By Nilesh Shah, Managing director, Kotak Mutual Fund
In a quaint village, a small market for curd thrived, where buyers paid upfront in cash. Alongside, there was a bustling derivatives market for future curd deliveries, where participants paid only a small margin upfront. Prices in both were interlinked, but the derivatives market dwarfed the spot market in trading volume. This set-up attracted quick-money addicts—speculators chasing a “zero to hero” trade, gambling in the derivatives market.
Enter a wealthy merchant from outside. Noticing the high trading volumes, he flexed his financial muscle, buying large quantities of curd in the spot market in the morning and driving up prices. The derivatives market followed suit, with curd futures prices soaring in tandem. By afternoon, the merchant escalated his game. He sold call options on curd at inflated prices, signalling to the market that prices would keep rising, while simultaneously buying put options at lower-than-market prices.
Quick-money addicts, lured by the steady price uptrend and convinced of further price rises, jumped in. They sold out-of-the-money put options at low premiums, hoping to pocket the premium for quick profits. Some bought deep out-of-the-money call options at low premiums, hoping that prices will rise to astronomical levels.
But late in the afternoon, the merchant pulled the rug. He dumped his curd holdings in the spot market at throwaway prices, causing a sharp collapse in both spot and derivatives prices. The quick-money addicts faced devastating losses. The merchant, while incurring some losses on his spot market sales, reaped massive profits in the derivatives market. Week after week, the merchant repeated this cycle at the village market, amassing wealth while the addicts suffered crushing losses. Eventually, the village market head caught wind of the scheme and ordered the merchant to repay his ill-gotten gains.
This story mirrors the Securities and Exchange Board of India’s (Sebi) recent order against Jane Street, a high-frequency trading (HFT) firm.On April 13, 1919, thousands of unarmed Indians were killed in Jallianwala Bagh. In our futures and options (F&O) markets, a similar massacre occurs every week, where millions of Indians get killed economically, not by bullets but by their greed. Sebi warns that nine out of 10 speculators lose money. Unfortunately, all 10 believe they belong to the winners’ category.
Let’s explore the broader implications and potential solutions to prevent fools and their money getting separated in capital markets.
Would HFT firms dare to do this in China?
It’s unlikely that an HFT firm would attempt such a trade in China’s markets for three reasons. First, Chinese markets are largely closed to foreign speculators for such activities, limiting access. Second, Chinese regulators wield formidable power, employing tactics akin to sam, dam, dand, bhed (persuasion, fines, punishment, or division) to enforce deterrence and compliance. Third, the memory of a well-known hedge fund being squeezed by the China Investment Corporation in a short renminbi trade serves as a powerful deterrent. India’s markets, by contrast, appear more vulnerable, lacking similar restrictions or fearsome power to regulate.
Strengthening regulatory powers
Sebi’s order against Jane Street demonstrates its ability to detect manipulation through meticulous data analysis, but the broader legal framework for the same remains inadequate. Cases from the 1992 securities scam still linger—companies go bankrupt but not the promoters, underscoring the system’s inefficiencies. In contrast, the US legal architecture enabled Irving Picard to recover nearly every penny for victims of Bernie Madoff’s Ponzi scheme. India’s legal architecture faces constraints in knowledge, infrastructure, and case backlogs, allowing manipulators to exploit the system. Commercial crimes, like market manipulation, often cause greater societal harm but face lenient treatment due to the absence of a “dead body”. Empowering Sebi with robust legal tools and fostering a fear of swift punishment are critical to deterring future violations.
Moving beyond the Union Carbide mentality
The 1984 Bhopal disaster saw Union Carbide escape with minimal consequences despite causing one of the world’s worst industrial tragedies. Similarly, Sebi’s order against Jane Street, based on impeccable analysis of 21 trading days, must go beyond recovering manipulated profits. An exemplary penalty is needed to deter future manipulations.
Need for counterbalancing mechanisms
India’s institutional investors, often limited to volume-weighted average price orders, lack the aggression or leverage to counter HFT firms effectively. Regulations rightfully restrict their ability to short markets or write unhedged options, but this leaves a gap in the market’s defences. A new institutional mechanism equipped with advanced data analytics, high-speed connectivity, and access to leverage is needed, as is the ability to act decisively to neutralise HFT dominance.
Quick-money addiction
Quick-money addicts, like drug addicts, chase instant gratification, often egged on by social media influencers promising sky-high returns through stock tips, crypto speculation, or Ponzi schemes. In some cases, they just pretend to be successful fund managers leveraging technology. They are akin to the mythological demon Raktabij—slay one, and a hundred more emerge. Just as the drug trade faces stringent controls, higher policing, restrictions on advertising and marketing, and severe punishment (at least on paper), speculative financial products and manipulative practices need similar controls. A concerted regulatory effort backed by effective policing, including swift and exemplary penalties, could curb this menace.
Power of financial education
A Gujarati proverb warns that crooks thrive where greed abounds. The antidote to greed is financial education, emphasising disciplined investing, the risks of trading, and the dangers of leverage. Sebi’s “Mutual Fund Sahi Hai” campaign has raised awareness about mutual funds. A similar and perhaps a slightly more hard-hitting approach is needed. Statutory warnings, similar to those in the tobacco industry, or a levy on F&O trading to fund investor warning campaigns could drive home the risks. Requiring traders to pass exams before engaging in leveraged trading might also filter out reckless participants.
Conclusion
Unchecked financial muscle and speculative frenzy can destabilise markets, leaving retail investors vulnerable. Sebi’s action against Jane Street is a step forward, but systemic reforms are essential. Strengthening regulatory powers, creating counterbalancing mechanisms, treating commercial crime seriously, curbing speculative mania, and prioritising financial education are critical to safeguarding India’s markets. Only by addressing these issues head-on can India prevent its markets from becoming playgrounds for manipulative merchants.