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Efficiency brings volatility

Y2K has already seen several 300-point plus sessions and one 600-point plus swing day. In percentage terms, this suggests that 5 per cent plus intra-day moves are likely to be the flavour of the year. If global trends are any indication, this volatility is likely to increase. The NYSE and NASDAQ are inured to huge daily moves and that is probably the direction in which India is heading. It's certainly true of the infotech sector, which has a better than 0.9 correlation with NASDAQ over the last year.

It seems a paradox at first glance that the more efficient the market, the greater the daily volatility. But a series of relatively large daily swings is a more efficient correction mechanism than general calm interspersed by occasional violence. In the earlier environment, the big swing was usually induced by either an unexpectedly good or bad budget or a change in government. It was managed and exploited by a relatively small number of big players who manipulated prices on relatively low volumes.

In the past six months, trading volumes have shot up almost logarithmically. We have also seen the advent of small-scale day traders who aim for "modest" 2-5 per cent daily return targets. This means that any developing trend is instantly tested by both profit-taking and also by very short-term speculative action. This creates short-term volatility. But a trend will not develop into a long bull-run or continuous bearishness simply due to one party trading in a certain direction. Large volumes rule out easy manipulation and also decrease the chance of a severe liquidity crunch on a given day. This means fewer defaults and less risk for individual traders who have a better assurance of being able to close positions at will.

A possibly beneficial consequence of larger intra-day volatility is a reworking of VAR models. The classic Value At Risk model equates risk with the daily volatility range that is mapped 99 per cent of the time. VAR has certainly increased. Everyone doesn't necessarily calculate VAR this way. In fact, a lot of Indian operators don't quantify risk at all. But everyone now knows that the daily risk is higher. People will continue to trade since greater volatility means greater rewards. But traders are likely to be better-capitalised and more prepared for regular margin calls. Again that is a healthy situation since it decreases the possibility of default.

However, there are several imperfections in the Indian market, which prevent more efficient trading. Right now, the Indian market is constrained by a circuit filter. This is eight per cent for stocks above Rs 20 where all the high-capitalisation index stocks generating 95 per cent of daily volumes come in.

But the mechanism is open to abuse especially in the less-traded low-cap stocks. Trading is automatically frozen at the limit. An unscrupulous trader can simply hit the limit with his first trade of the day thereby excluding everyone else. Several successive upper filters followed by selling are one popular way of operating. Thus, the circuit filters that are supposed to keep speculative elements under control actually create inefficiency.

US bourses don't have circuit filters. Speculative action on US exchanges is backed by a strong hedging mechanism in the form of an index-futures market. Risk in the US is further hedged, both by a system of stock-lending and an efficient lending cash-against-shares mechanism. All this helps to separate speculative action from the spot market and ensure the necessary liquidity to lay off positions.

Another useful US mechanism is a rolling settlement system that spreads out trading generated by settlement considerations. India doesn't have any of these systems so the spot market has to inevitably absorb more speculative action. A futures and derivatives market would certainly ease some of the pressure on spot. A rolling settlement would smoothen out the surges that occur every settlement day and opening day. A synchronisation of settlements across various bourses would also cut down speculative arbitrage action that distorts the price-discovery mechanism.

It is technically very easy to synchronise settlement dates and trading hours. It is less easy to introduce a rolling settlement although it is still well within technical limits. Indeed rolling settlement of specific stocks is on the way and we can hope that this will gradually include more counters. But synchronization faces a lot of opposition from arbitrageurs who generate a risk-free return from exploiting the lack of it.

A derivatives system has been on the cards for a long time - I remember the Baroda stock exchange proudly claiming in late 1994 that they could introduce index derivatives "inside of a week". Why this hasn't happened in the past six years should probably be the subject of another column. Stock-lending and cash-against-shares both face more clearly marked technical and legal barriers - not least a peculiar tax treatment.

There is another imperfection I should mention in passing, although I can't suggest any obvious natural remedy. Badla exists and it does a pretty good job of providing both monetary liquidity as well as a carry-forward mechanism. But I wish badla rates didn't differ so much on individual stock exchanges. The rate is a function of default risk and this is obviously governed by the mechanisms of different exchanges. The existence of different rates leads to a whole slew of interesting arbitrage opportunities for both equity traders as well as vyaj badla players. In the long run, it is obviously an undesirable factor however.

Devangshu Datta

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