THE BADLA SYSTEM Introduction When a bull market is gaining hold and when shares prices are expected to reach dizzying heights, the one common refrain among the small investors is the lack of alternatives for multiplying returns through leveraging one's investment. The question often arises when one has the capacity and standing to mobilize funds for investing in the market and one is looking for a systematic investment avenue.
We have heard of "options", "futures", and the even more exotic "derivatives", all of which help in increasing o ne's returns many times over if used correctly. The sophisticated derivatives which are in existence abroad developed from the commodity markets there. In India, sophisticated financing techniques existed in our commodity markets for centuries, long before the concept of options came into existence abroad.
With the beginning of the stock markets, many of these techniques which closely approximated options and futures came into our financial markets and the even more exotic "derivatives" thrived till they were banned in the '60s. One relic from those times still exists - the much maligned but still useful - badla financing. Badla can be useful for an active investor if he wishes to leverage on his investments thereby multiplying his returns.
The concept of Badla: Badla, in common parlance, is the Carry-Forward system which means getting something in return. The badla system of transactions has be en in practice for several decades in the Stock Exchange, Mumbai. The badla system serves an important need of the stock market. If an investor feels that the price of a particular share is expected to go up or down, without giving or taking the delivery he can participate in the possible fluctuation of the share. Financing in Badla, in effect, has two aspects to it, namely n amely
1. Seedha badla or Vyaj badla- Here the financiers participate 2. Undha badla - Here the stock lenders participate.
What is Badla? In the badla system, a position is carried forward, b e it a short sale or a long purchase. In the event of a long purchase, the market player may want to carry forward the transaction to the next settlement cycle and for doing this he has to compensate the other party in the contract .The 'seedha badla' financier enters into the system to lend money to the market player for a return. This is measured as interest on the funds made available for one settlement cycle, i.e. one week or a longer period in case of book closure badla system. Similarly 'undha badla' or contango charges are returns paid by the stock borrower to the stock lender. In a short sale, when the market player wants to carry forward the transaction to the next settlement cycle, he has to borrow the stocks to compensate the other party in the contract. The charge paid on the borrowed stock is called contango charges.
How is Baadla done ? On every Saturday in the Stock Exchange, Mumbai, a badla session is held. The scrip in which there are outstanding positions is listed along with the quantities outstanding. Depending on the demand and supply of money, the carry forward rates are determined. If the market is over bought, the demand for funds is more and the badla rates tend to be high. However, when the market is oversold , the badla rates are low or even reverse i.e. there is a demand for stocks and the person who is ready to lend stocks gets a return for the same. This is known as the undha badla. We can use an example to illustrate the concept of badla trading. You have purchased 100 shares of INFOSYS for Rs 7000, which is trading at Rs 7180 in the market at the end of the trading session which runs from Monday to Friday in BSE. You feel that the stock price will rise further. Therefore you wish to carry the contract forward to the next trading session by paying what are called badla charges. In any badla transaction there are two key elements, the hawala rate and the badla charge for the scrip. The badla charge is the interest payable by the investor for carrying forward
the position. The badla charge, as explained earlier, is market determined and primarily dependent on the supply of funds for financing a share. It is fixed individually for each scrip by the exchange every Saturday and it is calculated on what is called the hawala rate.The hawala rate is the price at which a share is squared up in the current settlement and carried forward into the next settlement in the next trading session. The existing position you have is squared up against the hawala rate fixed and carried forward after factoring in the badla rate. The difference is paid to your broker or received from him.
You have purchased 100 shares of INFOSYS at Rs.7000 in the current settlement and you wish to carry it forward to the next settlement. You have indicated to your broker that you wish to carry forward the transaction. The hawala rate is fixed at Rs.7180 and the badla rate say is fixed at Rs.24.23 for the settlement usually a week. The badla charge works out to an annualised rate of 18%, but badla is usually denoted in actual cash terms. In this case, the badla charges accrues to the investor. If the hawala rate is lower than the initial rate, the difference has to be paid to the broker.In actual practice, your broker will request you to maintain a margin for arranging the badla finance.
There can be other charges too and it can vary from broker to broker. All the charges apart from the badla charges depend on your relationship with your broker. The amount of leverage you get, effectively, depends on the margin insisted upon by your broker. If your broker insists on a 25% margin, you get 400% leverage or four times the amount you are ready to deposit as margin. At the end of each settlement, you carry forward your position at the hawala rate. This position will also be adjusted for badla. You can carry forward the transactions for settlements.
The use Badla to leverage one's positions? The concept of badla can be works as follows: Suppose you purchase 100 shares of HDFC Bank for Rs250, and the stock closes at Rs260 at the end of the trading session. You feel that the stock has potential to rise further in the coming days and you would like to hold the shares, however you do not have funds to pay the price and take delivery. The way out is to enter into a badla transaction, which your broker will carry out on your
behalf. Thus on Saturday during the badla session the market will arrive at a rate at which the financiers are willing to lend you funds to carry forward your HDFC Bank position. The funds that the financier supplies will be passed on the seller who is not aware that the shares he has sold in the market have not been delivered but are outstanding. In any badla transaction there are two key elements namely the hawala rate and the badla charge for the scrip. The badla charge is the interest payable by the investor for carrying forward the position. The badla charge, as explained earlier is market determined. It is fixed individually for each scrip by the market every Saturday and it is calculated on the hawala rate. The hawala rate is the price at which a share is squared up in the current settlement and carried forward into the next settlement in the next trading session (hawala entry is akin to a journal entry passed in double entry system of accounting). The existing position you have is squared up against the hawala rate fixed and carried forward after factoring in the badla rate. If the stock where you have decided to carry forward your position (either long or short) is very high you end up paying high badla charge consequently if the demand is low the badla rates are low. Say the 100 shares of HDFC Bank that you had purchased at Rs250 in the current settlement, which you now wish to carry forward to the next settlement. The hawala rate is fixed at Rs260 and the badla rate is fixed at Rs.0.85 for the settlement, which is usually a week. The badla charge works out to an annualized rate of 17%, but the badla is usually denoted in actual cash terms. Your purchase rate 250.00 Hawala rate 260.00 Difference 10.00* Add Badla charge 0.85 Carried forward rate 260.85 *(Accrues to the investor in this case. If the Hawala rate is lower than the initial rate, the difference has to be paid to the broker). In actual practice your broker will request you to maintain a margin for arranging the badla finance. There can be other charges too and it may vary from broker to broker. All the charges apart from the badla charges depend on your relationship with your b roker. The amount of leverage you get effectively depends on the margin insisted upon by your broker. If your broker insists on a 20% margin you get a 500% leverage or five times the amount you are ready to deposit as margin. At the end of each settlement you carry forward your position at the hawala rate and it is adjusted for badla. You can carry forward the transactions for settlements.
For the lay investor, badla offers another opportunity for investment - as a badla financier. This scheme offers an annual return of close to 18 to 24 per cent, which eventually works out to 16 and 22 per cent after deducting brokerage. As a badla financier you provide finance to the person who wants to take badla. As a badla financier, you are not required to take any risk of bad delivery or forged and fake shares or for physical mishandling of shares. No tax is deducted at source for the interest you receive, and in terms of liquidity you receive your money back on the 11th day from the Friday of the week in which you inform your broker. The shares against which finance is given are kept in the custody of the clearing-house of the Exchange.
However, the mechanism of badla financing can be a bit complicated when bonus, rights, dividends are declared or when books are closed. Therefore it is always advisable to understand the process fully before venturing into this area. It is meant for active investors with a speculative bend of mind. This automatically implies a certain capacity to bear losses.
Drawbacks More than speculation per se, there are a couple of things that always bothered lay investor about the way the carry forward system or "badla" worked. The most worrying was the uncertainty about the interest (badla) rates, in ad dition to the uncertainty of the share price movement - especially since these appeared to have little correlation. Badla rates vary widely from week to week, and even in the same settlement. If the investor knew a-priori what the carry-forward rate would be, then the investor could calculate the risk-reward equation much better. My second problem was the duration of the carry-forward. One week is too short for the investors liking. For instance, in today's depressed market the investor might be willing to take a call on Infosys or HLL six months down the line, but one week is impossible. Of course, this is born of my personal investment style, but the point is that the instruments should allow for long (or short) positions of varying periods. In recent weeks, we h ave seen a barrage of articles defending the badla system, and condemning SEBI's action in proposing to ban carry forwards. Though academics and experts agree that derivatives are the best long-term
solution, market-men disagree. Their arguments centre on the immediate impact of the ban. The crux of the problem is that trading volumes will collapse. This will impact not only traders, but also investors who will suffer due to po or liquidity. Needless to say, the worst affected will be the financial community (brokers) - whose business will dwindle considerably. The unwinding of long positions will also cause a near-term crash (already underway). As usual, critics and vested interests are calling for a "rollback". Some of them have even gone on to criticize futures and options, saying they are too complex, and will take a very long time to catch on. In this context, the lack of popularity of index futures in India is cited as proof of their unsuitability. Investors agree with the idea that speculation is a must for healthy markets. However, the system must be transparent and fool-proof, which badla is not. In the recent past, operators have succeeded in manipulating carry-forward positions through internal transactions. The source of funding for badla is never clear, and much is dependent on the ability of speculators to arrange financing. This could conceivably come from their own pockets, allowing them to ensure that interest rates are lower than gains in any particular scrip. As for volumes, they will be definitely impacted - but for all you know, this could provide a much needed boost to the B group stocks currently languishing for lack of interest. A market with 6000 scrips, of which only 200 are actively traded, is not a healthy sign. Typically, since inclusion in the forward category is decided on the basis of volumes alone and by people (BSE members) who might have vested interests, the system encouraged market operators. The lack of success of futures is not conclusive, as one could argue that they haven't taken off because the financial community has a vested interest in keeping badla alive. The lack of investor awareness about the new instruments is also not a valid reason to delay options, as Indian traders are smart and will pick up the nuances quickly enough, especially if they have no other option (pun intended). To the investor the major issue right now concerns SEBI's implementation tactics, which definitely leave much to be desired. Rather than a blanket ban with almost no notice, a well-defined transition period would have been more appropriate. Though badla is slated to end next month, we still don't have a clear timetable for introduction of options. Actually, this is where SEBI should be far more proactive and ensure that options for hundreds of scrips become available, and quickly. However, taking a long-term view, one
must recognise that the switch to derivatives is inevitable. It is probably better to do it now and get it over with, than to postpone the birth pains.
Badla grossly misused in capital markets: JPC Capital market experts deposing before the joint parliamentary committee probing the stock scam said on Friday that badla system as practised in the country has been grossly "misused" leading to total erosion of small investors' confidence in the bourses. Briefing newsmen on Friday's proceedings, JPC chairman, Shriprakash Mani Tripathi said two experts, S C Gupta and Ajit Dey, former Calcutta Stock Exchange president, felt the badla system (forward trading) in India had a lot of scope for misuse, which the brokers took advantage of. Though the experts view on whether the Indian stock exchanges should have badla system or not was divergent, they were unanimous on the total misuse leading to erosion of investors' confidence particularly that of small investors, he said. The badla system was banned in the country from 1994 to1996 after the 1992 multi billion securities scam (Harshad Mehta). It was reintroduced after D R Mehta took over as Sebi chairman. It is now being banned from July 2 in the face of the recent stock scam. Banning of badla system, no doubt, reduces the volatility of the capital markets, but at the same time it grossly reduced the volume of the trading, Tripathi quoted the experts as saying. The experts were also critical of Sebi for not being alert and felt the market regulator had failed to take timely action to prevent the stock scam.
Modern version to replace badla
The Ministry of Finance has indicated to the Joint Parliamentary Committee (JPC) on the stock scam that it would work out a permanent and refined carry-forward system, instead of the earlier badla system which has been banned since July 2. ''Finance Ministry officials informed us that they have held detailed discussions on the
issue and that the badla system would be curbed in its original form and a more modern system would be ushered in,'' Chairman, JPC, Mr Prakash Mani Tripathi, said on Wednesday.
Come july the concept of badla will no longer exist but will still remain, albeit through a different mode that is more regulated and transparent. The two most important aspects of the new market would be rolling settlement and derivatives. Rolling Settlement: With rolling settlement in place, investors cannot undertake intrasettlement speculation as they have to settle their acco unt at the end of each trading day. This will invariably bring down speculation in the spo t market. Therefore, liquidity dries up.
