No scientific basis for stress testing, unnecessarily spooking the market: Sandeep Parekh

"This is not the job of the regulator to predict either market levels (no matter how well-meaning, even accurate) or liquidity (which can't be predicted)," says Sandeep Parekh.

There is no scientific basis for stress testing and it is unnecessarily spooking the market, wrote securities lawyer Sandeep Parekh.

The founder of Finsec Law Advisors and former executive director of the Securities and Exchange Board of India (Sebi) posted a scathing Twitter thread on the regulator's new initiative.

From March 15, mutual funds have been asked to publish a stress report, which captures the ability of their small and mid-cap fund schemes to meet any sudden redemptions if there is an adverse market condition.

Also read: MF Stress Test: Why it matters and should investors be worried?

On the sidelines of an event organised by the Association of Mutual Funds in India (AMFI) on March 12, Sebi chairperson Madhabi Puri Buch said, "Every mutual fund will carry the disclosure about how numbers stack up in small-cap and mid-cap funds, so investors are aware about the possible outcome of investing in small-caps and mid-caps in a stressed situation."

Pointing out that the stress-test requirement has no scientific basis, Parekh wrote, "It assumes liquidity to be a constant at best and extrapolates the past into the future at worst. If liquidity actually vanishes in a particular stock, it can just vanish not in six days or 14 days or whatever other metric is used - it will vanish in a microsecond. Analysis by extrapolation may or may not work. Yes, liquidity is often higher with higher volatility - but it's not a given."

He cautioned that "this could act as a self-fulfilling prophecy. That is, by predicting that markets are overvalued and that liquidity will crash, you may just cause that fall in liquidity and prices".

According to him, this might be exceeding the regulator's mandate. "This is not the job of the regulator to predict either market levels (no matter how well-meaning, even accurate) or liquidity (which can't be predicted)."

He added that this "data-whispering tasks" should have been best left to "academic papers, rather than regulatory philosophy".

Parekh wrote that markets have a strong second and third wave order effects. "Trying to control the immediate effect could impact other stocks, other economic activity, etc. Best to stick to the philosophy of full disclosure and trust the process," he added.