Markets are always vulnerable to scams; regulators have to be vigilant

Stock market turnover runs into billions of dollars daily. Since big money is involved, the market is vulnerable to manipulation by scammers, fraudsters and rouge-traders. Even developed markets like the US have not been free from scams.

Bernie Madoff, the former chairman of NASDAQ, is now undergoing a 150-year sentence in prison for fraud. Nick Leeson, the rogue trader, single-handedly brought down the prestigious Bearings Bank. Financial history is replete with many instances of scams and frauds, which had profound consequences for the integrity of markets. In brief, markets are vulnerable to scams; therefore, the focus should be on pre-empting potential scams and mitigating their impact when they actually happen.

Harshad Mehta engineered the biggest stock market scam in India by diverting money from the banking system through banker's receipts. The scam led to a 50 percent crash in stock market eroding huge investor wealth. The regulatory system (stock exchanges were SROs - Self Regulating Organisations) failed to prevent the scam.

The BSE then was, to paraphrase Abraham Lincoln, "an exchange of the brokers, by the brokers, for the brokers". Harshad Mehta exploited the loopholes in the "badla" system and engineered an artificial bull run with the money siphoned off from the banking system. Absence of an empowered regulator, the monopoly of the dominant BSE, the "badla" system for carrying forward and absence of institutional checks and balances facilitated the scam.

The Harshad Mehta scam pressed the accelerator on the need for reforms in the capital market. Seizing the opportunity, the government introduced capital market reforms as part of the Structural Adjustment Program initiated in 1991. Sweeping institutional reforms like the setting up and empowerment of the SEBI and setting up of NSE (1994) revolutionised the Indian stock market.

Dematerialisation of securities (1996), online trading (2000) and compulsory rolling settlement (2001) substantially enhanced the efficiency and depth of the market. The opening up of the mutual fund industry to private players and allowing FIIs to invest in the Indian market deepened the market. But the reforms couldn't prevent scams. The Ketan Parekh scam (1998-2001) wreaked havoc in 2001. Capital market reforms and the regulator SEBI couldn't prevent the scam. Ketan Parekh was convicted in 2008.

But it has to be appreciated that capital market reforms have substantially benefitted the investors, companies and the economy at large. A decline in transaction costs has benefitted investors. Opening up of the mutual fund industry has enabled the growth of good private sector mutual funds and their investors benefitted. The entry of FIIs has deepened the markets and introduced modern best practices. Since funds invest in companies with good corporate governance standards, companies have been forced to improve standards. All these cumulatively facilitated the increasing financialisation of savings.

The sentencing of manipulators like the Ponzi-Scheme fraudster Bernie Madoff, 'the junk bond king' Michael Milken and the insider-trader Raj Rajaratnam happened in the most developed and largest stock market in the world – the US market. This means the market is vulnerable to manipulation. The regulator, the exchanges, stockbroking firms, mutual funds, in fact, all market participants have a responsibility for the smooth, efficient and healthy functioning of the stock market.

During the last 20 years, India didn't experience any scam. Even during the huge market crashes of 2008 and March 2020, trading happened smoothly reflecting the resilience of the system. The empowered SEBI, the demutualized exchanges, efficient electronic trading systems and the presence of large institutional investors – both domestic and foreign – have imparted strength and reinforced the resilience of the market. The eagle-eyed SEBI is leading from the front to regulate, develop and strengthen the market.

Even in well-governed societies with efficient police forces, crimes happen. Similarly, even with excellent institutional arrangement and state-of-the-art trading system, the markets are vulnerable. Therefore, eternal vigilance is the price of healthy markets.

(V K Vijayakumar, Chief Investment Strategist at Geojit Financial Services.)