Sucheta Dalal :Working around Sebi regulations
Sucheta Dalal

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Working around Sebi regulations  

Dec 13, 2004

‘Stock surveillance’ is not a legitimate business activity but it exists 

It is an interesting irony. Over the last four years, American stock market regulators have dug up so many dirty practices by their companies, mutual funds, stock exchanges and market intermediaries, that one begins to question the quality of regulation that is unaware of what is happening below its nose. Last week, Susan Pulliam of the Wall Street Journal reported that the mighty Securities Exchange Commission (SEC) was investigating the ‘stock surveillance business’ after CIBC Mellon Trust Co. reported that a legitimate ‘stock surveillance’ company had been offering inducements to its clerks (like cash payments and tickets to major hockey and baseball games) for passing on top secret trade information.

WSJ reports that SEC is now investigating this shadowy business of “gathering and selling real-time data about big investors’ stock trading transactions” that is so confidential and valuable that “a whole industry has sprung up around finding it out.” It involves putting together “small bits of trading data that can be gleaned through legitimate sources” to create a “perfectly legal” business model. But it is obviously supplemented by employing “improper means” to ferret out secret information.

Didn’t SEC ever suspect that ‘stock surveillance’ firms may be tempted to cross the line? Or that their information-gathering machinery may be mining data required by companies planning takeover bids, or speculators seeking to front-run large Funds?

In India, nobody runs a legitimate ‘stock surveillance’ business, but our stock exchanges are definitely aware of how brokers and large market operators work systematically at ‘breaking’ lower level officials and clerks at regulatory agencies to get access to price-sensitive information.

• Indians have created a parallel system which avoids legitimate trading

• Reducing tax provisions and lower tax-ation will encourage the legal market

In 1992, the late Big Bull Harshad Mehta had told us that one of his biggest stock breakthroughs happened when he figured out that Premier Auto’s militant labour union controlled the fate of that company. He befriended a union leader to get early warning about potential labour trouble and daily production data.

Many Indian brokers routinely ask their staff to befriend key officials to pass on market-sensitive data. For instance, it is an open secret that some firms get precise data on FII inflows before others. Similarly, employees at custodians and large mutual funds routinely ‘leak’ confidential information about clients.

Usually, they use the information for proprietary trading or pass it on to their favoured institutional clients as a value-added service. Many foreign companies have found, sometimes to their cost, that corruption is so pervasive that most confidential information routinely leaks into the public domain.

This means that Indian regulators have more to worry about, although ‘stock surveillance’ is not a legitimate business activity. Indians have figured out ways of working around market regulation to create a parallel system that caters to those who want to avoid legitimate trading systems, evade taxes or circumvent regulation.

Here are a few examples:

• There is sophisticated IT available with brokers and large traders who run illegal markets or dabba trading.

• Market sources say software is used to work permutations and combinations of application details for those who want to generate multiple applications to initial public offerings (IPOs).

• Many Sebi regulations are systematically circumvented. The head of a regional stock exchange reveals a simple trick employed to beat the ‘know your client’ rules requiring photo-identification of investors. Brokers have simply issued advertisements seeking ‘applications with photographs’ for BPO jobs. The response is generally in excess of 500 applications. The photographs are simply peeled off and stuck on to investor forms and end up providing a front for numerous shady operators. Will Sebi’s biometric identification eliminate this practice? No. Brokers will only use better technology to keep such transactions below Rs 1 lakh, or the market will simply move underground.

One way of reducing these practices is better supervision, but the market regulator is already over-burdened. The only real solution is to have drastically reduced tax provisions and significantly lower taxation that reduces corruption and acts as an incentive for citizens to operate in the legal market. The ministers and officials will be surprised at how much money surfaces. But can they bite the bullet?

-- Sucheta Dalal