Saturday 19 November 2011

Rule of law & Dangers of changing laws with retrospective effect

Rule of law & Dangers of changing laws with retrospective effect

Hi folks! This particular post of mine may be of interest only to those who are actually dealing directly with share brokers, and are either actually involved in or contemplating an active involvement in the derivatives market - whether shares, commodities or foreign exchange.

Take a look at this letter written by a futures & options broker to her clients, announcing the closure of her business:

When a broking house goes bust, as MF Global did, the rule of law as we understand things involve a clear and categorical separation of the client accounts and client money from the proprietary account of the broker and his / her funds. Bankruptcy of the broker ought to involve freezing the proprietary account, but certainly the clients ought to be allowed to withdraw their funds.

Apparently, subsequent to the closure of MF Global in US, the clients are stuck in a situation where they can't

  • Withdraw any money owed to them
  • Close any open futures & options contracts

Even worse, there is apparently some talk of "clawback" rules being enforced. This implies that any withdrawal by clients that took place within a certain days before the demise of MF global may in fact be reversed. This is nothing short of crazy and a nightmarish situation.

The relevance to you and me in the Indian context:

  • The respect for the rule of law and ease of enforcement of contracts is even less in India than in US. You just need to ask your friends in legal circles specialising in taxation related matters. They would enlighten you about the number of occasions when the Indian Parliament has actually changed the laws with retrospective effect, so as to enforce their point of view after the courts of the land have passed judgements against the government. In many instances, due to such retrospective change in laws, corporate entities are known to have lost several crores of rupees.
  • Hence, if any of the powerful brokerage houses go bust, you can be rest assured that their promoters would be able to "convince" the powers-that-be to cancel out any number of inconvenient contracts pertaining to their clients. I would not be unduly surprised.
  • In fact, I vaguely recall a few instances (including during the recent Muhurat trading on Diwali 2011 in the BSE) where contracts were reversed because of reasons ranging from "technical reasons" to "wild swings in prices" to "suspicious nature of transactions"

I'm not for a moment suggesting that there should be a free-for-all in the markets. There ought to be rules. But those rules must be framed in advance, and enforced uniformly at all points of time.

As a small investor, you may have, for instance, watch the news item a couple of years back about the Satyam mess and seen the share price coming down crashing from around Rs. 200/= to sub-Rs. 20/= levels.

You might have chosen to take a calculated risk and done the following series of transactions:

  • Sold a couple of lakhs worth of blue chips from your portfolio to generate adequate margins to go short on Satyam in the futures market
  • Gone short on Satyam at Rs. 150/=
  • Covered your shorts at Rs. 30/=
  • Gone long again on Satyam at Rs. 8/= in the cash markets with just your profits as a long-term investment.
  • Used your initial capital to buy back your original blue chip stocks at slightly higher prices than the original price at which you had sold in the morning panic.

You would have been thrilled that you had the presence of mind to react to the situation and be happy about the several thousands gained during the course of a few hours.

  • If SEBI suddenly wakes up and decides that the price movement in Satyam was "abnormal" and all transactions pertaining to Satyam or
  • If your broker had gone bankrupt as it had a huge "long position" on Satyam on the day before, due to which all transactions through that broker during the preceding 24 hours were to be treated as "null and void" and you are not even allowed to withdraw the funds from your broker

Imagine your plight??? Who will compensate for your losses? This is precisely what has happened in the case of MF Global in US. I will not be too surprised if similar reactions are there in Indian markets under similar circumstances.

Some suggested precautions for you to take:

  • Choose your brokers very carefully. Don't go exclusively by "lower brokerage" promises. Ensure that you have a reliable and trustworthy broker, preferably backed by a huge financial institution (like HDFC Securities or ICICI Direct, for instance)
  • Unless your portfolio size is too small, split your business over at least two different brokers. In case of need, you'll be able to shift to your second broker at very short notice.
  • If you must deal in futures and options, ensure that your risk is "manageable". Obviously, your F & O exposure must not be more than the amount that you can financially and psychologically afford to lose.
  • With all the online facilities available, make sure that you don't leave too much of "liquid cash" with your broker. After all, whenever you do need to transact, nothing prevents you from transferring funds online to the broker as and when it is actually needed.

More than anything else, remember: It is your money. If you don't care for it, who will?

Regards,

N


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