Experts disagree on F&O ban; agree on divestment via ETF

Deena Mehta, Asit C Mehta Investments and JR Varma, former member of Sebi discuss, on CNBC-TV18, the various aspects of Sebi's plan to ban companies with a high-pledged stake from the F&O segment. While both experts disagree on the ban proposal having a punitive and preventive impact, they managed to see eye-to-eye on the governments plan to divest via an ETF of PSU shares.

Below is an edited transcript of the discussion on CNBC-TV18 Q: Do you agree? Is this the right way to go to ban companies from F&Os who have high-pledge shares? Mehta: Yes. I think it is an excellent move by Sebi  to ban the companies from F&O. The pledged terms are private between the pledger and the pledge. As a result, investors who take future positions over one month, three months or even as long as a year are in the dark on this important information.
The futures segment can be misused also by heavy selling in these shares which leads to a Catch-22 situation because there is selling, the cash price goes down, there is a higher margin call, then the promoter will give more shares and this results in investors with 90-95 percent pledged shares before reaching a point when there is nothing further to be pledged.
So I think the Sebi ban is a very good move. I would take this opportunity to extend this even to the PSU shares in which less than 10 percent of the holding is with the public. There are big arbitrages being conducted with investors selling in the futures market where there is no delivery and a cash settlement with no link between the futures and the cash market. Stock markets are to be used for capital formation and cannot be used for these kinds of arbitrages. Q: At least the percentage of promoter shareholding that has been pledged is in the public domain. So, investors who are taking forward positions and not taking futures positions are aware of the percentage of shares that are pledged even if they don't know the terms between the pledger and the pledge. Would you agree that it is a good idea to ban futures and option (F&O) on these shares? Our calculations show that a third of the shares which are available for F&O have promoter-pledged shares issue, though ofcourse not all of them are in the 90 percent bracket?. Do you agree with it in concept and if you do, then what should be the dividing line, what percentage of pledged shares? Varma: If the Sebi implements the ban, it is actually protecting the promoter and preventing price discovery in the market. The regulatory authority is stepping in to say that, 'I want to protect the promoter from the share price collapsing due to short-selling'.
For a proper price-discovery, there has to be a balance between the leveraged buyer of shares in the form of the promoter taking leverage and buying the shares. The counterweight to that will come from the short-sellers who are selling shares which he doesn't have.
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One party is buying with money that he doesn’t have and the other party is selling shares that he doesn’t have. If you allow both then you have a balance in the market. If you allow only the leveraged long and you keep the shorts out, then you are effectively rigging the share price upward. That is my main worry with a proposal of this kind.
I agree that there could be a problem when it comes to the risk management of such a futures position because you would have a kind of a cliff risk that if the share price drops by maybe 10-15 percent at which the margin calls get triggered and the promoter is not able to meet the margin call, you get the forced liquidation and the cliff effect. There is a cliff risk and the tool to deal with that is margins.
Where the promoter pledging is high and the percentage of the promoters' total holding that is pledged is high, there is a big risk that the margin call cannot be met, then margins on futures should go up. It should go up to very high levels to protect the exchange from that cliff risk. Q: What would be your take on the fact that Sebi is really protecting a promoter who is weak as well to preference for a higher margining to a complete ban on these stocks in the F&O space? Mehta: When a share goes to the F&O space, very often there is a premium on the price to allow investors to take a longer position. It would be a negative factor for investors whose shares do not fall in the F&O list. I don't subscribe to that argument. In fact, I feel it is degrading if a stock is removed from the F&O list.
As far as price discovery is concerned, it depends on the demand and supply for shares. When we say that investors know that these shares are being pledged, the disclosures are not good enough.
The prospectus is also analysed after which a long position is taken. But I’m doubtful about the veracity of disclosures and investors are ignorant of the risk associated. I think it would be better if the share, with too many risk factors, is removed from the F&O segment. This ensures more safety and less volatility in the market. Q: Do you think Sebi will actually implement something like this? Varma: I can't predict what the regulator would do. Q: There are murmurs in the market that there is one exchange which is very strong in the F&O space, another exchange that is extremely weak and yet another other exchange actually trying to enter the space and therefore weakening the existing strong player would actually be a case of being partial and unfair to the dominant exchange. Any comments on this? Varma: I don't think this is an issue related to strengthening or weakening of a player. To my mind, the derivative products don’t exist to help the exchange or protect the promoter, they exist to allow investors to get better price-discovery in the market and to hedge their positions. I don’t agree that this is a way of giving prestige to a company or giving greater revenues to an exchange. The primary purpose of this is to allow investors to take positions more easily and hedge their risks more easily. Q: What is your sense with MCX now coming into the fray? How attractive are the rates and do you see volumes shifting from NSE to MCX when it does open up? Mehta: I feel it is too early to comment and each exchange would like to have a niche for itself. I think assigning motives to the various reforms in the markets is not proper and I feel that Sebi is taking adequate steps. The markets come first and that focus should not be forgotten, that is important. Q: There is a proposal to have an exchange traded fund (ETF) of public sector undertaking (PSU) shares which are dividend-paying and use that ETF to divest. Do you think it is a good idea? Varma: I think the market will decide whether it is a good idea or not. If there are enough investors who want to subscribe to that, then that is fine. Q: But as an idea - would that be a quick way to divest? Mehta: Yes. I think it is a very good idea and it will provide one more product available for investors. It will be done through mutual funds. The government would have its tap open for the funds rather than coming out with each issue daily. It is a smarter way of doing things and it is a good idea. I would definitely recommend such a product to my customers.
I think that whole operational process can be circumvented with just one pipeline with good stocks in the market. We definitely need lot of quality paper to give more depth to the market. I think providing dividend-paying and well-performing stocks would be a good idea without all the operational hassles associated with disinvestment.