Regulatory mishaps seem to dog the Indian financial markets permanently

One way out is to give constitutional status to regulatory agencies with systemic importance, like in the case of CAG, and CEC

A great deal has been written about short sales in the last three weeks. Adani and Hindenburg aside, there have always been two schools of thought concerning short sales.

One school believes that they are evil. The other thinks the opposite that they are good. Those who think they are bad point to the moral dimension. How can you disfigure a house and then buy it when its price falls — to pocket a profit?

Those who think they are good say that the disfigurement is not disfigurement at all. It's just a way of helping people discover the "right" price, which has been artificially bloated.

Although speculation happens in all markets, short sales, or shorting, happens almost exclusively in the financial markets. Basically, you sell shares or other financial products that you don't own.

In whimsical financial markets, where narratives take precedence over numbers, it doesn't take much to fan fears about bad governance and beat down a share. When the price falls, you buy the same share at a lower price to make good your sale. You thus end up wealthier.

And that's precisely where the problem lies because the promise of fat profits creates an incentive to influence the future price artificially. Arguably, this is true of long trades as well, where you buy shares on the margin.  

But the risk in short sales is higher, which is why the incentive to bring down the price is greater. A short seller has a much shorter window for his bet to work. It's this asymmetry, and incentive to gain from it, that no one has been able to address.

There's an argument that short selling helps correct the prices of overpriced financial products. But the question no one asks is if it should be left to a market participant with a vested interest in future prices. It's like asking the fielding team in a cricket match to use its players as umpires.

That's why if there's an overvaluation problem premised on fraud or misgovernance, it's for the market regulator to fix. In the Adani-Hindenburg episode, SEBI should have indicated to the market in whichever way the shareholding or valuation didn't pass its smell test. That alone would have led to a correction rather than the rout we have seen.

Indeed, the fact that the mutual funds stayed away should have alerted Sebi, and it could have alerted the markets in a dozen different ways. But because it didn't, it allowed an American short seller to play the market.

The irony is that Adani stocks are not widely held. In fact, it's this aspect that Sebi should have looked into if it is keen to enforce its own rules regarding minimum public holding of 25 per cent.

But Mr Adani can and will look after himself. So we need not concern ourselves with his travails. Our concern should be with the regulatory mishaps that seem to dog the Indian financial markets permanently.

There can be only three conclusions about why this is so: incompetence, venality or both. This is the problem that needs to be addressed. But can it be done when venality and incompetence are so utterly pervasive?

One way out is to give constitutional status to regulatory agencies with systemic importance. This is why the CAG, the CEC, the judiciary, etc., function much better than the other regulatory agencies.

We also need to adopt the participatory method for appointing all regulators that the Justice Venkatachelliah Committee had recommended in 2002 for appointing judges. That bill was ready but could not be presented because parliament was dissolved early.