5.6 Market Manipulation

The 1990s have seen a number of episodes of alleged market manipulation in the equities
market. Shah and Thomas (2001) identify eight significant episodes of alleged market
manipulation during the 1990s in the Indian stock markets. There can be some difference of
opinion on how many major market manipulation episodes have taken place because there is
a tendency among Indian policy makers to regard a large price swing as market manipulation
even if it is only a speculative bubble or even if it is justified by fundamentals. Nevertheless,
there is no denying that many of the episodes enumerated by Shah and Thomas do provide
cause for concern.
In my view, the single most important culprit for the frequency and severity of such episodes
is the strong restrictions on short selling that exist in India. All institutions (including banks,
financial institutions, mutual funds and foreign institutional investors) are prohibited from
short selling in the Indian capital market. This restriction has been in place for a long time,
but the restriction has become more serious with the progressive institutionalisation of the
capital market in the 1990s. Over a period of time, therefore, an increasingly large and
important segment of the market has been precluded from short selling. Moreover, at various
critical junctures (most recently in March 2001), the regulators have moved to impose a total
ban on short selling by all investors.
To understand why short selling restrictions are so important, we must first note that almost
all the episodes enumerated by Shah and Thomas involve alleged attempts by the companies
and their promoters to rig up the share prices of their own companies. In a free market, the
most powerful weapon against such attempts would be aggressive short selling by rational
investors. In the presence of short sale restrictions, however, the best that rational investors
can do is to sell all their holdings. Once they have done so, they make no further contribution
to price discovery. Market prices are then determined by the alleged manipulators and less
rational investors (momentum investors and passive /indexed investors). It now becomes
evident that short sale restrictions constitute an open invitation to promoters and© Centre for Civil Society, http://www.ccsindia.org. All Rights Reserved.
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managements to rig up the share prices of their own companies. Perhaps inadvertently, the
regulatory regime has come to fulfil the fondest dream of these market manipulators.
Even if it were argued that some of these episodes are non-manipulative market crashes, short
sale restrictions would be an important explanation for their number and severity. Recent
studies in the United States (Hong and Stein, 2001) argue that short sale restrictions in that
country are responsible for the high frequency of market crashes there. The mechanism is the
same as that described above – short sale restrictions prevent rational bearish investors from
contributing to price discovery in the build up to the crash. These studies are all the more
important because part of the justification for short sale restrictions in India is derived from
the fact that the United States has similar restrictions. It is often forgotten that the United
States introduced these restrictions as a misguided knee jerk reaction to the great depression,
and has merely persisted with that mistake. More importantly, if our markets are more
susceptible to market manipulations than the US market, we should move more aggressively
to remove these restrictions and pro-actively facilitate short selling.
In the United States itself, the scandals surrounding the bankruptcy of Enron have tarnished
the reputations of the Securities and Exchange Commission (SEC), the Financial Accounting
Standards Board (FASB), the auditors, the rating agencies, the analysts, the boards, the
financial press and almost every other element of the regulatory regime. The one group that
has come out with flying colours is the lowly short seller who kept pointing at the skeletons
in Enron’s cupboard when everybody else was intent on turning the other way. It is now
apparent that even the United States would therefore benefit from relying on the market
forces represented by the short sellers to police its markets.
Another important factor is the unwillingness of the stock exchanges and the regulators to
embrace modern software tools for market surveillance and investigation. Despite a longstanding effort to implement stock watch systems, the stock exchanges have yet to make
these systems fully effective. Most of the investigations into alleged market irregularities also
fail to embrace the tools of information technology. There is a large pool of software talent in
the country that could develop modern neural network and artificial intelligence tools that
could leapfrog the best in the world. This has not happened.
There has been a tendency to imitate the US model of market surveillance without
recognising that within the US itself, there is considerable disquiet about the model. This was
true even before the Enron scandal. As Oesterle (2000) points out in an incisive analysis:
“Although the U.S. securities markets are the world’s largest and most liquid, it does not
follow that the regulatory system has been an unqualified success. Strong economic
fundamentals have created and sustained financial markets, not NYSE policing of its
floor traders. … A fairer assessment is that the SRO regime has proved to be barely
adequate at best. … During quiet periods, the SEC largely relies on SROs to police
trading floors, and it routinely approves SRO rules and disciplinary decisions. In other
words, the SEC during such periods tends to be lazy and complacent. When a scandal
breaks in a trading market, there is embarrassment and handwringing over why the
exchange involved was not more vigilant in disciplining its members. The exchange
contritely proposes minor rule modifications, often at the SEC’s insistence, leaving the
exchange’s functions and membership largely intact. The SEC approves the changes and,© Centre for Civil Society, http://www.ccsindia.org. All Rights Reserved.
20
with some fanfare, the regulators and the regulated hail the virtues of the SRO system—
until the next scandal. In recent years the SEC has not been able to resist the temptation
to tinker too much with the rules of the exchanges. But the illusion that the SEC is
guaranteeing the integrity of exchanges removes an incentive for the exchanges
themselves to exercise diligence, lest they lose their customers. And customers are lulled
into a false sense of security, believing the SEC is closely policing the day-to-day
activities of the exchanges.”
There is a need to rethink the entire dirigiste model of regulatory surveillance and rely more
on countervailing power in the market place. Abolition of short sale restrictions is one way of
bringing countervailing power to bear. Another important step is greater transparency and
disclosure. Using modern artificial intelligence methods it should be possible for the trading
system to automatically generate alerts about suspicious trading patterns and price/volume
trends. Rather than feed these alerts to a set of error-prone human surveillance officials (with
potentially perverse incentives), these alerts should be publicly disseminated. By doing so,
the information is placed in the hands of those who have every incentive to take corrective
actions. If an automated surveillance alert indicates possible bear manipulation, the bulls are
immediately forewarned to protect their own interests. These forewarned investors become a
countervailing power to the power of the would-be manipulators. Such an approach would
reduce the role of human discretion and replace this discretion by the impersonal logic of
computing systems and free markets. This approach would also reduce the agency costs
associated with the regulatory approach. I would argue that India with its abundant software
talent is uniquely positioned to lead the world in such a process of development.