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Stock market scams and regulations - how they evolved

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Stock market scams and regulations - how they evolved

Globally, stock market regulation has been the outcome of some form of a scam with larger systemic implications. In the US, after the Stock Market Crash of 1929, the Glass Steagall Act was passed separating commercial banking from investment banking. The Sarbanes Oxley Act for greater accountability and transparency was an outcome of the collapse of Enron in 2001. More recently, the Dodd Frank Act was an outcome of the Sub-Prime crisis to make banks more crisis proof.

In a way, the case has been similar in India. Scams have played an important role in the evolution of regulation of capital markets in India. Here are five such key steps in the evolution of Indian capital markets.

A.     Harshad Mehta Scam and the first phase of Capital Market Reforms

One of the first major bull rallies that India saw was in 1991-92. After the Gulf War ended, the Sensex went on a one-way spiral from less than 1000 to 4600 with most cement and commodity stocks becoming 50-baggers and 100-baggers in no time. It eventually emerged that a high profile broker, Harshad Mehta, had artificially propped up the share prices by using the idle funds of banks and siphoning them via Banker Receipts (BRs). This led to the government immediately granting statutory status to SEBI in 1992 as the need was felt for a nodal regulator for all capital market regulation. As a response, the government also allowed Foreign Institutional Investors and private mutual funds to participate in a big way. Indian capital markets have never been the same again.

B.     Duplicate shares of RIL sets the tone for introduction of demat

Back in 1994, the market cap of Reliance Industries was just about $3 billion. At that point, the BSE suspended the shares of Reliance for 3 days for negligence by its in-house registrar in issuing duplicate share certificates of RIL to Dr. Rajul Vasa. It became a high profile fracas and RIL threatened to delist the shares of the group from the BSE. The entire episode starkly highlighted the darker side of physical certificates with all its concomitant problems. The government moved on a war footing with SEBI for shifting to demat. Within exactly 2 years, NSDL began the shift from physical certificates to demat. The acceptance of demat has been unprecedented. It made markets a lot more transparent.

C.     Ketan Parekh Scam and the big shift in market structure

In the late 1990s, Parekh was the first to spot the potential of IT stocks which could be easily rigged due to their complex business models. He got cooperative banks to issue dummy demand drafts and got finance against the DDs to artificially jack up the prices through circular trading. When a financier tried to cash the DD issued by Madhavpura Mercantile Bank, it bounced. That opened a can of worms and the so-called K-10 stocks crumbled like a pack of cards. This led to a series of swift structural reforms. The market shifted from weekly settlements to rolling settlements (first T+3 and then T+2). Badla and ALBM were scrapped and futures and options were introduced. Counter guarantee of trades became mandatory and the market became structurally a lot safer.

D.     IPO scam and penny stocks leads to KYC and PAN mapping

One of the big shifts in market regulation was the introduction of Know Your Client (KYC) regulations and mandatory mapping of trading account with the PAN card in 2007. This was triggered by the IPO scam of 2005 where dummy names were used by Karvy to open multiple demat accounts to ensure higher allotment. At the same time, SEBI found a pattern in operators rigging up penny stocks. KYC was introduced to better understand the client and PAN mapping ensured that there was an audit trail of the trading account. That marked a big shift.

E.     Reforms in the post Lehman period

Post 2008, the markets were rocked by the Lehman Crisis and it was a lot of fire fighting in the ensuing years. However, two key scams in the post Lehman era gave a trigger to regulation

  • In 2009, Satyam conceded that it had fudged its accounts books for the last many years and that it had no cash in its books. In its previous balance sheet, the company had shown cash balance of Rs.4400 crore. There were huge lapses in internal audit, external audit and the internal controls. Corporate governance was extended to include all stakeholders and it was made part of the Companies Act 2013.

  • In 2013, it emerged that the National Spot Exchange Limited (NSEL) had been trading dummy spread contracts all along, while acting as a spot exchange. When FMC banned rollovers, the exchange defaulted. It turned out that no assets were created and all funds had been siphoned. Rs.5600 crore was lost, which is yet to be recovered. It led to the FMC eventually being merged into SEBI.

The evolution of capital market reforms has largely been a response to the various scams over the years. But it has surely made the markets sounder and safer.

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