about Rs 90,000 crore by the turn of
the century, argues Dr Patil.
Dr Patil has identified the reforms that
have to be made on a priority basis besides
providing, for comparative purposes, brief
outlines on the functioning of the stock
exchanges in the US, UK, and Switzerland.
R H Pati] is Genera] Manager (Research
and Planning], Industrial Development
Bank of India, Bombay. His recent contribution to Vikalpa was on "Raising Funds
from the Capital Market: Challenges for the
Private Sector," April-June 1986.

For a healthy growth of capital markets, investors' rights

must be fully protected. Trading malpractices must be prevented. Government have decided to set up a separate
Board for the regulation and orderly functioning of Stock
Exchanges and the securities industry.

This is certainly one of the most important

policy statements of the government on the reform
of stock exchanges in the country.
The subject of stock exchange reforms has
been receiving wide attention for quite some time
in the press, public discussions, and academic institutions. A major stimulus to these discussions
was provided by the comprehensive report of the
High Powered Committee on Stock Exchange Reforms headed by G S Patel, ex-chairman, Unit
Trust of India. Another equally important reason
is that stock markets have become an important
channel of investment for the common man in the
last three to four years. An unprecedented number
of investors has locked up its savings in shares and
debentures; any noticeable fall in prices erodes
market value of its investments and the confidence
of an average investor is shaken. The sudden
change in market sentiments in February 1986
when the two year up-trend in stock prices suddenly halted has resulted in the realization that all
is not well with the functioning of stock markets.
An apprehension that prices would continue to
fall if institutions do not extend their support to
markets has affected the perceptions of millions of
investors, many of whom entered the stock markets only recently.
It is in the interest of investors as well as the
corporate units which raise funds on stock markets
that the market functions in an orderly fashion.
Through their prices, stock exchanges should reflect
the state of the health of the economy in general
and of the corporations whose securities are traded.

Growth and Development of

Stock Exchanges
Although India is one of the less developed
countries, its stock exchanges are more than 100
years old. In 1850, the Companies Act which introduced the concept of limited liability was enacted,
and the era of joint stock enterprise was ushered
into the country. The first organized stock

exchange was established in 1875 in Bombay. The

history of stock exchanges in India is characterized
by major upheavals till 1951 when planned
development began.
At present there are 14 stock exchanges and
there are plans to open many more stock exchanges in almost all important cities of the
country. The pattern of development of stock
exchanges is shown in Table 1. From 538 stocks

Table 1: Development Pattern of Stock Exchanges

valued at Rs 645 crore in 1961, the listing on the

Bombay Stock Exchange has increased to 2610
stocks valued at Rs 20,378 crore at the end of 1985.
Over one-third of the public limited companies are now listed on the stock exchanges. The
listed companies account for about 90 per cent of
the total paid-up capital of over 14,000 public
limited companies in the private corporate sector.
Since stock exchange as an institution enables
the corporate sector to mobilize funds from investors, its growth is linked directly to the growth
of the corporate sector. A wide network of financial institutions, both at the national and state
levels, has grown to assist and promote industrial
units.

Composition of Listed Capital

The composition of listed capital on the stock exchanges has changed significantly in this decade.
The equity market dominated until the early
1980s. During the mid-80s the rate of growth of
debenture capital was much higher. Both equity
and debenture markets have become equally important today. The structural and market-wise pattern of listed stock as of December 31, 1985, is
given in Table 2.
The secondary markets of the country have
witnessed a major1 spurt during the post-Independence period. The number of companies and
scrips listed have increased to four times the postIndependence level. Total reported annual turnover

on all the stock exchanges is now around Rs 18,000

crore, of which the Bombay Stock Exchange accounts for Rs 12,000 crore.

Box 1

If the stock exchanges continue to grow at the

same rate as they have done in the last five years or
so, the listed paid-up capital on the stock exchanges would more than double to Rs 16,240
crore by 1990. By the end of the century they
would grow more than nine-fold to Rs 90,000
crore. Impressive as they are, the figures indicate
the importance that stock exchanges would have
in the national economy. Can the stock exchanges
support such growth? .

The United States economy has the largest gross

national product in the world. Yet, it does not have
as many stock exchanges as India currently has. In
1966, the US had 14 registered national securities
exchanges. Only nine are reported to be active today. Excellent communication facilities and computerized linkages among the different securities
markets have enabled the US to manage with a
small number of stock exchanges. Of its nine stock
exchanges, the New York Stock Exchange (NYSE)
is dominant, accounting for over 60 per cent of all
transactions.

Prerequisites of Growth of
Stock Exchanges
There are three sets of major factors that would
determine the future growth of stock exchanges.
The national economy and the corporate sector
have to grow at a rapid rate. Government policies
would have to encourage people to invest in securities. Finally, the organization and management
of stock exchanges should be able to support the
envisaged growth. Let us examine whether these
conditions are likely to be met.
Since 1980, the economy has grown at a rate
higher than the so-called Hindu rate of growth of
3.5 per cent. All indicators suggest that the economy has moved on to a higher growth path and
there is promise of a growth rate higher than that
projected in the Seventh Plan.
A number of policy changes, including the
various liberalizations introduced by the government, have provided an incentive to invest in securities. Thus, prima facie, there is a strong case to
assume that the first two prerequisites will be
fulfilled.
Will the organization and management of
stock exchanges be able to support the envisaged
growth in listed capital? Will stock exchanges
facilitate the structural changes that would accompany the rapid growth of the organized capital
market?

Organization of Stock Exchanges

How are stock exchanges organized in free market
economies? There is no uniform pattern. The organizational structures and operating rules of
34

The United States Securities Exchange System

In addition to organized stock exchanges, the

US has an Over-the-Counter (OTC) market which
is an electronic market place in which prices of
traded securities are updated almost on a minute
to minute basis and flashed on computer video
screens. The OTC market is not "organized" in the
sense that it does not have a "floor" on which competing buyers and sellers assemble at predetermined hours to participate in an "auction"
type of market. In the OTC market whenever a
broker receives an order for purchase/sale of a security he uses the computer terminal in his office to
get quotations of the market makers who quote
bid/sell prices. The market makers are like
wholesalers keeping a stock of securities all the
time and are willing to purchase/sell such securities at their quoted prices. The brokers settle
their clients' orders by accepting the best bid/offer
price available in the market at that point of time.
New York Stock Exchange
NYSE is governed by a board of 23 directors of
whom 20 are elected by the members of the Exchange. These directors are grouped into two classes, ten representing the public and ten NYSE
members. The public representatives are appointed from a panel of names recommended by a
committee of NYSE members from among heads of
listed companies and representatives of financial
institutions such as investment companies, trust
companies, banks, and insurance companies. The
remaining three members of the Board are the
chairman, the vice-chairman, and chief operating
officer of the Exchange. They do not have personal
fiduciary interest in the trading and can be expected to be as objective in their approach as any
of the ten public representatives. These 13 members without trading interests are primarily responsible for the efficient functioning of NYSE.
NYSE has self-governance powers which it
uses judiciously in choosing distinguished and independent minded persons for its governing board.

Vikalpa

Market Surveillance
Market surveillance of NYSE may be regarded as
one of the best in the world. The total staff of NYSE
is more than 1000, of which well over 150 people
are continuously monitoring the functioning of the
market with their independent computer-linked
video screens. They keep continuous watch on the
price movement of all the scrips and are in close
touch with the specialists operating on the floor of
NYSE. The main job of the specialists is to ensure
that prices of scrips allotted to them by NYSE authorities do not behave in an erratic fashion. This
they do by quoting their own bid and offer prices.
Securities Exchange Commission
The Securities Exchange Commission (SEC) is an
independent, bipartisan, quasi-judicial body established by a statute for the purpose of administering Federal securities laws that seek to protect investors' interests. It plays a major role in the efficient management of stock exchanges. SEC insists
on full disclosure of all pertinent information by
everyone who intends to acquire over 5 per cent of a
company's securities. It controls trading practices
on the stock exchanges and in the OTC market. It is
responsible for establishing the general regulatory
pattern and for promulgating rules and regulations
for their implementation. There are many areas
where the stock exchanges and SEC may independently investigate malpractices. For example, insider trading, market rigging, or market manipulation may be investigated independently by both
NYSE and SEC. The very presence of SEC, with its
watchdog activities, prompts the stock exchange
authorities to remain alert all the time to ensure that
the market operates smoothly.
SEC has a staff of about 2000 composed of law
graduates, accountants, security analysts and examiners, engineers, and other professionals. In the
course of administering the provisions of the Securities Act of 1933 and the Securities Exchanges
Act of 1934, SEC investigates complaints or other
indications of violations of law such as fraud, insider trading, and market rigging or manipulations.
It ensures that brokers and dealers adopt business
practices that conform to the standards prescribed
by law. It is empowered to suspend any member of
the stock exchange.
SEC regulates all mutual funds which have to
be registered with it and prescribes general rules for
investment of their funds. All those in the business
of investment advice and fund management have to
get themselves registered with SEC and have to
abide by the rules and regulations it prescribes.

Vol. 12, No. 3, July-September 1987

stock exchanges in each country have evolved to

meet its national economic needs and ethos.
Countries like ours that intend to accelerate the
pace of growth of the capital market can examine
the various models of stock exchanges and adopt
features suitable to our environment. Three important stock exchange models, viz. United States,
United Kingdom, and Switzerland, are described
briefly in the adjoining columns.

Stock Exchanges in India:

Major Weaknesses
On surveying the Indian scene, three major inadequacies of stock exchanges come to the fore:
weak organizational structure
non-professional, limited membership
domination by large member-brokers.
These weaknesses are discussed below.
Weak Organizational Structure
There are 14 stock exchanges established as associated or limited liability companies. Each stock
exchange is self-governed under the provisions of
the Securities Contracts Regulation Act (SCRA).
Rules and bye-laws of Indian stock exchanges have
to be approved by the government which has power
(under the SCRA) to amend them suo motu.
Well over 75 per cent of the members of the
governing board of each of the stock exchanges are
elected representatives of the members. The members are individuals or partnership organizations.
Government appoints three of its nominees on the
boards of stock exchanges. While the government
can issue guidelines on various matters, day-to-day
functioning of a stock exchange remains the responsibility of its governing board, which is controlled by large member-brokers.
This is a weak organizational structure. The
rules and bye-laws framed and approved by the
government are not implemented effectively since
the governing bodies do not have the will to implement them. The decisions taken by such governing
boards tend to subserve the interests of the powerful members of stock exchanges.
Non-Professional Limited Membership
The stock exchanges have not been able to
35

broadbase, professionalize, and increase membership in keeping with the rapid growth in volume and
complexity of the business. Malpractices such as
market rigging, insider trading, speculative buildup, default in commitments to clients, and neglect
of investors' interests are common occurrences.
Domination by Large Member-Brokers

Large member-brokers dominate the weak ones in

several ways. They get away with infringement of
important rules and bye-laws. They also use small
brokers as conduits for malpractices. With the
help of willing brokers, some of the highly resourceful speculators find it easy to destabilize the
operations of stock exchanges to serve their selfish
interests. Because the governing boards are
dominated by the same large brokers, members fail
to honour their obligations to clients and other
brokers. Occasionally the market closes. Prices
fluctuate widely. These are all detrimental to a
healthy and rapid growth of the capital market.
Unless these shortcomings are remedied, Indian stock exchanges will prove unequal to the
task of sustaining the high growth in listed capital
envisaged. What are the much needed reforms?

Priority Reforms
Government's concern for reforming stock exchanges is reflected in its appointment of a high
powered committee under G S Patel's chairmanship. The Committee has produced a voluminous
report and has made wide-ranging recommendations covering model rules, regulations, and byelaws of stock exchanges.
It is not possible to deal with the entire gamut
of stock exchange reforms in a short article. What I
have done is to indicate the key areas where reforms are urgently needed.

Broadbase Governing Boards

with Non-Member Experts

Box 2
The UK Model of Stock Exchanges

In the United Kingdom, there were, prior to 1973,

14 provincial stock exchanges, in addition to the
London Stock Exchange (LSE). After March 1973,
all the English provincial, the Scottish, and the
Irish Stock Exchanges were merged to form The
Stock Exchange. All the members of these stock
exchanges have access to the London floor just as
the London brokers have access to the floors
located at Liverpool, Belfast, Birmingham, Dublin,
Glasgow, and Manchester. Electronic linkages
among all the floors of the stock exchanges have
made it possible for all the floors to function as a
single stock exchange of the country.
The stock exchanges in UK have functioned
all along on the principle of self-governance. This
is similar to the Indian system: the stock exchanges formulate their own rules and regulations
and the governing body of a stock exchange is
composed mainly of representatives of its
members.
The UK system is as efficacious in protecting
investors' interests as the US system. As in US, UK
has also its own OTC market. Securities of other
countries are also listed and actively traded on
LSE. However, the governing board is composed
differently. The UK system also differs from the
US system in another way; there is no statutorily
established regulatory body to supervise the activity of the stock exchanges.
Recently, some noticeable changes have been
introduced in this field. A new law called the Financial Services Act received Royal consent in
November 1986. It is a complex act which replaces
investor protection legislation and extends or consolidates other pieces of legislation on insider
trading and listing of securities. Under the new
Act, Self Regulatory Organizations (SROs), including the stock exchanges, will regulate themselves
based on certain rules and regulations. The Securities Industries Board (SIB) (in some respects
comparable to the SEC in US) will oversee them.

Recognizing that success or failure of an institution depends ultimately on the type of its management, the Committee has recommended major
changes in the composition of governing boards of
stock exchanges.
The Patel Committee has suggested that the
government should appoint the chairman and the

36

Vikalpa

Securities Industries Board

SIB is not a statutory body, but will derive its authority from the powers delegated to it by the
Trade Secretary who has been empowered to administer the new act. SIB will set standards for the
SRO's own rules. The Office of the Fair Trade will
whet the rule book which will be sent to the Trade
Secretary for approval. The Trade Secretary will
then request Parliament to delegate powers to SIB.
Though it is not yet clear as to what powers will be
delegated to SIB, it appears from the current debate that SIB will not be as strong as SEC. SIB
appears to be a compromise between the SEC type
of regulatory agency and the earlier system of selfregulation, a compromise reached to maintain a
flexible policing framework. SIB will oversee the
operations of five SROs:
the International Stock Exchange of the
UK and Ireland
Association of Futures and Brokers and
Dealers
Financial Intermediates, Managers, and
Brokers Regulatory Association
Investment Managers Regulatory Organi
zation
Life Assurance and Unit Trust Regulatory
Organization
Each SRO is expected to frame its own rules and
operate under the supervision of SIB. Thus, it may
be noted that the UK system is making a transition
from the purely self-regulatory system to a partially self-regulatory system by accepting SIB as
the supervisory body. Such a system would be appropriate for a country like UK which has excelled
in the working of a self-regulatory system. Selfregulation as a system can function efficiently provided the parties who operate the system agree to
abide by certain standards in their operations.
Such a system would function efficiently only if
the security dealers possess a high degree of
integrity.

chief executive of each stock exchange to be designated as managing director. This appointment
would be based on a panel of three names of independent persons of eminence recommended to the
government by the governing body of the stock exchange. The government is expected to choose one
of them for appointment as the managing director.
Only one half of the remaining governing body
members (not exceeding 18) is to be elected from
amongst the members of the stock exchange. The
other half is to be appointed by the government to
represent various interests such as those of financial institutions, banks, professional bodies like the
Institute of Chartered Accountants, Institute of
Company Secretaries, Institute of Costs and Works
Accountants, investment specialists, institutes of
management, and the Reserve Bank of India. With
such a composition, it is believed that stock exchanges will be managed without fear or favour and
that indiscipline among members and their indifference to investors' interest can be tackled effectively. To strengthen the hands of the reconstituted
governing boards, the Patel Committee has recommended that governing boards be vested with adequate powers and authority to institute appropriate
civil or criminal proceedings against members and
non-members for breach of SCRA provisions, byelaws, and rules and regulations.
The composition of the governing board as recommended by the Patel Committee is somewhat
similar to that of the New York Stock Exchange
(NYSE) (Box l). NYSE has adopted it voluntarily; it
was not imposed by the government of the
United States. Since it is not possible to bring about
the desired changes with the concurrence of the
existing members of stock exchanges, the Patel
Committee has recommended suitable legislative
changes to accomplish them.

Increasing Membership
For a large country with 14 stock exchanges, the
total number of brokers or members of stock exchanges is only about 2,200. This is thoroughly
inadequate for a shareholder strength of 3 million
currently. The number of brokers has not increased with the rapidly growing volume of business mainly because exchanges are organized as
exclusive clubs, and these clubs are interested in
keeping the number of members restricted for their
selfish purposes.
Any Indian citizen who has passed his secondary

Vol. 12, No. 3, July-September 1987

37

school certificate examination and who is 21 can

become a member of a stock exchange by paying the
required security deposit and obtaining the membership card of an existing member-broker. Although some of the newer stock exchanges have
been liberal in admitting new members, admission
as a new member is dependent on such extraneous
considerations as close family links with existing
members. It has been observed that certain family
groups have cornered the membership of some of
these stock exchanges and control their functioning.
Membership fee should be kept reasonable
and admission of new members should be based
on qualification and experience relevant to the
securities industry.
In the older stock exchanges which have not
been admitting new members, the right of membership (called membership badge on the Bombay
Stock Exchange) can be bought. The current going
price is stated to be in the range of Rs 7.5 lakh in
Bombay and New Delhi Stock Exchanges. The
price for membership is continuously going up.
The restrictive practices on membership have led
to an undesirable situation: there are a number of
inactive members. They continue to remain members with the sole intention of reaping speculative

38

profits. They do not conduct securities business.

For instance, the number of inactive members on
the Bombay Stock Exchange is reported to be 173
out of a total membership of 504 (29 per cent). The
inactive members are significantly larger than the
active members on the Calcutta (60 per cent) and
the Ahmedabad Stock Exchanges (61 per cent).
The proportion of inactive members taking all the
stock exchanges together is about 40 per cent.

Terminate Inactive Members

Admission to stock exchanges should be framed essentially on functional criteria: only those who are
interested in securities business should be allowed
to become members. Once a member remains inactive for more than one year, his membership should
be automatically cancelled. Such rules can be introduced only if membership is not recognized as a
hereditary right or as an asset that can be sold. The
malpractices related to membership rights would
disappear once the governing boards accept the
basic principles that membership size should vary
with the volume of securities business and that
only persons with requisite skills and resources
should be admitted as members.

Vikalpa

Admit Corporate Bodies and

Banks as Members
At present, only individuals and partnership firms
are eligible to become members of stock exchanges. In 1984, the government sought the opinion of the stock exchanges on the desirability of
admitting corporate bodies as members. It is reported that most of the stock exchanges opposed it
on the ground that admission of limited companies would lead to concentration of business in
the hands of a few powerful members.
The stock exchanges, as they are constituted
today, do not have a high degree of concern for
providing more efficient services to their clients.
Several existing members are not accepting
new clients because their resources are overstretched. Surprisingly, these are the very same
members who oppose the admission of new members, whether proprietary, partnership, or corporate bodies. Corporate bodies with strong financial
and organizational base with qualified staff spread
over a wide network of offices have such resources
and can guide and advise investors competently.
Corporations and banks have to be allowed to become members.
Adapting the Swiss model (Box 3), we should
encourage commercial banks to take up membership of stock exchanges. A vast number of investors have much greater faith in commercial
banks than in the broker community. Banks enjoy
the highest level of credibility with the investing
public as well as with the brokers. Moreover, with
their widespread branch network, banks will be
able to widen the geographical spread of the business. Banks would be the best agencies for activizing over-the-counter type of transactions all over
the country.
We should also encourage corporate members.
For example, Merryll Lynch of the US operates
with thousands of their dealing staff spread over
the country.

Extend Membership to other Exchanges

As noted in the adjoining columns, the US and UK
markets are getting more integrated. Two-way
flow of orders and deals are common among different stock exchanges.
The efficiency of spatially separated markets
Vol. 12, No. 3, July-September 1987

is directly proportional to the speed with which

transactions are completed and inversely to the
costs of such transactions. For a more efficient integration of different stock exchanges, it is desirable that the membership is not limited to only one
stock exchange as it is at present. If an investor
wants to purchase a security listed on some other
stock exchange, his broker should be in a position
to complete the transaction speedily, without another transaction with a member of the other stock
exchange. This he can do if he is allowed to become
a member of all the prominent stock exchanges in
the country. Multiple membership of stock exchanges should be permitted so that a national
market develops for all listed securities. The price
differentials among different stock exchanges
would be reduced to the lowest. Our basic objective
should be to see that arbitrage transactions are not
as profitable as they are today.

Trading Arrangements
Investors all over the world prefer assets that are
liquid. Active secondary markets help in augmenting the pool of savings in favour of the securities
that get listed on stock exchanges.
The main function of stock exchanges is to
provide active secondary markets that ensure liquidity, transferability, and price stability to the
listed capital so that investors can easily buy and
sell their holding of securities.
Trading arrangements have to contribute to
this function.

Excessive Speculation
To function efficiently, all markets, commodity and
securities alike, need a class of dealers whose main
function is to even out day-to-day gaps in demands
and supplies. Such dealers emerge as sellers or
purchasers depending on the prices at which other
purchasers and sellers are making bids and offers
for rearranging their investment portfolios. When
the dealers or market makers build large, speculative
positions in certain securities, the prices of such
securities may move up or down excessively. In real
life situations it is somewhat difficult to identify
clearly when excessive speculative build-ups have
taken place. To do so, one has to decide what level of
transactions constitutes an excessive or unwarranted build-up during a given period of time.
39

Although there is excessive speculation on

Indian stock exchanges, there was no quantitative
indicator for it. The Patel Committee has provided a meaningful indicator. The Committee
points out that about 90 per cent of the transactions taking place in specified shares are settled
without actual deliveries of shares. They are concluded merely through settlement of differences.
Only 20 to 30 per cent of the remaining 10 per
cent of transactions are genuine deliveries in
favour of investors. The rest are carry forward or
badla transactions. Thus, only about 2 to 3 per
cent of the reported transactions in specified
shares result in actual purchases or sales by investors. If we make suitable adjustments for transactions that are squared up daily and for those
that are not reported to stock exchange authorities, the extent of excessive speculation becomes clear.

Reasonable Speculation
All the same, a reasonable level of speculation,
which does not destabilize markets, is necessary,
provided it is based on:
indepth studies of balance sheets
demand and profitability prospects for
the company's products
careful study of the general economic
conditions
intelligent anticipation of future events
shrewd analysis of market forces.
Such speculation helps in imparting a greater
degree of liquidity to the markets especially
when large buy or sell orders from genuine investors have to be executed without causing undue fluctuations in market prices. Some speculation per se is, therefore, not harmful to orderly
functioning of markets.

As John Maynard Keynes put it:

Speculators may do no harm as bubbles on a steady
stream of enterprise. But the position is serious when
enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes
a by-product of the activities of a casino, the job is likely
tn be ill-done.

40

Eliminate Kerb Trading

It should be made obligatory for those dealing in
securities to report all their transactions to stock
exchange authorities. The present malpractice of
kerb trading, i.e. trading outside market hours of
stock exchanges and not reporting to the authorities, should be effectively curbed. Any
member indulging in this malpractice should be
punished with a fine if the offence is not of a
serious character. But if the member makes a
habit of indulging in it regularly, he should be
both fined and suspended for a period of one or
two weeks. If the member is not disciplined even
after being punished, he should be de-registered.
Trading should be permitted only during
market hours so that it takes place under the
supervision of the authorities of the stock exchanges which can ensure that it is fair and equitable to all involved. At present, the stock exchange bye-laws and regulations permit trading
after market hours, if it is conducted on the telephone between brokers. Increasingly transactions
take place at all hours all over the world made
possible by instantaneous communication links.
It is essential, however, that all transactions
are reported to stock exchanges so that the authorities have an opportunity to find out whether
any of the transactions are carried on with
malafide intentions.

Impose Trading Margins

India is one of the very few countries which has
not adopted the standard practice of imposing regularly margins on all the trading that takes place
on stock exchanges. Hence, there is an opportunity to enter into transactions without shelling out
even small amounts of money. This poses a temptation to indulge in overtrading resulting in market
disruptions. As a result, some parties are unable to
honour their commitments fully on the settlement
day. In the United States as well as in several other
countries all persons entering into securities
transactions should have required funds to honour
their commitments when they are called upon to
do so.
Margins are stipulated at a level which is adequate to safeguard the interests of the other party
entering into the transaction. In other words,
when the price at which a purchaser enters into a
commitment subsequently declines and, in case.
Vikalpa

the purchaser does not intend to take delivery, the

margin amount provided by him should be enough
to square up the transaction at the lower price.
Therefore, the margin amount should be equal to
at least the likely difference between the purchase
price and the actual price on the settlement date.
Under reasonably normal trading conditions
the level of margin should be around 10 to 15 per
cent of the price at which the purchaser enters into
a commitment. The level of margins may vary depending on market situation. If the stock exchange
authorities feel that excessive speculative build up
is taking place, not only should they step up
promptly the margins but should also ensure that
there is accurate and complete reporting of all
transactions.

Curb Insider Trading

Insider trading is defined as "trading in securities
based on secret information about working of companies or any other relevant information of vital
importance accessible only to a few persons on
account of their key position in the company or
their access to key persons working in the company." Insider trading is rampant on Indian stock
exchanges. The disclosure requirements about
working of listed companies are not as stringent as
in some developed countries. It is only recently
that the stock exchanges have made it obligatory
on the part of all the large listed companies to disclose preliminary working results on a half-yearly
basis so that investors are kept well informed. Disclosure requirements could be made quarterly. If
trading is to be fair, all those who deal in securities
should have equal access to all the vital information. Since in India such a situation does not prevail, the general class of shareholders is at a great
disadvantage vis-a-vis those who have easy access
to information.
In the United States, United Kingdom, and
Australia insider trading is a major punishable offence. Australian law is quite stringent in this regard: insider trading is a criminal offence punishable with heavy fines and imprisonment. In the
United States, SEC recommended in 1983 imposition of civil penalties, criminal proceedings, and
tines up to three times the profits gained or losses
avoided (Box 1). In the United Kingdom also the
Companies Act was amended in 1981 to make insider trading a criminal offence (Box 2).
Unfortunately, there are no legal provisions at
Vol. 12. No. 3. July-September 1987

the moment to punish those indulging in insider

trading. We must have stringent provisions similar to those in other countries. Operations of those
in key corporate positions and of their brokers
should be closely monitored and wherever there is
prima facie evidence about insider trading, the matter should be thoroughly investigated by stock exchange authorities. An apex body of stock exchanges
should keep close watch to ascertain whether stock
exchanges are monitoring thoroughly the trading
malpractices and whether they are taking effective
measures to curb insider trading.

Improve Market Surveillance

Apart from insider trading, there are a number of
other malpractices observed on Indian stock exchanges. Excessive speculation, market manipulation, and price rigging are common features of the
day. Takeover attempts by "corporate raiders" are
reported quite frequently. The present company
law provisions empower the board of directors to
reject transfer of shares to parties hostile to it:
some takeover bids, therefore, do not succeed. But
in the interregnum, there is considerable anxiety
among non-management shareholders. The stock
exchanges have accepted the code of ethics of the
City of London, according to which the price paid
for management takeover of shares should be offered to other shareholders willing to sell their
shares. In practice, it is difficult to implement this
code. The recorded price in the management sale
of shares does not disclose the true nature of the
transaction and hence the other shareholders are
at a disadvantage.
Any attempt or intention of management
changeover should be immediately reported to the
stock exchange. Parties failing to do so should not
be allowed to take over management at a subsequent stage. In other words, it should be ensured
that the general class of shareholders is informed
well in advance of any possible move of corporate
raiders.
It is useful to note the market surveillance
system at NYSE. As noted in Box 1. well over 150
people keep a continuous watch on the price
movement of the scrips dealt on the floor of NYSE
on a minute-to-minute basis on the video screens
installed in their rooms. NYSE has evolved certain
normal price behaviour patterns for different
shares. The computer screens or video screens
automatically flash a message when a price moves
41

out of the normal range. The person monitoring

the scrip asks the specialist on the floor of NYSE
for an explanation. If the explanation provided by
the specialist is not satisfactory, he immediately
contacts the top management of the company concerned to find out whether any price sensitive
developments
concerning
the
company's
operations are likely_ to have become known to
any person/ persons. The intention is also to
know whether any corporate raider is trying to
corner the shares. The brokers and the
specialists are obliged to name the party trying
to corner the shares. The information is flashed
immediately to all, including newspapers. These
surveillance measures effectively curb attempts at
market rigging and price manipulation. Stock
exchanges in India should evolve similar
measures.

Stipulate and Enforce Brokers' Ratio of

Owned Funds to Aggregate Indebtedness
Member brokers should put in adequate funds of
their own to support their continuous trading and
financial commitments. The size of their (own)
funds should bear some relation to the aggregate
commitments they make whether on their own or
on behalf of their clients. If the commitments are
excessive and the market turns adverse, they
would not be able to honour their commitments.
Hence stock exchanges should fix a limit on the
aggregate indebtedness of a broker to ensure his
solvency and of the market.
NYSE does not allow aggregate indebtedness
of a member to exceed ten times his net owned
capital. It has defined aggregate indebtedness for
the purpose of this rule and has prescribed steps to
be taken when a member's indebtedness exceeds
the stipulated ratio.1 India can examine this and
1

For the purpose of this rule, aggregate indebtedness is de

fined as "total money liabilities including borrowed funds,
amounts payable against securities loaned and securities
failed to receive, the market value of securities borrowed to the
extent to which no equivalent value is paid or credited,
customers' and non-customers' account having short positions
in securities and equities in customers' and future accounts,
and credit balances." Indebtedness, however, does not include
items such as liabilities adequately covered, credit balances in
the accounts of partners, and indebtedness for which adequate
collateral exists. A member's net capital is loosely defined as
member's liquid networth or owned funds. Whenever the ratio
of indebtedness to owned funds rises above ten times, an early
warning is issued to the member and the member is not permit
ted to expand his business further. If the member does not
heed this warning and the ratio rises above 12 times, he is
directed to take suitable steps to reduce indebtedness. If the
member disobeys the directive and the ratio rises above 15
times, he is forced to go into liquidation.

adopt such
modifications.

measures

with

appropriate

Enable Limited Liability Membership

At present corporate bodies, with limited liability, cannot become members of Indian stock exchanges. One of the arguments put forth in not
permitting corporate bodies as members is that
their directors' and shareholders' liability is by
definition limited and hence it is difficult to protect the interests of those parties who deal with
such corporate bodies. Under the current arrangements, the liability of a member is unlimited. All
his personal assets are available for meeting his
commitments. However, in practice, dishonest
members transfer all their personal assets in the
names of their relatives and friends when they
foresee the risk of a loss. As a result, the existing
provision of unlimited liability of members does
not serve the intended purpose when the member's firm goes into liquidation.
One way of solving this difficulty is to stipulate a desirable exposure ratio taking the cue from
NYSE so that the member's overall exposure always remains within reasonable limits. Such a
rule can be made applicable to all members, irrespective of whether they are proprietary or partnership firms or limited liability companies.
The provision for unlimited liability will
have to be done away with. Only if their liability
is limited will professionals take up directorship
as salaried employees of corporate members of
stock exchanges.

Smoothen and Speed up

Transfer of Shares
The present legal provisions governing transfer of
securities from buyers to sellers are cumbersome
and time consuming. The average time lag between the point of sale and the actual receipt of
share certificates after they are registered in the
name of the purchaser is reported to be three to
four months. In some cases where disputes arise,
the transfer process takes more than six months.
Such delays affect adversely the volume of transactions, float of shares, and the costs of trading.
Several suggestions have been put forward to
simplify and minimize the time lag. Some of the
radical suggestions are to do away with the system
Vikalpa

42

of transfer forms and share certificates. Instead, a

passbook system is suggested whereby the ownership of shares is indicated by suitable entries.
Section 108 of the Companies Act stipulates
that transfer of shares from seller to purchaser is
not valid unless it is done through a dated transfer
form signed by the seller and the purchaser and
authenticated by witnesses. Under this system, the
duly completed transfer form together with the
share certificates have to be lodged with the company. The board of directors of the company has to
formally approve the transfer of share certificates
in the name of the purchaser. The whole procedure
is quite outdated. There are too many movements
of transfer forms and share certificates back and
forth.
One suggestion is in favour of doing away
with the dated transfer form so that difficulties
arising out of the closure of the members' register
and consequent invalidation of the transfer deed
could be avoided.2

All-India financial institutions have taken a

first step in this direction by indicating their desire to set up a Stock Holding Corporation of India.
This body is to provide post-trade service facilities
for the institutions. Government has also indicated
its intention to permit private sector bodies to be
set up on similar lines to obviate the difficulties
involved in the transfer of shares from sellers to
purchasers.

Conclusion
Reforms that need urgent attention have been
pointed out. They have to be carried out expeditiously in view of the galloping speed at which the
capital market has been growing. Failure to do so
may render the capital market unhealthy and incapable of sustained growth. We would be missing
an opportunity of ensuring sound growth of the
capital market and the economy.

An organization could be set up which could

hold custody of all share certificates on behalf of
investors and carry out the transfer of shares from
seller to purchaser based on the advice of seller
and duly approved by the concerned company's
board of directors. Under this arrangement advices
could be issued in the form of cheques in favour of
the purchaser and the purchaser in turn submits
the advice to the corporation which would seek
approval of the company. This arrangement not
only avoids unnecessary movement of documents
but also minimizes the time lag between the transfer of shares from seller to buyer. This could have a
salutary effect of increasing the floating stock of
shares in the, market. Under the present system a
large number of shares which are under transfer in
effect get immobilized. The floating stock in the
market is considerably depleted. Since management holdings and institutional holdings of shares
are not available for sale except in large quantums,
any reduction in the floating stock provides an opportunity for the speculators to manipulate market
prices as they are sure that large deliveries would
not be forthcoming in the intervening period on
account of limited floating stock.
2

The argument against such arrangement is that such a system

would encourage benami transactions as the documents could
move from buyer to buyer as bearer bonds. But it must be stated
that even under the present system of dated transfer deeds
benami transactions can take place if shares are registered in
fictitious names.

Vol. 12, No.3, July-September 1987

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