Market regulations and stock market activity

Abstract

Stock Exchanges provide a market structure for the enforcement of contract and guiding the price making process. These activities in turn affect resource allocation. Because of these ramifications, public policy makers monitor and express concern over the activities of Stock Exchanges through regulations. The study researches into the market related (as distinct from the legal and administrative) regulatory policies of Stock Exchanges in India. It broadly enquires into:

1. How rationally are regulatory policies decided upon? 2. Whether regulatory policies are effective in meeting their desired objectives?

The study uses a framework linking regulatory policies to the market. It focuses on two active instruments of regulatory policy, namely margins and limits on trading activity and then attempts and market activity variables namely, stability and liquidity. The study also views the adequacy of margins in maintaining contractual solvency.

Regulatory policies of Bombay Stock Exchange (BSE) have been studied over a four year period (July 1986-June 1990). Daily price data, settlement prices, trading volume and open positions of twenty seven scrips, selected from the specified list of the Exchange have been chosen for the study.

The findings of the study show that regulatory authorities decide changes in their margin policy on the basis of market activity. Regression results establish that changes in carry over margins are prompted by changes in settlement returns, price volatility, trading volume and open positions. Granger causality results show that there is limited causality in the reverse direction: margin changes do not affect returns, and have only a limited impact on price volatility, trading volume and open positions. Event study methodology applied to daily margins yielded similar results, except that daily margin on sellers did not appear to be affected by market variables. Further, there is also evidence of under margining leading to excessively levered positions, thereby increasing the insolvency risk. An increase in carry over margins is therefore warranted. The above results reveal that regulations through these instruments have had only a marginal impact on the dual objectives of controlling market activity and insolvency risk.

The study makes a contribution to the understanding of regulatory policies in organized security markets. Much of the previous research in this area has been in the US, where margins are applied uniformly across scrips, and changed rather infrequently. The study therefore, not only enhances the understanding of the regulatory processes of the Indian capital market, but also contributes to the theory of capital market regulations in general. In the field of regulatory policy, the study makes out a strong case for according primacy to solvency rather than price stability as a major regulatory goal. The study can be extended by factoring in regulatory enforcement mechanisms since margins and trading limits are not always strictly enforced. Further research can also study other less used regulatory instruments such as price bands, suspension of trading, shift to spot trading and carry over duration limit.