Reports suggest that as of 24 March 2020, the Indian bourses’ drubbing following the COVID-19 pandemic has wiped-out INR14.2 trillion of investor wealth. Since June 2008, for the first time markets have fallen for seven consecutive weeks, resultant in a 33% erosion in value. This has also resulted in some discussion on whether exchanges ought to be temporarily shut down as a volatility control measure.
The protective and regulatory role of SEBI therefore acquires all the more significance in handling the precarious situation at hand. This article seeks to provide an overview of SEBI’s role from a legal and practical standpoint in curbing market volatility.
ENABLING FRAMEWORK
SEBI’s parent enactment, the Securities and Exchange Board of India Act, 1992, provides it with sweeping powers of control over the securities market. Section 11(1) thereof, in its broad language, works as a strong enabling provision to this effect. SEBI has frequently used Section 11(1) to issue specific directions in alignment with objectives specified in the provision. For instance, in the present situation it has introduced various compliance relaxations under key regulations like the SAST and LODR. A fluid ability to exercise powers also ensures SEBI is able to issue directions promptly to meet ever changing market dynamics.
Additionally, depending on the development of the COVID-19 situation, significant implications may arise for the actual functioning of stock exchanges. As per the Securities Contracts (Regulation) Act, 1956, Section 12 states that the Central Government may exercise powers to notify and suspend business of recognised stock exchanges for a period of 7 days, if an “emergency’’ has arisen in its opinion. Such a notification may be extended in public interest from time to time.
Any prior exercise of this provision is not discernible, and thus could potentially result in the use of emergency measures for the first time in the capital markets by factoring their substantial deterioration.
WHAT VOLATILITY CONTROL MEASURES ARE AT PLAY?
Currently, two key sets of measures are at play:
1. Circuit breaking
Vide a circular dated 28 June 2001, SEBI introduced an “index based market wide circuit breaking mechanism”. The mechanism applies at three stages of an index’s movement either way (upward or downward) at 10%, 15% and 20% thresholds, to introduce a stoppage in trading for stipulated intervals in a day, depending on what time it is. For example, on 13 March 2020, a 10.07% drop in the Nifty (966 points) before 1:00 p.m. triggered a trading halt for 45 minutes.
2. Press release dated 20 March 2020 (PR No.18/2020)
This release was issued specifically pursuant to the COVID-19 outbreak inter alia, “Taking note of the continued abnormally high volatility in the market”, with the objectives of, “orderly trading and settlement, effective risk management, price discovery and maintenance of market integrity”. Directions issued (for a 1-month timeframe) therein, are on the following lines:
I. Derivatives
Futures and options stocks
a) Reducing the number of contracts (open positions) to half of the existing limit in this segment, for stocks meeting certain indicators on price variation and trading activity. Stocks meeting these criteria would also attract an increased margin requirement for margin trading (i.e. shares are purchased only by furnishing the margin, with the balance to be paid after the trade), which is to be implemented in a phased manner leading up to 40% margin from 30 March 2020 for such leveraged trades. Increasing the margin requirements therefore effectively makes it more difficult for traders to place risky leveraged bets on a stock’s price.
b) If more than 95% of the available open positions/ contracts are utilized in a security, then a ban period kicks in for derivative contracts. Investors would only be permitted to offset their liabilities, and not increase open positions. This would check volatility by restricting creation of further positions.
Index derivatives
If the derivative is linked to a particular index (e.g. the Nifty 50):
a) Short positions (generally taken in anticipation of a price drop) cannot exceed the total value of one’s (mutual fund/ foreign portfolio investor/ proprietary trading member/client) stock holdings.
b) Long positions (generally taken in anticipation of a price rise) shall not exceed the notional value of one’s holdings in cash, government securities, T-Bills and similar instruments.
c) In addition to the above-stated restrictions on short and long positions aimed at capping and securing over-leveraged trades; contracts/positions in equity index futures and options, each, cannot exceed Rs. 500 crores. Exceeding this limit would result in doubling of margin requirements for margin trading. Such a margin shall be retained by the stock exchange/ clearing corporation for 3 months.
d) The above requirements apply for 1 month with effect from 23 March 2020 for institutions and proprietary trading members, and from 27 March 2020 for others.
Flexing for futures and options
To slow down price variation in securities, an additional requirement of a 15-minute “cooling-off period”, has been introduced, which applies in addition to, and from the time, when a security’s price movement meets the existing criteria specified by stock exchanges for flexing.
II. Non-derivative stocks
For non-derivative stocks with a price band of 20%, similar enhancements to margin requirements as derivatives, leading up to 40% from 26 March 2020, will apply for a month. However, if the maximum intraday high-low price variation as a percentage during the last 1 month is higher for a stock than 40%, this higher percentage shall apply instead w.e.f. 30 March 2020.
WHY ISN’T THE STOCK MARKET CLOSING?
Arguably a shutdown may curtail heavy selling and speculation, and the criterion of an “emergency” is met during a pandemic, for the Central Government to exercise its powers.
However, more overwhelmingly a shutdown simply delays the inevitable, since it does not substantively address or allay the fears of investors, besides the difficulty in answering what duration would ensure effectiveness of such an action. As a recent example, the Philippine index dropped by 13.3% after a 2-day shut-down and further dropped by 24% to reach its lowest valuation in 11 years.
Moreover, a shut-down becomes particularly unnecessary when remote trading is possible with modern technology, and hazards of being physically present at a stock exchange are limited.
CONCLUSION
SEBI has adopted an approach of carefully placed checks rather than extreme measures. For example, some European economies imposed an outright ban on short selling for limited periods. SEBI’s approach on the other hand aims to balance maintaining market liquidity and natural price discovery vis-à-vis controlling volatility.
As said by Winston Churchill, never waste a good crisis. SEBI’s measured response, that is firmly rooted in practicalities of constant flux in markets, despite its wide powers, is an exemplar of the ideal approach to regulation in the time of crisis, and how not to waste it.
The Authors are Practising Lawyers in Delhi.