Mis-selling: from impressions to evidence

by Renuka Sane.

Retail finance in India is once again in the news for reasons of fraud, this time in the form of the Saradha Group in West Bengal. There is a general sense that such schemes proliferate because of the failure of financial inclusion, and that better supervision by current regulators will bring us back on track. The problems of mis-selling however, are not confined to the unregulated chit-fund industry. For many years now, problems of consumer protection have been gathering prominence. While there is concern about the collision between hard-driving financial firms and the average unsophisticated investor, it has been over-ridden with the argument that the problems are minor, sporadic and over-stated by a sensationalist media.

Evidence on mis-selling

There may not be consensus in policy circles on the pervasiveness of mis-selling, but the incipient academic literature on the problems of consumer protection in household financial choice in India reflects otherwise. The following papers are of note:

  • Anagol and Kim (2010) study a 22 month period in which closed-end mutual funds were allowed to charge an arguably shrouded amortized fee whereas open-end funds were forced to charge standard entry loads. They find that inflows into the more expensive funds were much higher, and that investors paid approximately 500 million dollars in extra fees in this period.
  • Sane and Thomas (2013) discuss the failure of consumer protection in the micro-finance crisis in Andhra Pradesh in 2010.
  • Anagol, Cole and Sarkar (2013) conduct audit studies of insurance agents. They find that insurance agents overwhelmingly recommend products which provide high commissions to the agent and are unsuitable for the customers. This is exacerbated for customers who appear to be less financially literate.
  • Halan, Sane and Thomas (2013) study the lapsation in insurance policies after the introduction of unit-linked insurance plans (ULIPs) and find that investors lost more than a trillion rupees from mis-selling over the 2005-2012 period. This shows us that while chit funds are a problem in India, (regulated) ULIPs have imposed bigger losses upon households than (unregulated) chit funds.

These papers offer hard evidence about the problems of consumer protection across products and income-groups and establish that the magnitudes of money involved are substantial. It is not easy to now argue that the problems are sporadic and small and of second-order importance.

Weak regulation

These problems have not taken place in an environment of unregulated finance. The regulation in India is product oriented, focuses on form and not function, and places great emphasis on prudential regulation. While protection of customer interests is a key part of the mandate of all regulators, there is no framework on how to bring this about. Each regulator has its own procedures for licensing and registration of intermediaries, expected code of conduct, caps on commissions, grievance redress procedures. The focus is on inputs, and checking the correct boxes, and not on outcomes. This often leads to instances of regulatory arbitrage, or leaves open the possibility that several entities slip through the cracks and get regulated by no one regulator. The system does not clearly identify the rights of the customer, or place responsibility of outcomes on the distributor. There is no basic definition of whether a product is suitable for a specific customer and no standard to which distributors can be held responsible for what they sell. Once investors get duped into signing consent forms, redress seems unlikely. The evidence that the current redress systems are effective in providing relief to customers is also very weak.

Early regulatory responses

The response from Indian regulators has been in the form of policy changes that should prevent mis-selling that has been seen in the past decade. The key milestones are:

Each of these initiatives is an incremental response by a regulatory agency that became uncomfortable with the status quo. However, they do not add up to a comprehensive and internally consistent strategy for consumer protection, and they are not adequately rooted in law. One regulator has banned commissions for a product, while similar products are permitted to charge commissions under a different regulator. Various distributors such as banks come under far less scrutiny on distribution because they fall under a different banking regulator. SEBI regulations on investment advisors do not apply to agents who provide advice solely on one financial product. This implies that the existing network of agents, including banks, can continue to function in the current framework which does not require agents to act in a fiduciary capacity towards their clients.

Considering the low financial literacy and low access to finance in India, perhaps it is also not advisable to require each agent to have a fiduciary responsibility. There is a strong case to be made for simple products that may be sold without the imposition of high suitability standards. However, no such provision exists in the current regulations. The micro-finance regulations focus predominantly on prudential regulation, even when the problems in the sector arose on issues of customer protection. There is also no understanding of whether the measures imposed have brought about the desired change. A framework for evaluation of the costs and benefits of various regulatory interventions is completely missing from the current regulatory discourse in India, and the response so far has continued to ignore its importance.

The Indian Financial Code will yield transformative change

The Indian Financial Code (IFC) is an important landmark in financial regulation in that it identifies customer protection as a central goal of regulation. The draft law enshrines the customer with rights to prevent mis-selling at the time of sale, and provides for a redress system after an event has occurred. In the IFC, the consumer has a right to get fair disclosure and suitable advice from financial service providers. This recognises that the market for financial products is an uneven playing ground with customers not being in a position to evaluate financial products, especially over long horizons. The code also requires the regulator to undertake measures to promote financial awareness.

The IFC has appreciated the possibility that excessive regulation may have its costs which ultimately get borne by the customer. It has put in place several checks to ensure that regulation is not stifling the market, including that of continuous evaluation of outcomes brought about by policy. Section 54, of Chapter 13 specifies that the financial agency is required to measures the costs and benefits of regulations by using the best available data and the best scientific method when such data is available. There are important connections between the incipient literature on household finance in India, and the requirements for analysis that are embedded in the IFC.

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Addressing ponzi schemes: the three parts of the solution strategy

Addressing ponzi schemes: the three parts of the solution strategy

There is a great deal of moral outrage about ponzi schemes. Parliament is being asked to “do something!”. We have seen this movie in India before. Laws are enacted as a knee-jerk response to an event. Quick and dirty responses are poorly thought through, which perpetuates the cycle of underperformance in public administration [example, example].

Laws are the DNA of government, and the drafting of laws should be done with extreme care. The drafting of law should:

  • Be rooted in adequate technical expertise from four fields: in the subject matter, in public administration, in law and in public economics.
  • Reflect diverse viewpoints and interests
  • Be rooted in a consultative process
  • Reflect an understanding of international experience
  • Be forged out of a sophisticated debate about alternative design choices.
All too often, in India, we rush in to offer a legislative response while cutting corners on these six requirements.
In the field of finance, the process of policy reform began with a committee process from 2005 to 2011 which mapped out the big ideas for policy reform through a series of expert committee reports. This led up to the establishment of the Financial Sector Legislative Reforms Commission (FSLRC) which worked for two years. A cast of 146 participated in the work of FSLRC, which has drafted the Indian Financial Code. In addition, hundreds of people participated in the committee process that led up to FSLRC. If this full process of policy analysis, from 2005 to 2013, had not been undertaken, the solutions at hand would be a lot inferior.
With this knowledge in hand, it is possible to isolate the three elements of dealing with ponzi schemes, which are in the three blog posts that I just put up on this blog:
  1. The first issue is the question of jurisdiction: Is X a regulated activity and who is the regulator in charge? (By Smriti Parsheera and Suyash Rai).
  2. The second issue is about regulatory strategy, and the Indian Financial Code has three elements that would impinge on ponzi schemes: micro-prudential regulation, resolution and consumer protection. (By Suyash Rai and Smriti Parsheera). The approach is, of course, more general and applies to all savings/investment schemes. But it’s interesting and important to understand how this approach addresses the immediate problem that we face today.
  3. The third issue is that of the investigation and enforcement process, where certain maladies have afflicted existing approaches. (By Shubho Roy).
Also see The law that can kill ponzis, once and for all by K. P. Krishnan, Smriti Parsheera and Suyash Rai in the Economic Times.
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Regulatory strategy for savings/investment schemes, that would address ponzi schemes

by Suyash Rai and Smriti Parsheera

The first task in dealing with ponzi schemes is correctly defining the scope of financial regulation. Once a firm is classified as a financial service provider, the appropriate regulator must choose a regulatory strategy for it. Assuming SEBI had clear jurisdiction with Sahara or MMM, what would SEBI do?

Safety and soundness regulation (also called micro-prudential regulation) is an expensive form of regulation, which includes requirements relating to maintenance of capital, investment restrictions, corporate governance, risk management systems, etc. This type of regulation can not apply equally to every financial institution. For example, the regulator should be able to distinguish between small member-controlled chit funds and larger chit funds.

Differences also need to be drawn based on the nature of the activity being carried out. Micro-prudential regulation should be less stringent for investment schemes as compared to deposit-takers, given the difference in the nature of promises being made to consumers. However, at the very least, the scheme would require authorisation from the regulator. In the MMM India example, had the scheme sought such approval, its promoters would have to satisfy basic fit and proper person requirements. Given that the scheme has been floated by Sergey Mavrodi, a convicted fraudster and the man behind Russia’s largest Ponzi scheme, it is likely that the scheme would have failed on this count.

This points to the need for a sophisticated approach to ensure optimal regulation. The law should allow the regulators to apply safety and soundness regulation wherever required, but the decision can’t be left to the regulators unconditionally. The law must provide some guidance to them, to make them accountable. What could be the form of this guidance?

Consider the following examples:

  • A bank with Rs. 10,000 crores of deposits from 1 crore depositors.
  • A local chit fund with Rs. 10,000 from 20 members.
  • A chit fund with Rs. 1000 crores from 1 crore members.
  • A hedge fund investing Rs. 1,000 crores, from 50 investors.
  • A mutual fund investing 10,000 crores, from 1 crore investors.

Where should safety and soundness regulation apply, and what should be the intensity of the regulation? A closer look reveals a few distinctions on four dimensions.

The bank and the large chit fund are more opaque than the others – most of the important information about their asset quality is not visible. That is why we are often taken aback when they fail. In small chit funds, people have reasonable visibility, since the money is with one of the members and is distributed regularly. Hedge funds and mutual funds are also quite easy to monitor, as long as they report fairly, because they invest in securities that visible in the market on a real time basis.

Bank and the chit funds make promises that are inherently more difficult to fulfill – they must return money, irrespective of their financial position. Banks more so, because the deposits are callable at par. Hedge funds and mutual funds invest on behalf of investors, with no guaranteed rate of return and so the market risk stays with the investors. Institutions making promises inherently more difficult to fulfill are at a greater risk of failing to keep the promises.

There is a difference in the influence the consumers can wield over the institution. In a small chit fund, members have significant influence over each other. In game theory terms, they are in a repeated game over a long horizon – small amounts are saved over short periods, and this is repeated. When a few people become managers of funds for a large number of people, the moral hazard problem increases exponentially, and the consumers’ ability to influence the institution drops. Similar difference can be seen in the hedge fund (small number of high value investors), and the mutual fund (large number of small value investors).

The institutions differ in terms of consequences of their failure. If a bank or a chit fund fails, many poor and middle class people lose their savings and many suffer significant hardships. We are seeing this in Saradha’s case.

Each of these four distinctions is relevant for deciding where safety and soundness regulation should apply. They can be stated in terms of principles, but do not translate into a set of ex-ante rules in terms of institution-types. If the law states them in terms of rules, it may be gamed. The principles, therefore, must be in the law.

Section 151(1) of the Indian Financial Code provides four principles-based tests, based on the four distinctions discussed above, that will help the regulators decide where and to what extent safety and soundness regulation should apply. The regulators will use a combination of these principles to take the decision. For example, it is not enough that the promise is inherently more difficult to fulfill, the institution should score high on some other tests as well. From the five examples listed earlier, the bank and the large chit fund will be intensely regulated for safety and soundness, and the mutual fund would attract some regulation to ensure that it is acting prudently and reporting fairly. The small chit fund and the hedge fund may be largely exempt.

Handling failure

Even among the licensed and regulated deposit-taking institutions, some will become weak. In such situations, there are ways of stemming the decline, and if the institution fails, minimising the loss to depositors. Dealing with failure requires a sound resolution and deposit insurance system. Deposit insurance covers deposits, upto a limit, against the risk of failure of the institution.

At present, banks in India are covered by a deposit insurance system, which, as demonstrated by the experience of many urban cooperative banks, often takes a long time to settle claims. Bank-like institutions, such as deposit-taking NBFCs, are not covered by deposit insurance. Countries like US and Canada have elaborate systems of resolution, which may include sale of the firm, management through a bridge institution, and temporary public ownership. The agencies responsible for resolution are also empowered to take corrective action if a firm’s soundness declines. In India, there is no system for resolving failing firms, and no structured framework for corrective action.

Part VII of the IFC provides for a resolution corporation, which will provide deposit insurance to certain institutions, take corrective actions on firms becoming weak and resolve institutions before they become insolvent, by arranging a sale of the firm, managing it through a bridge institution, or facilitating temporary public ownership. Section 260 enables extension of deposit insurance to institutions taking deposits. The regulators, in consultation with the resolution corporation, will decide which institutions will be covered by deposit insurance. This decision will be taken based on tests like the ones proposed for deciding where safety and soundness regulation will apply.

Enhanced consumer protection

The operators of the MMM scheme claim to make full disclosures to their members about the uncertainty of returns and the risk to their funds. But is mere disclosure sufficient to absolve Ponzi scheme operators from all liability? Certainly not. While disclosure and transparency requirements are integral components of an effective consumer protection regime, research shows that when faced with complex financial decisions, consumers often suffer from cognitive biases which can result in sub-optimal decision making.

It is for this reason that IFC contains additional protections when retail consumers are advised on financial products. This is in the form of suitability assessment requirements that compel the managers and distributors of financial products to assess the relevant personal circumstances of individual scheme members and the suitability of the product for their purposes before advising them to join such schemes.

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Investigating ponzi schemes: A malady

by Shubho Roy.

What has happened?

SEBI was investigating Saradha for more than 3 years before the deposit schemes of the company collapsed (See here). Saradha seems to have used two methods to delay the investigation:

  1. When SEBI asserted its authority to stop Saradha group from collecting money, Saradha challenged the jurisdiction of SEBI in district courts. It quickly got orders to prevent SEBI interfering in its businesses. These orders were eventually overturned by the High Court.
  2. When SEBI requested information from Saradha about their schemes and investors, Saradha responded by providing large volumes of documentation without specifically answering SEBI’s questions. This slowed down the entire investigation.

Why is this a problem?

In those three years Saradha took on new depositors and collected money from existing ones. All this money is now lost. Two years of investigation were required to stop what seems to be a run of the mill ponzi scheme. The tactics employed by Saradha are not new. They are similar to those employed by Sahara in delaying investigations in the OFCD schemes and in many other white collar crime investigations. The disturbing fact is that they seem to succeed time and again. While SEBI has wide powers of entities registered with it, if someone does not register with SEBI, the system of enforcement of laws changes completely. The current system requires SEBI to approach the local courts for prosecuting violations of the SEBI Act which constitute an offence. Moreover, SEBI cannot directly appoint lawyers for prosecuting the offences and must rely on the state government prosecution machinery to get criminal prosecution started.

The source of these difficulties

The present system suffers from a number of weaknesses, two of the most important are:

  1. The normal court systems do not have the time or expertise to enforce violations of investment and securities laws. This leads to confusing orders which sometimes exceed the jurisdiction of the courts. Even in the case of Saradha, the High Court set aside the orders preventing SEBI from exercising its powers over Saradha, noting that the courts were out of jurisdiction when they prohibited SEBI. However, High Court orders take time, and in this time period the operator of the ponzi scheme can continue to collect money or misappropriate the money already deposited. Expertise in deciding jurisdiction and applicability of SEBI laws is also not available in most normal district courts. It will be extremely expensive and wasteful to train all district judges in securities laws for the once-in-a-decade case in financial laws.
  2. The use of state public prosecutors for violations of financial laws is problematic for two reasons. First, the normal public prosecutors office is flooded with normal criminal cases like theft, murder, etc. A complex financial law case will never be the priority of the normal public prosecutors office. Second, the average public prosecutor who is extremely busy with the daily load of run of the mill criminal cases is not trained investment and securities laws. Just like district judges, it is not cost effective to train all public prosecutors in securities laws.

How would this work under the IFC?

The Indian Financial Code, drafted by the Financial Sector Legislative Commission, addresses these issues in the following ways:

  1. The whole system of investigation is formalised under an investigator appointed by the regulator. The terms of reference for the investigator, the system of investigation and the time for investigation has to be written down at the onset. Since all incomplete investigations will require extensions, there will be system of raising alarms for an unusually long investigation. See draft clause 394 of the IFC.
  2. The code allows the investigator to apply for a warrant for the search and seizure of documents. The investigator does not have to go to the area where the scheme is operating. He can apply for a warrant with the magistrate where the head office of the regulator is situated. This allows the government to create a special magistrate’s office. This magistrate can be trained in issues of finance and fraud and be a proper judicial check for warrants. See draft clause 396 of the IFC.
  3. The code also allows the financial agency to make an order preventing transfer of any money or assets pending an investigation if there is a reasonable fear that the assets of clients are at risk. Any violation of such orders is also punishable by imprisonment up to five years. See draft clause 398 of the IFC.
  4. The code empowers the central government to set up special courts to try cases involving the violation of investment laws. This allows for far quicker and more efficient disposal of cases. These courts will be district courts and follow all due process of law required under the Evidence Act and the Criminal Procedure Code. However, unlike general criminal courts, judges in these courts can be experts in securities and investment laws. See draft clause 417 of the IFC.
  5. Finally the code envisages that the financial sector regulator appoints its own lawyers to prosecute cases of criminal offences. These lawyers will have the same powers as a prosecuting lawyer under the criminal procedure law. Since most financial regulators have legal officers on staff today, this allows specialised expertise to head the prosecution of these crimes rather than a generalist public prosecutor.

The strategy used in the IFC is similar to that used in securities laws in the U.S., where dedicated federal court benches are used to prosecute securities frauds. Even in India, special courts and prosecutors have been created for the CBI and for prosecution of offences under the Prevention of Corruption Act. The longer a ponzi scheme lingers the more victims it accumulates. The Indian Financial Code provides a system to effectively shut down schemes like these and a specialised criminal law system to prosecute violators.

The loss of critical savings by many have raised demands for retribution. A hurried response to such demands can bring in laws which dilutes the principle of `innocent until proved guilty’ or reduce the procedural and evidentiary standards. The Code scrupulously avoids this by placing the power of issuing warrants and convicting offences on the same standards as envisaged in the laws of evidence and criminal procedure. However, it addresses the problems of a slow judicial system and dedicated expertise in resolving financial crimes.

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Correctly defining the scope of financial regulation so as to block ponzi schemes

by Smriti Parsheera and Suyash Rai.

Attack of the ponzi schemes

The Saradha Group has gained notoriety in recent weeks with outstanding public deposits reportedly exceeding Rs.200 billion. There was anger and panic. The state government has stepped in with partial redress.

As we watch this saga unfold, there may be another crisis waiting to happen in the form of a pyramid scheme offered by `Mavrodi Mondial Moneybox (MMM)’ that is taking rural India by storm. MMM claims to be a `social financial network’ in which members voluntarily share money with each other by buying and selling MAVROS – a currency-like unit devised by the operators of the scheme. MMM claims to generate returns of over 40% per month, although the returns are not guaranteed. It may be a ponzi scheme: one where money collected from new investors is used to pay returns to old investors. The cycle will continue till inflows into the scheme exceed outflows.

Saradha and MMM are not isolated examples. Other recent schemes have involved promises of unrealistic returns from investments in goats, pigs, emu, teak wood and potatoes.

The history of savings and investments in India is replete with tragedies where financial firms fail to return deposits or investments. This is particularly problematic in a country where 70% of the people earn under 2 dollars a day and hence have small amounts of money saved up. If savings are not safe, the central objective of regulation – consumer protection – is not met. What we need is for institutions that take deposits or run investment schemes to operate in a safe and sound manner, within the bounds of financial regulation.


Under the present system there are many institutions that offer deposit or investment services without any form of approval or regulation. Under a fragmented regulatory system, hazy lines of work have been drawn between financial regulators, the Central Government and State Governments. This has led to the problem of under policing – anything that does not fall squarely within the lines tends to pass unnoticed from under the radar of regulation. Saradha presents a good example – its activities could be argued to fall under any of the following categories: running a collective investment scheme (regulated by SEBI); running a chit fund (regulated by the state government); a private company taking deposits for its business (regulated by the Registrar of Companies); and taking public deposits as a non-banking financial company (regulated by RBI). The Saradha Group chose to seek permission from none of these.

There is also inconsistency in the manner and extent of regulation of financial institutions performing similar activities. For instance, 265 non-banking financial companies and 18 housing finance companies are allowed to take public deposits, but they don’t enjoy the same deposit insurance protection that is available to banks. If the main rationale for deposit insurance is to protect depositors from the risk of a financial institution becoming unable to make good on its promise to refund public deposits, should the same logic not apply to all deposit takers?

Chit funds, which are governed by State governments, also suffer from the problem of inconsistent treatment. Differences in enforcement levels across States have resulted in some States becoming more prone to ponzi schemes. In addition, most this sector may be operating in the form of unregistered chit funds: it is estimated that registered chit funds have collected Rs.300 billion worth of deposits while the collection of unregistered funds is much higher at Rs.30 trillion.

The regulation of collective investment schemes that come under SEBI’s scanner has also left much to be desired. This is largely on account of the restrictive mandate. Section 11AA of the SEBI Act defines “collective investment schemes” in terms of principles to identify such schemes, but it contains exemptions for institutions such as chit funds, nidhis and cooperative societies. Pointing to the huge investment grey market that plagues the financial sector, the SEBI chairman U. K. Sinha observed that the loopholes in the existing laws are the primary cause for the situation. He pointed out the need for a single regulatory body to look into the regulation of all companies that take illegal deposits from the public.

Eliminating the threat of ponzi schemes: The sound answer

The draft Indian Financial Code (IFC) framed by the Financial Sector Legislative Reforms Commission (FSLRC) presents a comprehensive solution to address the problems of under-regulation. The FSLRC has recommended a clearer and more comprehensive regulatory architecture as compared to what we currently have – RBI would regulate banking and payments, and a Unified Financial Authority (UFA) would cover all other financial services and products. Within this structure, there would be no scope for confusion about who should regulate a Saradha or MMM India as this responsibility would clearly vest with the UFA. This will also bring about more consistency in the regulatory treatment of a range of institutions undertaking similar activities, irrespective of the institution-type.

A central law like the IFC cannot address the problem of dual regulation of cooperative banks, which are regulated by the state governments and the RBI. The FSLRC has recommended that state governments accept the authority of Parliament (under Article 252 of the Constitution) to legislate on regulation and supervision of co-operatives carrying on financial services. Once they do that, financial regulation can fully apply to these institutions.

Defining financial products and services

In the IFC, the definitions of financial products and services are broad and principles-based, with no statutory exemptions. All kinds of deposit-taking and investment schemes (including chit funds) are covered by these definitions. A deposit is defined as a contribution of money, made other than for the purpose of acquiring a security, which may be repayable at the demand of the contributor. In Section 2(90), an investment scheme means:

any arrangement with respect to property of any description, including money, the purpose or effect of which is to enable persons taking part in the arrangement, whether by becoming owners of the property or any part of it or otherwise, to participate in or receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income, where:

  • persons participating in such schemes do not have day-to-day control over the management of the property, whether or not they have the right to be consulted or to give directions; and
  • the arrangement has either or both of the following characteristics:
    • the contributions of the participants and the profits or income out of which payments are to be made to them are pooled; or
    • the property is managed as a whole by or on behalf of the operator of the scheme.

Anyone in the business of accepting deposits or managing investment schemes would need to get authorisation from the UFA. Accordingly, both Saradha and MMM would be covered under the IFC, the former as a deposit-taking firm, and the latter as an investment scheme. In case of the MMM scheme, a unit of MAVRO is the underlying property in which the members invest. The other tests of the definition are also met as the scheme members do not have the ability to control the unit, which is managed by the operators of the scheme.

The IFC also empowers the central government to expand the definitions of financial products and services. When a new financial product or service is observed, instead of waiting for an amendment to the law, the Central Government can include the new product or service in the definition.


Given the limitations of existing financial institutions in meeting the savings and investment appetite of all Indians, innovations in this field are both inevitable and necessary. However, to ensure that this does not happen at the cost of consumer interests, the scope of formal financial regulation needs to be expanded to include large segments of the currently excluded investment grey markets. This also requires us to move away from the present system of having regulatory responsibilities divided among financial regulators and State Governments. The FSLRC’s draft law offers a viable solution in terms of conferring the duty of regulating all investment schemes on a single regulatory body that will be fully accountable for this task. The complete, principles-based framework of definitions, that can adapt over the years, will also help minimise regulatory gaps.

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Sugar: Letting the invisible hand work

by Apoorva Gupta.

The recent announcement that dismantled the levy and monthly release mechanisms, in the sugar industry, will make the industry more efficient and competitive. But much remains to be done. This is a good time to look at the government interventions in this industry, the implications of recent decisions, and the way forward.

Major government controls

With an aim of offering farmers, firms, and consumers a fair deal, the government intervenes in production and distribution through various controls:

  1. Minimum price for cane: Under the Sugarcane (Control) Order, 1966 (SCO), the Central government announces a `Fair and Remunerative Price’ (FRP) to ensure a good return to farmers. The state governments announce a `State Advised Price’ (SAP) which has typically been higher than the FRP, thus making the FRP redundant. In 2010-11, the SAP was 47% higher than the FRP.
  2. Cane Reservation Area: To guarantee continuous and sufficient supply of cane to all mills, the area from which a mill can procure cane is reserved. It is also obligatory for the farmer to sell all  produce to the mill in that area. The state has the power to reserve this area under the SCO.
  3. Minimum Distance Criterion: The Central government, under the SCO, has set a requirement of a 15 km. minimum distance between two mills to ensure supply of cane to all. States are authorised to increase this limit with prior approval from the Center. Punjab, Haryana and Maharashtra have a minimum distance requirement of 25 km.
  4. Levy Obligation: Under the Levy Sugar Supply (Control) Order, 1979, till recently, mills had to sell 10% of their produce to the government at a price lower than the market price, and this sugar was distributed through the public distribution system.
  5. Monthly release mechanism: The central government dictated the amount of sugar a mill could release each month in the open market, under the Essential Commodities Act, 1955 and the SCO. This allowed the government to control the prices of sugar in the market. In 2012, the release orders became quarterly.
  6. Trade Policy: To ensure national food security and contain price volatility, the government has historically used quantitative restrictions on export and import, depending on domestic and foreign conditions.
  7. Controls on by-products of sugar manufacture: Molasses is used to produce alcohol which is used in the production of potable alcohol, chemicals and blending with petrol. States impose restrictions on the movement of molasses, and artificially reduce the price for the benefit of liquor barons. The Center has not yet released a clear policy on pricing of ethanol for blending in petrol. The state also imposes restrictions on open access sale of power generated from bagasse.
  8. Compulsory jute packaging : The central government has made it compulsory for mills to pack 40% of the sugar produce in jute bags.
These controls add up to a comprehensive central planning system that blankets the sugar industry.

No one gains!

Each of these controls has created distortions.

#1: The minimum support price aims to ensure a fair price for cane to farmers, but on the contrary, it is the leading cause of accumulation of cane arrears (Rs 5495.04 crore for 2011-12 sugar season). The SAP is often not commensurate with the market price of sugar, making it hard for the mills to pay the farmers in time. Farmers shift to cultivation of a different crop because of delayed payments and this leads to shortages of cane. With lower production of sugar and higher market prices, the mills are able to reduce cane arrears and this incentivises the farmer to shift back to cane cultivation and the cycle is repeated. The graph below shows these fluctuations.

The figure above shows cyclicality in total production, total cane arrears and the average PBDIT of a balanced panel of 50 sugar companies observed in the CMIE Prowess database. There is a direct relationship between the production of sugar and the cane arrears, and an inverse relationship between total production and firm profit. This cycle is characteristic of the present restricted industry industry.  The price and supply of sugar are extremely volatile, even though consumption has been growing at a steady pace. The mills are often working under capacity and many small ones are shut down in the lean season since production is not economically viable. Farmers are burdened with delayed payments, and consumer welfare is reduced due to volatile prices.

#2 and #3: The cane reservation area and minimum distance requirement have fostered creation of monopolies. The farmer is obliged to sell his produce to a mill irrespective of its past payment record and cannot search for the best price for his produce. This gives monopoly power and artificial protection to firms, and helps inefficient firms to persist in the market. Currently, there are approximately 500 mills, some of which operate only in times when the cane is in surplus, produce as little as 500 tonnes of sugar in a year, and have a very low ratio of recovery of sugar from cane. Moreover, these controls do not allow high productivity firms to expand and achieve economies of scale, invest in increasing the acreage and sucrose content of cane.

#4 and #5: The levy obligation imposed a direct cost on mills to the tune of Rs.3000 crore in 2011-12. In 2011-12, the levy sugar price was Rs. 1904 per quintal, while the price of non-levy sugar was Rs. 2749 per quintal, excluding excise. The mills passed on these losses to consumers in the form of higher prices, and to farmers by delaying payments. The monthly release mechanism led to high inventory accumulation costs and made it hard for mills to manage cash flows. These two controls also incentivised mills to hoard inventory, increasing the administrative and litigation costs of implementing these controls.

#6: The abrupt and unanticipated trade barriers in the form of duties and outright bans, has not achieved the desired reduction in price volatility. Besides the dead weight loss of restricting trade, the unstable policy regarding export and import has reduced the ability of mills to foster long term contracts abroad.

#7 and #8: Mills lose money by selling molasses to liquor barons at an artificially low price. The unclear policy on ethanol pricing for oil marketing companies leads to unfulfilled contracts between sugar mills and OMCs and increases losses for both industries, since blending ethanol reduces the price of petrol for OMCs, and mills do not get revenues from the sale of molasses. The restriction on open sale of power generated from bagasse imposes an environmental cost. Compulsory packing in jute bags adds Rs 0.40 per kg of sugar. These policies, which try to develop one industry at the cost of another, eventually increase the cost for consumers and farmers.

Rangarajan Committee recommendations

The Rangarajan Committee was appointed to study the issues related to regulation of the sugar industry in early 2012. They recommended phased decontrol of the industry.

The recommendations include immediate removal of the levy obligation and monthly release mechanism, and phasing out of cane reservation area, minimum distance criterion and trade barriers over the next couple of years. Concerning cane pricing, the committee recommends that cane price should be a combination of FRP and a share in value of sugar. On international trade, they suggest that the current policy should be replaced by moderate duties not exceeding 5-10 percent. The need to deregulate the movement, pricing and quantitative restrictions on by-products of sugar, and abolish mandatory packaging or sugar in jute bags is also emphasised.

Recent decisions on decontrol

The Cabinet Committee on Economic Affairs has recently approved the removal of levy obligation and the monthly release mechanism (#4 and #5), as suggested by the Rangarajan Committee. The markets welcomed this decision, with a cumulative abnormal return of the CMIE COSPI Sugar Industry Index of 9% over the 2 days after the announcement. The spot price of sugar also spiked after the announcement. The market was over-exuberant at the partial decontrol of the industry and some of these gains have been reversed.

The implications of this partial decontrol are:

  1. Impact on finances: The removal of levy implies a direct increase in profit for mills of about Rs.3000 crore since they no longer have to sell 10% of the produce at significantly low prices. With the freedom to release stock, the mills will have choices about selling in India and abroad. The mills facing financial problems can liquidate their inventory when needed.
  2. Reduction in cane arrears: Mills with large cane arrears will now be able to release stock to make pending payments. But as elections come closer, there is a possibility that the SAP is increased and cane arrears accumulate. This will hurt the financial health of the firms.
  3. Volatility in prices: If mills release too much stock to reduce cane arrears or due to sheer inexperience with a free market, prices might plummet. The strategic moves of mills, rather than decisions of politicians and bureaucrats, will determine prices.
  4. Greater trading: Since cane is crushed seasonally and the mills have full freedom to release sugar, the trading on futures market will matter more. The futures market will become much more important in shaping decisions of everyone involved in sugar.
  5. Survival of the best: Until now the government regulated the amount of sugar released in the market, and the firms had no experience in thinking strategically. Reaching a Bayesian equilibrium will involve learning by doing, and creative destruction in the industry. Mills will require building up financial depth and skills in hedging using futures. Large firms, which have diversified into production of power and alcohol, will have an upper hand.
  6. Stability in acreage and cyclicality: The ability to manage cash flows would increase the security of payment to farmers, incentivising them to continue with cane cultivation. The mills and farmers (in the area reserved for them) might enter into contracts where the supply of cane is guaranteed, in return for timely payments. This can considerably reduce the amplitude of the sugar cycle and lead to an improvement in cane acreage.
  7. Impact on the growth of sector: With a better balance sheet, mills will be able to invest more. The global perception of the industry is going to change from highly regulated to partially decontrolled and this might give greater foreign investment. The freedom to release stock in domestic and foreign markets (provided export policy is not binding) will increase the international presence of mills.

Next steps

Of the list of eight controls, the government has removed two. Most of the pending controls come under the purview of the state governments and decontrol of this industry is now largely their task.

#1: Reforming the regulation of price is essential to reduce cyclicality in cane production, which is a leading cause of cane arrears and low profitability. The recommendation of the Rangarajan Committee on pricing of cane suggests that the farmer will be better off as he is protected from uncertainty in the market due to a guaranteed FRP, and also encourages him to invest in increasing the yield of cane for he has a share in the value.

#2 and #3: Abolishing the minimum distance requirement and the cane reservation area will lead to competitive bidding for cane and farmers would be able choose the best price on offer across an array of choices [analogy]. The increased competition to acquire cane might encourage mills to enter into long term contracts with farmers and offer them other benefits such as timely payments irrespective of the phase of the cycle, make them shareholders, and also assist in increasing cane yield. The inefficient firms are likely to perish with more competition in the market, leading to a more consolidated industry.

#6: Removal of trade barriers is likely to make trade more stable, foster global relationships between firms and make Indian firms internationally competitive. In the recent past, imports were duty free and export release orders were removed, suggesting that the government is slowly liberalising trade.

#7 and #8: Decontrolling movement, pricing and allocation of molasses can contribute significantly to the reduction of cyclicality in the sugar industry. In years of a bumper stock, cane can be used to produce molasses directly and can be distributed to all players at competitive prices. This will also make the sector more profitable. Co-generation from bagasse can become a reliable source of power. Removing restriction on sugar packaging will lead to a direct cut in costs of manufacturing.


The government needs to hasten the process of adopting the Rangarajan Committee recommendations. The job of the government is to focus on public goods, such as improved road and rail networks for the transportation of a heavy and perishable good like cane, improved irrigation facilities to reduce the dependence on monsoons and improved information dissemination for price discovery. Market forces will furnish higher efficiency and growth in the system by ensuring the survival of the best firms, fostering mutually beneficial contracts between the farmers and mills, and stabilising the price of sugar for the consumers.


This article has greatly benefited from suggestions from Dr. K. P. Krishnan, Dr. Ajit Ranade and Dr. G. S. C. Rao.

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Obtaining liquidity for illiquid stocks

The problem

While there are thousands of listed companies in India, for all practical purposes, stock market liquidity is the exclusive preserve of large companies. For small securities, the conventional continuous market presents daunting problems of liquidity. In conventional continuous trading, the price is made by the orders that come in from one second to the next. However, within a few seconds, there may not be many orders. The price may get swayed sharply by one large order.
An illiquid market suffers from two main problems: Investors suffer large transactions costs when entering and exiting, and there is a heightened danger of market abuse. Market abuse is the falsification of information about prices, spreads, turnover, etc. Innocent participants get sucked into making wrong decisions about investment when they see prices, spreads, turnover which are not the result of normal market forces, but are caused by a deceptive scheme. The possibility of market abuse, in turn, deters market participation and exacerbates illiquidity. This sets up a vicious cycle where fear causes illiquidity, illiquidity engenders market abuse, and the presence of market abuse causes fear. Detecting and blocking market abuse is the central function of infrastructure institutions and regulators.
While illiquidity is partly inherent to the listed firm, it is also influenced by the market design. There are mechanisms through which an improved market design can yield improved liquidity. As an example, when we moved from floor trading to continuous screen-based trading in India, liquidity improved.

The call auction

An alternative design — the call auction — helps address this problem. In a 30 minute call auction (say), orders that come in over a 30 minute period are pooled. The equilibrium price is worked out based on the supply and demand over this 30 minute period. This is likely to be a more robust price when compared with the price that is discovered moment to moment, under certain circumstances.
In India, at present, the call auction is used in three settings:
  1. The opening price is discovered using a call auction. This allows the market to absorb overnight news.
  2. When trading halts owing to a circuit breaker (i.e. a large price movement), the news is absorbed into the market using a call auction when trading recommences. Example.
  3. At first listing (or after re-listing), the price discovery in the first 60 minutes is done using a call auction.
In general, trading through call auctions is not exciting to securities firms since turnover is more limited. However, call auctions are good for investors (zero impact cost), issuers (lowered liquidity premium) and the economy at large (reduced market abuse).

SEBI announcement on new market mechanism for illiquid stocks

On 14 February, SEBI announced that for illiquid stocks, the market design shall constitute a series of one-hour blocks in the day which are call auctions. The SEBI circular gives a precise definition of what constitutes an illiquid stock. This is a fairly big initiative: it will affect 263 stocks on NSE and 2050 stocks on BSE. The new market mechanism will be in place from Monday the 8th of April onwards.
If this works well, it will have four effects:
  1. From the viewpoint of investors, the ability to enter and exit a stock with zero impact cost should yield a reduced liquidity premium. The valuation of stocks that trade through the call auction should be better when compared with the valuation of stocks that trade in the continuous market, where the round-trip transactions cost (i.e. two payments of impact cost, at entry and exit) can be a substantial expense.
  2. When an episode of market abuse comes together, there are extreme fluctuations of prices or turnover. This should take place to a reduced extent; the problems of market abuse are smaller for illiquid stocks under the call auction.
  3. For unsophisticated investors, the call auction is more attractive as there is a reduced possibility of market abuse. Firms in this mechanism should be able to achieve a more diversified investor base. This would also yield an improved valuation.
  4. The price in the call auction, revealed each hour, should be a better estimator of true value when compared with the price seen under continuous trading. There should be fewer departures from market efficiency, such as mean reversion. This will reflect a combination of two effects: avoiding the temporary price pressure associated with illiquidity, and avoiding market abuse.

Reflections on the regulatory process at SEBI

Now that the draft Indian Financial Code is in front of us, we see regulation-making in new light. This gives us a fresh perspective upon what SEBI has done. Why does SEBI use a `Circular’ as a legal instrument? The only two legal instruments that SEBI should use are Regulations and Orders. It is nice to see that this circular was discussed at an Advisory Council (the existing SEBI SMAC). However, the SEBI document does not do enough in terms of analysis. What is the problem that this regulation seeks to solve? How will this intervention solve this problem? What are the costs and benefits? Where was the notice-and-comment period?

S.59 of the draft Code requires that three years after the issue of regulations, a review should take place. It requires measuring the costs and benefits. The clarity of articulating objectives (e.g. points 1..4 above) becomes the natural frame through which this review would be done. The extent to which these four outcomes are achieved constitutes a mapping of the benefits.

When we think of how one specific regulation (e.g. period call auction trading for illiquid securities) would work out under the Code, we see that the superior regulation-making process embedded in the Code would  push regulators towards more thought, and thus improve the quality of regulation-making.

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Unanticipated consequences of Finance Bill provisions on securitisation

by Bindu Ananth and Kshama Fernandes

Over 2006-12, RBI and SEBI have created a strong and conducive regulatory environment for securitisation, listing of securitised debt instruments, and standards of transparency and reporting. Securitisation volumes have picked up and we recently witnessed the first listed transaction.

In October 2011, the income tax authorities issued a claim on certain securitisation special purpose vehicles (SPVs), stating that the gross income of such SPVs was liable to tax. The matter is presently under sub judice with the Bombay High Court. Several industry participants approached the Ministry of Finance (MoF) to seek clarity and reinforce the “pass through” status of a securitisation SPV.

The Finance Bill, 2013, has sought to clarify the tax position by stating that securitisation SPVs are not liable to pay income tax. However, the Bill also states that trustees of such SPVs must pay tax on distributed income.

The above amendment has an unintentional and significantly negative implication, on account of which taxable investors would be disincentivised from participating in securitisations.

This memo explains the issues and the unintended implications caused by the present draft of the Finance Bill in relation to securitisation SPVs, and provides a possible solution for addressing these issues.

Objectives of the MoF with respect to taxation of Securitisation SPVs

The Finance Minister (FM) in his speech presenting the Budget for the year 2013-14, set out his intent in presenting the proposed changes to the taxation of Securitisation SPVs: “In order to facilitate financial institutions to securitise their assets through a special purpose vehicle”.

The depth and vibrancy of the asset securitisation market is an essential building block in transfer of risk and transmission of capital from well capitalised investors to high quality originators. The framework for a well-functioning securitisation market has been laid down in considerable detail by the Reserve Bank of India (in 2006, further strengthened in 2012) and the Securities and Exchange Board of India (detailed guidelines in 2008 and listing guidelines in 2011).

It is our understanding that the objective of the Ministry of Finance in providing the basis of taxation of securitisation SPVs, is to clarify and establish the pass-through status of securitisation.

Changes proposed by the Finance Bill, 2013

Given below is the text proposed to be introduced into the Income Tax Act, 1961 by the Finance Bill, 2013:




  1. Notwithstanding anything contained in any other provisions of the Act, any amount of income distributed by the securitisation trust to its investors shall be chargeable to tax and such securitisation trust shall be liable to pay additional income-tax on such distributed income at the rate of–
    1. twenty-five per cent. on income distributed to any person being an individual or a Hindu undivided family;
    2. thirty per cent. on income distributed to any other person:

    Provided that nothing contained in this sub-section shall apply in respect of any income distributed by the securitisation trust to any person in whose case income, irrespective of its nature and source, is not chargeable to tax under the Act.

  2. The person responsible for making payment of the income distributed by the securitisation trust shall be liable to pay tax to the credit of the Central Government within fourteen days from the date of distribution or payment of such income, whichever is earlier.
  3. The person responsible for making payment of the income distributed by the securitisation trust shall, on or before the 15th day of September in each year, furnish to the prescribed income-tax authority, a statement in the prescribed form and verified in the prescribed manner, giving the details of the amount of income distributed to investors during the previous year, the tax paid thereon and such other relevant details, as may be prescribed.
  4. No deduction under any other provisions of this Act shall be allowed to the securitisation trust in respect of the income which has been charged to tax under sub-section (1).


Where the person responsible for making payment of the income distributed by the securitisation trust and the securitisation trust fails to pay the whole or any part of the tax referred to in sub-section (1) of section 115TA, within the time allowed under sub-section (2) of that section, he or it shall be liable to pay simple interest at the rate of one per cent. every month or part thereof on the amount of such tax for the period beginning on the date immediately after the last date on which such tax was payable and ending with the date on which the tax is actually paid.


If any person responsible for making payment of the income distributed by the securitisation trust and the securitisation trust does not pay tax, as referred to in sub-section (1) of section 115TA, then, he or it shall be deemed to be an assessee in default in respect of the amount of tax payable by him or it and all the provisions of this Act for the collection and recovery of income-tax shall apply.

Explanation. — For the purposes of this Chapter,–

  1. “investor” means a person who is holder of any securitised debt instrument or securities issued by the securitisation trust;
  2. “securities” means debt securities issued by a Special Purpose Vehicle as referred to in the guidelines on securitisation of standard assets issued by the Reserve Bank of India;
  3. “securitised debt instrument” shall have the same meaning as assigned to it in clause (s) of sub-regulation (1) of regulation 2 of the Securities and Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956;
  4. “securitisation trust” means a trust, being a-
    1. “special purpose distinct entity” as defined in clause (u) of sub-regulation (1) of regulation 2 of the Securities and Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956, and regulated under the said regulations; or
    2. “Special Purpose Vehicle” as defined in, and regulated by, the guidelines on securitisation of standard assets issued by the Reserve Bank of India, which fulfils such conditions, as may be prescribed.”

The following additions of Section 10 (23DA) and Section 10(35A) are also proposed to exempt from income tax certain income related to Securitisation SPVs:

(23DA) any income of a securitisation trust from the activity of securitisation.

Explanation.”For the purposes of this clause,”

  1. “securitisation” shall have the same meaning as assigned to it -
    1. in clause (r) of sub-regulation (1) of regulation 2 of the Securities an<>d Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956; or
    2. under the guidelines on securitisation of standard assets issued by the Reserve Bank of India;
  2. “securitisation trust” shall have the meaning assigned to it in the Explanation below section 115TC;”
    “(35A) any income by way of distributed income referred to in section 115TA received from a securitisation trust by any person being an investor of the said trust”

Unanticipated implications of the proposed text

Securitisation of assets by financial institutions requires the existence of a wide range of investors for whom investment in Securitisation SPVs is a viable option. Currently, predominant investors in the securitisation market in India (particularly in the securitisation related to financial inclusion) are banks. Banks are sophisticated investors and sit on large pools of capital that they must deploy appropriately. Securitisation has been an important way for banks to efficiently and effectively deploy capital where it is needed.

Other investors in securitisation, such as Mutual Funds and private investors currently provide significant but far less capital through securitisation. Yet other investors, such as insurance companies and pension funds, are yet to join the market.

However, it appears that the proposed changes would make the investment in Securitisation SPVs unviable for all but a certain class of income tax exempt investors (such as Mutual Funds). To elaborate on this, given below is a brief synopsis of the tax position of an investor in such SPVs, along with that of the SPVs themselves, as well as the issues arising out of the proposed amendments in the Finance Bill:

  • The current language of the proposed provision states that “any amount of income distributed by the securitisation trust to its investors shall be chargeable to tax and such securitisation trust shall be liable to pay additional income-tax on such distributed income” but as SPVs are designed to be mere mechanisms to route payments. It is not clear how its “income distributed” will be determined for the purpose of Section 115TA.
  • The language used in Section 115TA clearly indicates that the liability to pay “additional” income tax is placed upon the SPVs. It is not clear what this tax is in addition to.
  • Howsoever its income may be determined, as a result of Section 14A, no deduction will be permitted for expenses out of its total income.
  • Income under Section 10 (23DA) or under Section 10 (35A) is income not includable in total income.
  • In terms of Section 14A, no deduction is permitted with respect of income described in Section 10 (23DA) or Section 10 (35A).
  • Investors, other than “any person in whose case income, irrespective of its nature and source, is not chargeable to tax under the Act”, however, often do have incomes and incur expenses in raising money to invest in securitisation transactions.


  • A bank uses Rs. 1,000 of money it has accepted as deposits at the rate of 7.5% to invest in PTCs with a principal amount of Rs. 1,000 with a term of one year.
  • The PTC offers a yield of 13%, translating into a sum of Rs. 1,130 of which (assuming the taxable “income distributed” is Rs. 130) Rs. 39 will be deducted as tax in terms of Section 115TA leaving Rs. 1,091
  • But the bank has to return INR 1,075 to the depositors. Under Section 14A, the interest cost of Rs 75 is not deductible
  • For a pre-tax profit of Rs 55, the post-tax profit of the bank is Rs. 16 i.e. a profit of 1.6 percent. The tax paid in this transaction is Rs. 39. Effectively, the rate of taxation relative to income in the hands of the investor is over 70%.

For the investor, Section 10(23DA), Section 10 (35A) and Section 14A have an effect similar to the taxation of revenue rather than taxation of income.

On the other hand, if the investment in the SPVs was treated, as it was traditionally, as pass-through, the bank would treat the income from investment as any other income and pay tax on its net income (in the example above: Rs 130 – Rs 75 = Rs 55), with an effective rate determined by the net income of the bank, which would be far less than the 70 percent indicated by the proposed language of the Finance Bill, 2013.

Therefore, the unanticipated consequences of the present draft of the Finance Bill are:

Higher effective rate of taxation of income from securitisation, when compared to other sources of income of an investor

Tax paying investors will stay away. Banks, NBFCs etc. may not be willing to invest in securitised debt instruments, unless compensated for the higher tax payable

Severe impact on market depth and liquidity. Banks are presently the largest investors in securitisations and their absence would severely inhibit the growth of the market

No incentive for new investor classes to participate. Investors such as private wealth, corporate treasuries, AIFs etc. may find securitisation an unviable investment option

An alternative draft

It may be noted that the taxation of private trusts is well understood and has been relatively stable for a significant period of time. If we wish to avoid the unanticipated consequences as outlined above, we would require reinforcement and restatement the existing position of law.

Attention may also be drawn to the provisions of Section 160, relating to representative assessees, which would also apply to trustees of private trusts, including Securitisation SPVs. The proposed addition of Section 10 (23DA) and Section 10 (35A) should be removed and no changes must be made to Section 10 in this regard.

It may be beneficial if the proposed Section 115TA read (in a restatement of the existing law) as follows:




(1) Any amount of income received by an investor from a securitisation trust shall be chargeable to tax as part of the total income of such investor.

Provided that nothing contained in this sub-section shall apply in respect of any income distributed by the securitisation trust to any person in whose case income, irrespective of its nature and source, is not chargeable to tax under the Act.

Explanation.–For the purposes of this Chapter, –

  1. “investor” means a person who is holder of any securitised debt instrument or securities issued by the securitisation trust;
  2. “securities” means debt securities issued by a Special Purpose Vehicle as referred to in the guidelines on securitisation of standard assets issued by the Reserve Bank of India;
  3. “securitised debt instrument” shall have the same meaning as assigned to it in clause (s) of sub-regulation (1) of regulation 2 of the Securities and Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956;
  4. “securitisation trust” means a trust, being a-
    1. “special purpose distinct entity” as defined in clause (u) of sub-regulation (1) of regulation 2 of the Securities and Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956, and regulated under the said regulations; or
    2. “Special Purpose Vehicle” as defined in, and regulated by, the guidelines on securitisation of standard assets issued by the Reserve Bank of India, which fulfils such conditions, as may be prescribed.”

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The changes in taxation of transactions in futures on equity and commodity underlyings

Taxation of transactions in India began with the equity market in 2004. Prior to 2008, the securities transaction tax (STT) was allowed as a rebate against tax liability against Section 88E of the Income Tax Act. This treatment was withdrawn by the 2008 Budget announcement. After that, STT became a substantial influence on the equity market. In understanding the consequences of the STT, there is an absolute perspective and there is a relative perspective.

In absolute terms, suppose you embark on a spot-futures arbitrage and do an early unwind. In this, you buy shares (pay 10), sell futures (1.7) and then reverse yourself (10). Your tax burden is 21.7 basis points. This is a lot of money when compared with the typical bid-offer spread of the Nifty futures which is around 0.5 basis points. The dominant cost faced in doing spot-futures arbitrage is taxation.

In relative terms, there are two issues. The first is an intra-India comparison between equities and commodities. When activity on the equity market was taxed, eyeballs and capital moved to commodities trading. Commodity futures trading has grown by 3.5 times after 2008, while equities activity has stagnated. Most policy makers think this was an undesirable effect, particularly given the fact that India can free ride on global price discovery for non-agricultural commodities but must foster liquid markets in its own equities.

And then, there is an international dimension. When the activities of non-residents in India are taxed in any fashion, they favour taking their custom to places like Singapore, which practice `residence-based taxation’ where the tax base comprises the activities of residents only. We got a sharp shift in equities activity towards locations outside India.

Putting these absolute and relative perspectives together, from 2008 onwards, equity market liquidity has fared badly. This yields an elevated cost of equity capital.

The budget speech has done two things. First, it has dropped the STT rate on futures on equity underlyings from 1.7 basis points to 1 basis points. This is helpful for certain kinds of trading strategies but not for others (e.g. the spot-futures arbitrage described above will gain little). HF strategies that do not involve the spot market will particularly benefit – e.g. imagine an options market maker who does delta neutral hedging on the futures market. Second, it has introduced taxation for non-agricultural commodity futures on an identical basis to the equity futures (i.e. at 1 basis points).

This will have the following interesting implications:

  1. Capital and labour in securities firms will be less inclined to be in non-agricultural commodity futures. It will tend to move towards agricultural commodity futures, currency futures and equity futures.
  2. The comparison between offshore venues and the onshore market will move in favour of the onshore market for certain kinds of trading strategies.
  3. The bias in favour of equity options will reduce; some business will move to equity futures.
  4. The pricing efficiency of futures will go up.

In this environment, there seems to be a fair arrangement between the equity futures and commodity futures. Conditions seem to be unfair with the equity spot (too high), equity options (too low) and currency derivatives (too low). The next moves on this may appear in July 2014 when the new government unveils its next budget.

One more announcement of the budget speech concerns currency futures: it was stated that FII activity on currency futures will commence. This will also give more activity on currency futures; we now have two reasons for expecting more activity on currency futures (the taxation of commodity futures and the entry of FII order flow). However, the shifting of FII order flow will be a slow process, and a lot of time will be lost on their due diligence of the exchange, safety of the clearinghouse, and so on. While, in the long run, removing capital controls against FII order flow in India is a good thing, it is not an effect that will kick in quickly. Apart from this, most of the action will take place fairly quickly, in early April.

Future finance ministers will need to navigate the difficult landscape of gradually scaling down taxation of transactions while retaining low taxation of capital gains (which has unfortunately come to be seen as a linked issue in the Indian discourse). Along this path, the first priority should be to remove distortions. Our first priority should be to achieve a low rate, a wide base, and the minimal distortions. Reduced rates will always yield welfare gains. The Budget 2013 announcement makes progress on two things (reduction from 1.7 to 1, and reduced distortions between equities and non-agricultural commodities). There is much more waiting to be done: integrating currencies and fixed income, bringing sense to options, and getting away from the very high rates on the equity spot market.

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Imagine That!

Some interesting news from Michigan:

Michigan workers are not going to suffer. They have simply been given the freedom to join or not join a union, to pay or not pay dues. And while wages in right-to-work states such as Virginia, Tennessee, Texas and Florida are slightly below those of other states, employment in right-to-work states is higher. [Emphasis added.]

So, states with higher price floors for labor have higher unemployment rates while states with lower price floors for labor have lower unemployment.  I wonder if there is any sort of explanation for why this might be the case.  Is there possibly a rule about this sort of economic phenomena?   I wonder…