The Indian stock market has tumbled more than at any time in recent memory. At its worst, the decline was about 50 percent from its highs. This was the largest decline of any broad based (tech and non-tech) index in the world. And it occurred after, and despite, what was universally acknowledged to be the best budget since Manmohan Singh’s budgets of a decade earlier. If fundamentals are of any relevance to stock markets – as they should be – then the behavior of Sensex, post-budget, cries out for an explanation. And simply saying that the Indian market was following bearish world trends just does not wash. Because by declining the most, we far exceeded, by a non-trivial margin, any derived trend.

The Indian investor feels cheated by the system. Should she? Yes. But we should be grateful for our extraordinary losses - for because of these losses, it is likely that the feudal Indian stock market will soon become capitalist.

What did the system do wrong? If the father and son (F&S) combination of the Ministry of Finance, and the regulator, SEBI, is to be believed, the system failed because (i) we did not have rolling settlements and (ii) the carry-forward mechanisms (badla) did it! As usual, F&S are applying band-aids, and since blood is overflowing, they are only able to target the approximate area of the wound. The wound is likely to heal on its own, and F&S will vainly take credit for their "solution". Until the next "accident". And the next band-aid. And the band-aids will run out - then F&S will decide to ban the occurrence of all accidents. By banning the stock market. No money for stocks, all the money for financing the fiscal deficit. Sort of like a small savings scheme, nee scam.

So what needs to be done to heal the patient and approximate a state of the art stock exchange system? Very little! Because most of the requirements of a modern stock system will soon be in place. A modern stock market has two legs - a cash for delivery market and a speculative, margin, market. In a cash market, an investor buys or sells shares, and puts in or receives cash for the amount of the transaction. There are several desirable elements, however, to this "simple" transaction. First, it is preferable to have paperless transactions. The completion of demat (paperless trading) is a major SEBI achievement. Second, ex-post that there be no anonymity in the market place i.e. after a transaction is complete, there is a trail leading to the buyer and seller. This is not possible if a person, or firm, is able to open multiple accounts in multiple names. Fraud and insider trading can more easily be identified in a transparent system. The regulation in this regard has been in process and by August 2001, it should be complete.

Third, investors should be able to trust the exchange through which transactions are taking place. This trust becomes difficult if the stock brokers and the exchange are one and the same. Something like the broker being both the umpire and the bastman, and when he so decides, the bowler as well. If that sounds like a terribly stupid (albeit funny) idea then sit back and recognize that has precisely been the situation for the last 100 years in India with the feudal Bombay Stock Exchange. These landlords have resisted every change, as they should, given their pedigree, and their self-interest. The delinking of exchange management from ownership (demutualization) of the BSE is now, thanks to the stock market crisis, in process. (Though don't be surprised if the BSE pulls off yet another miracle in its favour by derailing the process; after all, they have succeeded for a 100 years).

Finally, in a cash market, "rolling settlements" are desirable. Why? Every capital market in the world (including the as yet unveiled plans in North Korea and Cuba) has rolling settlements. But that is not sufficient reason. Sufficiency is provided by the fact that rolling settlements considerably lower transaction costs. Brokers and exchanges cannot profit from owning shares/money in transit before settlement. Such profiting can involve mischief. Remember Harshad Mehta in 1992?

The second pillar of strength of a well-functioning stock market is speculation. All stock markets require liquidity, and speculation means liquidity. Speculation is made possible by leverage i.e. margin buying and margin (short) selling. Margin buying is putting up say Rs. 25 to buy Rs. 100 worth of stock. Investors are the engine, but speculators are the oil that helps keep the engine running efficiently. Very soon, we will have an engine worthy of a Ferrari, but the oil that is used is mitti ka tel. Hence, the periodic, and ever so predictable (except to F&S) accidents.

For every transaction, there is a buyer and seller. Speculative transactions require a buyer to borrow money for purchase and a seller to borrow money in order to borrow shares to (short) sell. Both the buyer and seller are borrowing money and both should pay the interest on the funds borrowed. The two are indistinguishable sides of the same coin. Simple and straightforward. But not so in badla India where a short-seller speculator receives funds! Let me see - I do not have an asset, I borrow shares to accommodate my short-selling, and I get paid a financing charge for doing so!

So what reforms are needed to make speculation transparent, and the system efficient? The exchange is the intermediary through which buying and selling of forward contracts takes place. (It already is). Stock lending by all the owners of stocks is allowed. (It already is via the custodians). All market participants should be able to lend money to the exchange, in return for which they get a return, to finance the expenditures of the buyers. This at present is not allowed i.e. banks, mutual funds, are not allowed to lend money for badla financing. Don't ask why - as a regulator once told me, do not ask for a logical explanation for babu rules if you want to change the rules.

In simple terms, the only reform that is needed, in addition to rolling settlements, is as follows: all market participants are allowed to either lend money, or lend stocks, to the speculators buying, or selling, on margin. The intermediation is done through an exchange which undertakes all transactions for a small fee. And both buyer and seller pay identical charges for borrowing money, or stocks.

The real explanation behind the prohibition of bank involvement in the financing of forward (badla) transactions is that some people gain from the excess returns achieved by this distortion. Who might these be? Obviously the existing rent-seeking financiers in badla transactions - corporates, brokers with large girths (also called fat cats), and the short-sellers who receive something for nothing. The three are often the same. And they are influential. Influential enough to stop all reform attempts.

Indeed, the above reforms were proposed by the SEBI appointed B.D. Shah committee two years ago. But investors were never allowed to see the light of that report. Today, when the crisis foreseen by the Shah committee has occurred, what do F&S do - offer a leaky band-aid solution - ban forward contracts, introduce stock futures and never mind that the two can be rigged in the same manner.