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January 18, 2000

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Perils of badla financing

Murali Iyer

Do you think you really earn 20 per cent returns on badla financing all the time? Do you think that such a return is risk-free? The answer is no for both the questions. The truth is that badla is a complex system that contains many a pitfall for the uninitiated and the unwary. Investors need to be aware of the problems, especially when brokers on BSE and other regional stock exchanges are marketing vyaj badla schemes to their clients aggressively.

Before you start believing in the stories of superlative returns (in excess of 20 per cent), coupled with liquidity, safety and flexibility, it is imperative that one takes a hard, rational look at the entire mechanism. This is so because financing badla is a definite no-no for the first-time investor in the stock market and also for those who don't have the time to constantly monitor the status of his/her investments and fluctuations in the market.

Returns
In the vyaj badla system, there is a very high chance that you may end up with an average annual return of 14-18 per cent or sometimes even higher. But having said that, unfortunately, the returns are not guaranteed. This rosy picture could well be a reality during a bull run, but when the market is under a bear hug, returns could diminish to just around 6-8 per cent a year. Compare it with a steady 12 per cent annual return offered by a bank fixed deposit or any AAA rated corporate bond. The high-risk and uncertain return of vyaj badla would start looking like a bad investment option.

And then the taxman cometh! Vyaj badla transactions are treated as purchase and sale of shares, thus getting subjected to capital gains tax of 30 per cent. Thus, your final returns get lopped off to that extent. Although naysayers might feel that vyaj badla provides an investor with an opportunity to maximise his earnings in a bull market, the fact remains that it is a good option for the experienced investor. Else, the nerve-wracking tension that accompanies stock market fluctuations may well take its toll.

How does the system function?
Assume that there have been 12 trades of 100 shares each in "ABC" stock, and there are 12 separate buyers and sellers respectively. Among the buyers, while six want to carry forward their positions, six want to take delivery. Of the sellers, eight wish to deliver the shares while four are keen on carrying their positions forward. Now six buyers make the payment for their purchases, while eight sellers effect delivery. Six buyers and six sellers get squared off. Four "buy" carry-forward positions get matched against four "sell" carry-forward positions.

To ensure payment to the remaining two sellers for their 200 shares, vyaj badla financiers come in. This financier charges interest (badla) for the money paid on behalf of the two buyers for them. The demand and supply of funds and shares determine this rate. Shares delivered by the seller are kept by the exchange in the clearing-house and allocated to the financier's broker in a special account, forming the financier's collateral.

On the BSE, brokers who are sure of taking or making delivery of shares mark their respective "for delivery" positions. This helps the exchange to arrive at the net outstanding positions on Friday evening (the last day of the settlement on BSE), by deducting them from the broker's weekly outstandings. The difference is thrown open to the market's badla trading session on Saturday. Nowadays, the entire session is automated and is conducted on the trading screens of the brokers.

Prior to the commencement of this session, the base price (hawala rate) is fixed, which is normally the closing price of the scrip on Friday. An outstanding "buy" position in a stock sees a "seedha badla" where the financiers participate. An outstanding "sell" position in the stock sees an "ulta" or "undha badla" where the stock lenders participate. Specified quantities of the stock on offer are bought and sold at the financier's desired interest rate - the badla rate.

In this case, let's assume the hawala rate to be Rs 69. If the financier wants to pay for 100 shares at 20 per cent per annum and the trade gets matched, the interest rate is converted into a weekly figure. In this case, it would be 0.38 per cent. On the hawala rate of Rs 69, this 0.38 per cent works out to 26 paise. The terminals would constantly keep flashing the best badla rate and the best annual yield for each stock on offer for a particular quantity. A constant fluctuation in these values during the two-and-a-half hour session is due to the constant change in demand and supply, and also market perception. The broker would give the financier a badla bill or informal contract note, which would have two entries. One would show a purchase of 100 shares at Rs 69 per share, while the other would show a sale of 100 shares at Rs 69.26 per share. The difference will be the financiers earning for that week. With the next trading cycle ending, the financier can either receive the difference or roll over his/her money to a new badla transaction.

Who can participate?
Not all brokers can participate in the badla process. Memberships on BSE are split between type-I and type-II brokers. Only the former can carry out badla trades, for they maintain higher margins with the exchange. Hence, if you are keen on becoming a vyaj badla financier, you should approach the type-I broker.

Most brokers don't accept anything less than Rs 1 lakh per client for badla financing. And the stock selection too is at their discretion. But it would be prudent for you to know the basis of allocation of stocks to you, as you would be one among a lot of clients whose money has been collectively invested in vyaj badla. Badla rates vary between stocks, depending upon their demand and supply. These rates fluctuate considerably throughout the session.

Ideally, brokers using the discretionary allocation of stocks to the badla account should pay a weighted average return to each client. This should be reflected in the badla bills. For getting the weighted average return on badla finance, it is advisable to look for brokers who have automated this process.

As in any other market transaction, one cannot avoid brokerage in a vyaj badla transaction too. Brokerage for such deals could range between 1-2.5 per cent, trimming down your annual yield further. It is advisable to enter into a firm brokerage percentage prior to the commencement of the relationship.

Are you safe?
What is your safeguard in times of default? If the forward buyer defaults, you get the shares held in the exchange's clearing house against your broker's name, on which you have a lien through your badla bill. But you risk erosion in the value of the share during the days that it takes to release the shares.

In the recent history of BSE, there have been instances of brokers (having large carry-forward positions in highly speculative stocks) defaulting. Although these shares were enjoying very high badla rates at the time of the default, the prices had dipped sharply by the time the financiers got their shares.

If the broker defaults, the financier is in a larger mess. Apart from the large institutional brokers, most brokers on BSE have a net worth of Rs 1-2 crore. Badla positions taken by them sometimes go up to 15-20 times their net worth. Even a 10 per cent downward shift in their position would wipe out the broker's entire net worth. And then you could bid goodbye to your money too. The BSE's Trade Guarantee Fund could be of some succour and solace in these situations, but just that.

Failure to cash in on your interest gain at the end of the trading cycle gives the confidence to your broker to automatically roll over your investment to the next cycle. While opting out, always time your exit. By virtue of the exchange's settlement cycle, your money gets released within a ten-day period. This further reduces your yield.

As in the case of defaults, the delay in the release of your money can be detrimental. So factor in those extra days while calculating your actual return. Although vyaj badla is considered to be an effective short-term instrument, as is the case with all such instruments, the delay can really eat into your returns. Given the quirks of the vyaj badla transactions and the inherent risks involved, it can be concluded that amateurs should stay away - it is strictly for the pro and the strong hearted.

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