Economists have a simple theory to explain every problem. Hence, after the Securities and Exchange Board of India (Sebi) exposed the rampant misuse of the depository system to corner shares reserved for retail investors, they said the answer is to eliminate market inefficiencies by scrapping the retail quota.
They pointed out that while institutional quotas were subscribed many times over, the over-subscription in the retail segment was much lower. The fact that there was a higher probability of receiving an allotment through the retail segment creates a distortion and tempts large investors and financiers to make multiple retail applications through benami accounts. The allotments are then aggregated by transferring the shares before these are listed.
This theory ignores the fact that the “distortion” is not in the retail quota, but in the fake over-subscription of the segment reserved for Qualified Institutional Buyers (QIBs). A system of discretionary allotment and the absence of margins for institutional investors led to the formation of neat cartels (among investment bankers and their large clients) and the deliberate drumming up of over-subscription within minutes after issue opening. This distorted IPO subscription and pricing, misled retail investors and sent false signals regarding the probable listing price on the secondary market.
The distortion caused by discretionary allotment was acknowledged by three different Sebi-appointed committees. Even then, it was a tough job for the regulator to ignore powerful pressure to not scrap the discretionary allotment in the institutional segment. Institutional investors, much to their chagrin, have also been asked to pay an upfront margin to discourage bubble subscriptions.
The IDFC issue, which is now being examined in connection with the IPO scam, was the last to be allotted by the discretionary allo-tment method. Over-subscription in the institutional segment has fallen substantially in subsequent issues, signalling that one market distortion is partly corrected. In order to create a truly level playing field, it is not enough to eliminate the reservation for retail investors, but also bring institutional and retail investors on par in terms of margin and payments. This may be resisted by institutional investors and investment banks on the grounds of “international” practice and because our IPO process tends to block funds, which is unacceptable to foreign investors.
One solution, proposed by an economist, is to use an electronic auction to place an IPO through stock exchanges. This will allow retail and institutional investors to bid on the same screen and fix the price. This sounds perfect in theory, but there can be several distortions in this process too. We are justifiably proud of our automated trading system that allows people across the country to participate in a single order book; yet the system is completely biased against the retail investor. It is also increasingly evident that the inadequacy of market infrastructure has forced several unhealthy compromises. First, there aren’t enough Depository Participants (DPs), especially in smaller towns and city suburbs. This forces investors to rely on brokers by signing over a Power of Attorney (POA) allowing them to operate their DP and bank accounts. A growing number of investor complaints have recently exposed the dangerous extent of this risk.
• Abolishing retail quotas won’t help, as the distortion wasn’t caused here
• The DP system is loaded against investors; much needs to be addressed
• Sebi must move to an automated IPO process only after fixing these issues
Second, the DP system is also loaded against investors and the regulator has made little effort to answer niggling issues such as high charges, the absence of standardised POAs with clear rights and responsibilities on the part of investors and intermediaries and the problem of defunct company shares, where custody charges are often higher than the quoted share price and investors are stuck making payments on dead investments. Third, the IPO scam itself has shown that retail investors aren’t exactly rush-ing back to the capital market, the growth in demat accounts was mainly due to fraud. Fourth, although retail investors seem to be investing through mutual funds in a big way, it would be foolish to shut out retail investors until mutual funds prove themselves through a bull and bear cycle.
Finally, market prices and trends are already dictated by Foreign Institutional Investors (FIIs) and we do not have enough Indian institutional investors to provide a proper counterbalance. Any move that seems to devalue or shut out retail investors, who add volume to a narrow and illiquid market, will increase distortions instead of eliminating these. A raging bull market is not the time to rush for quick-fix solutions without studying the problem more carefully. Sebi has done well in unearthing the IPO scam, eliminating distortions in the institutional subscription process and has zeroed its attention on stock exchange and depository systems and procedures. But it must now focus on other systemic issues. For instance, it must protect investors by examining and standardising the documentation forced on them by brokers; this includes unfair, unsafe and one-sided POAs. Simul-taneously, Sebi must find a way to eliminate fee and payment distortions that have made some intermediary businesses such as DPs and R&T services unattractive and prevent the spread of the equity cult across India.
If anything, the IPO scam has shown that a machine, however powerful, has no native intelligence. It may be incredibly fast and efficient and create clear audit trails, but it does not increase transparency without a proper design and the right algorithms to catch irregular trades and shady activities. Sebi can move to a more sophisticated and automated IPO process only when it has fixed systemic issues and distortions that have already been detected.