Agree with SEBI trading curbs, but not process: JR Varma

Excerpts from Bazaar on CNBC-TV18 Watch the full show »

The Securities Exchange Board of India announced in June that promoter holding in companies will have to be in the dematerialized form by September end, failing which it will shift to trade-to-trade segment. With the deadline fast approaching, over 1,000 non-compliant companies may be hit, including names like GAIL and BHEL . JR Varma, former SEBI member and professor at IIM Ahmedabad believes that this is a necessary move by the regulator, but is not happy with the method adopted.

"If the promoters are dragging their feet, you need to find ways to penalize them. You need to say that dividends won't be paid on physical shares or that physical shares will not be allowed to vote" he said exclusively to CNBC-TV18. He goes on to say that this methodology hurts investors more than promoters.

But his greater worry is that promoters will intentionally hold onto their physical shares so as to enter the trade for trade segment. "With share prices collapsing, you like everything to be on trade for trade because it will keep the short seller out" he added saying that this will further benefit the promoters.

Below is an edited transcript of his interview with Sonia Shenoy and Mitali Mukherjee. Also watch the accompanying video.

Q: Could give us clarity on this entire situation and what kind of companies could get hit because of this?

A: I think there is an issue about prevalence of physical shares and that needs to be demated, I think there is no question about that and we need to move quickly on that. However, the methodology which is being used is a very problematic issue because what one needs to do is to ensure that the penalties fall on those who are dragging their feet. So if the promoters are dragging their feet, you need to find ways to penalize them. You need to say that you will not pay dividends on physical shares, not allow physical shares to vote etc. That is the way I think that one should proceed rather than to say that it moves in to a trade for trade settlement. I don't think that hurts promoters as it hurts other investors and this could become a very big problem.

However, my greater fear is that if the promoters think that they are in a bear market, they might actually be happy to see things go to trade for trade because then it becomes harder for people to short sell the shares. With share prices collapsing, you like low volume, you like everything to be on trade for trade because it will keep the short seller out. So I wouldn't really be surprised if some promoters actually hold back saying that this is protecting our shares in a bear market.

So I think the mechanism that they have used, the penalties that they are imposing is something that needs to be reconsidered. You need to go after those who are not demating their shares. You need to go after those who are holding onto physical shares. That's the way that one should proceed.

Q: So what would be the more elegant solution over here to move in terms of steps and more so for some of the public sector companies which are apparently at this point 100% non-compliant?

A: I think this is something where the people need to be educated. I am quite surprised that the Comptroller and Auditor General (CAG) is not worried about this because physical shares are extremely prone to fraud. I would imagine that if the CAG were appraised of the situation, it would actually accuse the government of exposing itself to fraud and loss by holding shares in physical form and will insist that all shares should be demated to protect the tax payers' interest.

People are not recognizing how great the risks are with physical shares. I think people have forgotten things incidents like Vatsa Music where we saw the problems that could come with physical shares, forged shares, duplicate shares and so on. I think that this is something that the government should wake up to. The government is exposing themselves and the taxpayer to risk if shares are held in physical form and somehow they get stolen or they get transferred in some way and the government is left holding forged or fake shares. I think that's a very serious risk and people like the CAG should actually be looking at that and putting their foot down and saying that all shares have to be in demat form.

Q: You briefly touched upon the T to T impact. Can you just explain what the likely fallout over there could be, because the fear is that perhaps derivative trading as well could get a bit unsettled because of this process?

A: Absolutely. Trading becomes difficult which leads to price discovery getting affected. I think the regulator's thought was that in a bull market if you impede trading, then the price gets retarded and the promoters would then want to restore normal trading so that the share price moves up. But I think what we need to recognize is that when you put these kinds of trading curbs, what you are doing is that you are slowing down the process of price discovery. So in a bull market, the price rise gets slowed down because you are not able to trade quickly.

But it is equally true that it will work the other way in a bear market. Since price discovery is not happening fast enough, the share price doesn't fall as fast as it would otherwise do. Therefore, in a bear market, a promoter who is really seeing a share price crumble might actually be very happy to see go on trade for trade.

So I think that we should not assume that trade for trade is always bad for the promoter. It could actually be good under certain conditions for some small cap and mid cap companies which might actually welcome it. In fact, even people who are actually intending to demat might actually hold believing this to be a wonderful opportunity to manipulate shares by keeping the short seller out.

The main point is that the penalty for any action should fall on the guilty party. How can you penalize the normal investors for something that the promoters have not done? I think that's completely wrong. You are penalizing innocent people for a failure on the part of somebody else, whether it is government or another promoter. The penalty should fall on them and they should feel the pinch for not converting. If somebody else suffers why should the promoter or the government care? You got to put the pain onto them.

I even believe that we should actually amend the Depositories Act, we should simply abolish physical certificates. We should set a target date and say that shares from this point on will only be electronic. Physical shares will become worthless, in the same way that currency is demonetized. Give a date and after that cancel shares that are in the physical form. You will find that all these people will demat their share because they are afraid of the risk that those shares will just disappear.

Q: So what do you see as the way forward? Ss of June 30th, a big chunk of the companies out of the Nifty are non-compliant. So you think this will affect the liquidity?

A: We know that lot of things happen at the last minute, so if the deadline is September 30th, I am sure there will be people demating on September 30th and not on September 29th. It is also possible that under pressure the deadline may get extended.

But if none of that happens and if neither side blinks, then yes we would have a serious impact on liquidity. If you have Nifty stocks on trade for trade, then the ability to do cash with future arbitrage becomes very limited. It will impact not only future trading on those stocks but also the ability to do index arbitrage.

So yes, the entire market would feel the pinch if such a large number of largecap stocks are put on something like trade for trade which really impedes price discovery. That is a serious risk.

Watch the accompanying video to hear CNBC-TV18's Tanvi Shukla's views on the trading curbs imposed by SEBI.