Several listed Indian majors filed their quarterly and annual financial results for the financial year 2020 (FY20) with the stock exchanges in April 2020. The Covid-19 lockdown was announced by the government on March 24. Naturally, the impact of the Covid pandemic on the financial results would be immaterial for FY20. However, it is such an important event after the balance sheet date that companies cannot ignore mentioning it. Investors expect companies to disclose the possible impact of the pandemic on their financial health. The full financial implications of Covid-19 will only be reflected in the ongoing financial year and possibly thereafter. One may mention that the news about Covid-19 and its pandemic nature ‘was all over the media since February 2020 and Indian companies, particularly those that have a substantial number of European and US customers, were already alarmed about the huge impact of the disease. Hence it is imperative that firms identify the sources of pandemic risk and highlight their preparedness in this regarding their annual filings.

HOW THEY STACK UP                                                                                                   (figures in  ₹ crore)

The common concerns in Covid-related disclosure include its potential impact on future business and on the asset quality. Covid has caused unprecedented damage to the oil and gas sector with the contraction of demand and crude prices plummeting to a level unheard of in recent history. The major private sector oil company, Reliance Industries, has recognized the impact of the pandemic and made a provision of 34,245 crore of extraordinary loss in FY20.

Another sector that has already started experiencing disruptions is information technology as the Indian software companies generate most of their revenue overseas and the bulk of it comes from clients in financial services, manufacturing and communications sectors. However, the IT majors did not make any extraordinary provisions for possible under-recoveries. Though a handful of IT companies have filed their financial results so far, the level of Covid-related disclosure varies widely. For example, while one may find a mention of Covid in several pages in the Infosys annual filing (in A6 ofa395-page annual filing), the same is not the case with its competitor TCS.

Covid-19 may have significant impact on the asset quality of the Indian IT companies in the following ways: (a) slow recovery of carrying amount of trade receivables; (b) impairment of unbilled receivables; and (c)impairment of short-term investments. Though the impact of the pandemic on these balance-sheet items could not be ascertained in FY20, the first two quarters of the present financial year (FY21) would show how much of the current assets of the IT companies are recoverable. The four IT companies that have filed their financial results have an average of 41 percent of the total assets as receivables and current investments (see table “How they stack up”).

Obviously, one would expect that these companies would at least make some provisions for possible shortfall in recoveries. But none has done so. On the contrary, barring Wipro, the other three IT companies have recommended a final dividend of close to 6,800 crore. Perhaps the decision to declare final dividend was to provide some relief to the investors and to bring cheer to the Stock market. Incidentally, these companies have already paid a handsome interim dividend —TCS had paid an interim dividend of 67 per share and has further recommended a final dividend of ₹6 a share. When India and the entire world is struggling to find resources to feed the poor and help the business enterprises survive, it would have been a good gesture on part of these companies to resist from declaring dividend now. Was there any pressure from institutional investors or business group?

Banks in India, on the other hand, have walked with caution — partly due to prudence and also due to regulatory oversight. The RBI did not allow banks to declare any further dividend for the FY20. The central bank has advised all banks to conserve liquidity in this period of crisis. It was mentioned that the restriction on dividend payments would be reviewed after September 2020. Unlike the IT companies, banks in India have made provisions for potential impact of Covid-19. They have disclosed Covid impact on (a) other income (includes, card fees and third-party distribution income); (b) asset quality. The impact of Covid-19 pandemic on other income was severe for a few banks. HDFC Bank has reported a lower other income to the tune of ₹ 450 crore in the fourth quarter FY20. Banks have also mentioned the impact of the three-month moratorium on payment of all term loans. For example, IndusInd Bank has made a provision of 23 crore towards impact of moratorium. Other banks (which have filed their financial results with the stock exchanges) have noted that the floating provision would take care of impact of loan moratorium, if any. However, the overall Covid-related provisions made by the four leading private sector banks (Axis bank, HDFC Bank, ICICI Bank and IndusInd Bank) were to the tune of  ₹ 7,558 crore.

It is expected that Indian companies while filing their financial results for FY20 would adequately address the Covid-19 related concerns and its impact on the asset quality. It would be better if corporate India refrains from distributing largesse to shareholders at this moment. The long-term investors can afford to survive without dividend for at least six months.

The March 2020 issue of Artha would have been incomplete without discussions on two important issues- one that has almost locked down the entire world (COVID-19) and the other that has shaken the confidence of people on Indian banks (near collapse of Yes Bank). The present issue looks at economic implications of COVID-19 and there are two pieces on Yes Bank.

Was there any early warning signal for Yes Bank? Or was it like COVID-19- without anyone knowing about this pandemic disease even three months ago? For example, Yes Bank had raised Rs.3,042 crore in September 2018 through issue of listed non-convertible unsecured bonds. The issue had secured a credit rating of CARE AAA and AA+ (India Ratings), signifying highest level of safety for the investors. One year later, in December 2019, Moody’s downgraded Yes Bank’s ratings to ‘b2’ (high credit risk) and further to ‘ca’(very near default) in February 2020. Thus, the actions of the rating agencies suggest that Yes Bank did something horribly wrong in the past one and half years. This conclusion is not correct. Way back in 2015, an article quoted in The Quint[1] showed that almost a fifth of Yes Bank’s loans were given to stressed companies and the Yes Bank’s exposure to these companies tripled in three years, between 2011-12 and 2014-15. It seems the regulators (RBI), the Board of the Yes Bank, and even the Finance Ministry chose to ignore the warning of the two young analysts of the Swiss investment Bank, UBS[2].

The present financial year (2019-20) has exposed all ills of Yes Bank (Bank). The Bank reported a quarterly loss of Rs.630 crore in Q2 and a staggering loss of Rs. 18,564 crore in Q3 FY2020. The total loss in the first nine months of the current financial year stood at Rs. 19,098 crore, which is 71% of the equity of the Bank at the end of the previous financial year (2018-19). The Bank has eroded about three-fourths of its equity in just nine months!

The promoters deserted the sinking Bank well in time. Sensing trouble, the former MD and CEO, Mr. Rana Kapoor sold his entire stake in the company and exited before the news became public. While depositors with the Bank were not allowed to withdraw more than Rs.50,000 cash in early March 2020 (the restriction was lifted since 19 March 2020), wife of one of the cofounders of the Bank could sell 2.5 crore equity shares at Rs.65 per share on 18 March (the highest price in past one month), taking home a cool Rs.161 crore.

Financial Analysis

A survey of the financial statements of the Bank for the past fifteen years (Table 1)reveals some signs of trouble. Deposits grew 343 times in the past fifteen years and so was the advances (317 times). Credit-to-deposit ratio was less than one in most of the years. Yet the Bank had borrowed significant sums in recent years and it stood at almost third of interest bearing debt of the Bank. Did the Bank borrow to invest in financial instruments? Return on investment for 2018-19 was barely equal to the 10-year G-sec yield (7.3%)- definitely not any indication of efficient treasury management. Alternatively, the Bank might have borrowed aggressively in the past six years (Rs.80,000 crore net addition to borrowing during this period) for capital adequacy purposes. If the alternative explanation is true, it raises question on the quality of advances that the Bank was making in the past six years. Where the advances grew five times in the past six years, the provision on advances has risen 21 times during the same period.   This is despite the tendency of the Bank to under provide for non-performing loans (NPA). For example, in 2015-16, the Bank had reported an NPA of Rs. 749 crore. Later it was forced to revise it to Rs. 4926 crore- almost seven times bigger. Again in 2018-19, the Bank underreported NPA to the tune of Rs. 3277 crore[3]. Thus, though the balance Sheet size of the Bank increased almost 300 times in the past fifteen years, it severely dented the asset quality. This did not happen in the last eighteen months. It all started about a decade back when the Bank, in pursuit of abnormal growth, had recklessly lent money to big corporates flouting all risk management norms. The other liabilities for FY 2019 included a provision for standard assets to the tune of Rs.3,000 crore (which was only Rs.950 crore in the previous financial year). So, an additional provision of Rs.2000 crore for standard assets in FY 2019 implies that even the quality of standard assets was doubtful.

Table 1: Financial Statements of Yes Bank (all figures in Rs. Crore)

Source: Ace Equity

Performance of the bank during 2018-19 was significantly inferior compared to the immediate previous year (Table 2) and yet no one raised any alarm. Even the rating agency did not notice the deterioration till mid-2019. The asset mix of the Bank changed noticeably between FY 2013 and FY2019. The loan book (63% of total assets)  in FY 2019 has grown to almost FY2005 and FY 2010 levels. It is worth noting that the economy was growing at more than 8% in 2005 and similarly the financial stimuli post global financial crisis was at all-time high in 2010.  Therefore, a surge in loan book during these periods was more a procyclical phenomenon. But the bulging loan book in FY 2019 was at a time when the economy was under stress and the country witnessed some big ticket corporate defaults. For example, we all know about big defaults by NBFCs in India in recent times and yet the Bank had provided a fresh loan of Rs. 6994 crore to NBFCs during FY2019. The change of asset mix had an adverse impact on return on equity and net profit margin.

Table 2: Select Financial Health indicators

Source: Author’s estimates

Auditors’ Role

Did the auditors of the Bank highlight any trouble in their audit report? The audit report for the FY 2019 (the worst year for the Bank) was a clean report. In fact, there was hardly any material difference in the observations of the auditors with the report of the previous year. There was no qualified opinion on any matters. Rather the auditors mentioned that the Bank had adequate internal financial controls and it had made provisions as per extant laws. The auditors did not mention anything about the under-provisioning of advances or quality of advances. The same auditors, while commenting on the third quarter results of the Bank in FY 2020, mentioned material uncertainty related to the going concern assumption at a time when the entire world came to know about the poor corporate governance in the Bank. Responding to allegations on the quality of financial statements of the Bank, the institute of Chartered Accountants of India (ICAI) has decided to review the financial statements of the Bank for FY2018 and FY 2019[4]. This is not a good news for the auditors of the Bank.

Conclusions

The crisis at Yes Bank is not a manifestation of poor market or credit risk management. It is another example of clear disregard to the most dangerous risk that every bank faces-the threat of operational risk. Mishandling of credit and market risks may result on loss of revenue or profit. But ignoring signs of operational risk is a sure recipe for disaster. The entire supply chain of corporate governance has to share the blame- the regulator, auditors, and the Board. The bailout package hurriedly put together under the Yes Bank Reconstruction Scheme 2020 may provide some temporary relief to the deposit holders of the Bank and much needed capital to the Bank, but it is surely not going to solve the main ailment of the bank- poor governance. The Bank witnessed a reduction of deposit of more than Rs. 18,000 crore in the first six months of FY2020. The State Bank of India and the consortium of a few more Banks that have agreed to invest more than Rs.6,000 crore in Yes Bank should find out, as early as possible, a strategic investor with a proven track record on governance. A sound corporate governance structure with professional management may save the Bank from collapse and regain investor confidence.

************

[1] https://www.goanews.com/blogs_disp.php?bpid=1350

[2] ibid

[3] https://www.businesstoday.in/sectors/banks/6-reasons-why-yes-bank-collapsed/story/397655.html

[4] https://www.livemint.com/companies/news/icai-to-review-books-of-yes-bank-for-fy18-fy19-11583941262292.html

It may not be an exaggeration to say that excitement on crypto-currencies / crypto-assets of generation Y (or Z, may be) has not necessarily been shared by the global regulators, perhaps belonging to an earlier generation. Christine Lagarde, then Managing Director of the International Monetary Fund (IMF) compared the “dizzying gyrations of crypto-assets such as Bitcoin” with the “tulip mania that swept Holland in the 17^th century and the recent dot-com bubble”, and went on to say, “With more than 1,600 crypto-assets in circulation, it seems inevitable that many will not surviveia the process of creative destruction.”[1]

While the initial idea of crypto-currency perhaps dates back to 1998 when Wei Dai first discussed the idea of digital money named “B-money”, for all practical purpose its popularity / emergence can be traced since October 2008, when a presumed pseudonymous developer(s) Satoshi Nakamoto published a nine-page paper titled, “Bitcoin: A Peer-to-Peer Electronic Cash System” (https://bitcoin.org/bitcoin.pdf).[2]  In broad terms, a cryptocurrency is a virtual or digital money that takes the form of tokens or “coins.” The prefix “crypto” owes its origin to complicated cryptography that allows for the creation and processing of digital currencies and their transactions across decentralized systems. Primarily, cryptocurrencies are developed as code by teams who build in mechanisms for issuance (often through a process called “mining”) and other controls. Over the last five years Bitcoin price has increased more than 700 times; and there are at least 35 Bitcoin exchange markets where Bitcoin prices are quoted in standard currencies, each with the daily transaction volume above one million USD (Pichl and Kaizoji, 2019).[3]

Interestingly, while the ambit of crypto-currencies was confined to a relatively closed community till about 2016, since the beginning of 2017, the demand for crypto-currencies increased exponentially. Notwithstanding their popularity, regulators were somewhat cagey about their financial stability implications. Accordingly, different countries exhibited inhibitions of differing degrees. India was no exception. After an initial period of informal instructions, the Reserve Bank of India (RBI), on April 6 2018, issued a circular prohibiting all commercial banks to deal with, what RBI termed as, “virtual currencies” (VCs). More recently, on March 4, 2020 the Supreme Court of India in a judgment quashed this RBI circular. Much excitement has been generated among the VC community about this judgement.

What has been the RBI rationale for prohibiting VCs? What has been the regulatory landscape in this regard?  Will the Supreme Court judgment pave the way for VCs in India? This short note seeks to probe into some of these issues.

Towards a Cookbook on Cryptocurrency

At the risk of appearing to write a cookbook, one needs to note that the origin of crypto-assets can be traced in blockchain, which is essentially “electronic ledger that records and verifies transactions made using crypto-assets”.[4] Bank of England in a submission to a Treasury Committee to the UK Parliament explained how blockchain emerged with crypto-assets:

“The innovations behind blockchain emerged from the initial cryptoasset, Bitcoin,…. Bitcoin was an attempt to build a payment system that did not rely on a trusted authority (such as a commercial or central bank) to maintain the record of payments and balances (the ‘ledger’). Importantly, anyone can participate in the validation of Bitcoin transactions—the network is ‘permissionless’ and its underlying blockchain (the database or ledger of transactions) is public. The Bitcoin network relies on multiple participants maintaining identical copies of the ledger and employs a process to come to consensus on the contents of, and updates to, this ledger.”[5]

Thus, the crucial difference between bitcoin and a standard paper currency lies essentially in the backing of the centralized register in case of currency by the central bank.[6] The new system of Distributed ledger technology (DLT) is of key importance here (Figure 1).

Figure 1: Distributed Ledger versus Centralized Ledger

Source: BIS Quarterly Review, September 2017.

It is useful to refer to the research of Bank for International Settlement which puts it succinctly:

“DLT refers to “the protocols and supporting infrastructure that allow computers in different locations to propose and validate transactions and update records in a synchronised way across a network. The idea of a distributed ledger – a common record of activity that is shared across computers in different locations – is not new. Such ledgers are used by organisations (eg supermarket chains) that have branches or offices across a given country or across countries. However, in a traditional distributed database, a system administrator typically performs the key functions that are necessary to maintain consistency across the multiple copies of the ledger. The simplest way to do this is for the system administrator to maintain a master copy of the ledger which is periodically updated and shared with all network participants. By contrast, the new systems based on DLT, most notably Bitcoin and Ethereum, are designed to function without a trusted authority. Bitcoin maintains a distributed database in a decentralised way by using a consensus-based validation procedure and cryptographic signatures. In such systems, transactions are conducted in a peer-to-peer fashion and broadcast to the entire set of participants who work to validate them in batches known as “blocks”. Since the ledger of activity is organised into separate but connected blocks, this type of DLT is often referred to as “blockchain technology”. [7]

Volatility in the Exchange Rate of Cryptocurrency

The exchange rate of Bitcoin exhibited huge volatility since the end of 2017 (Figure 2).[8]  Pichl and Kaizoji (2019) highlighted the following traits of exchange rate of Bitcoin.

• The log return distribution of the Bitcoin exchange rate shows the fat tail covering the extreme event region of bubbles and crashes.
• The price of Bitcoin is highly volatile and not supported by “fundamentals” that is, any real economy in behind of cryptocurrency, and may have random walk (martingale) property.
• Arbitrage opportunities in the Bitcoin market cannot be ruled out.

Figure  1: Exchange Rate of Coinbase Bitcoin (USD)

Source: Coinbase, Coinbase Bitcoin [CBBTCUSD], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CBBTCUSD, March 13, 2020.

These features of exchange rates of cryptocurrency formed the basis of regulatory concerns.

Regulatory Oversight

Most of the regulators have shown concern about the unbridled growth of the cryptocurrencies. Very recently, in February 2020, Randal K. Quarles, Chairman of Financial Stability Board, mentioned, “Technology is changing the nature of traditional finance”.[9] Federal Reserve’s Chairman Jerome Powell described the rise of Libra project by Facebook as a “wake-up-call” for the regulators. During G20 Summit 2019 in Osaka, all the member countries had agreed to create a regulatory framework for cryptocurrency and crypto-assets following the standards set by the Financial Action Task Force (FATF), the global money laundering and terrorist financing watchdog.[10]

Over the past few years cryptocurrency became more systemically important, and have emerged as estate assets. In this environment as there is no agreed upon definition of cryptocurrency different countries have enacted different regulatory policies. Some countries like China have prohibited the use of any cryptocurrencies entirely and some countries (Example Switzerland and Venezuela) have embraced the idea of cryptocurrency to attract foreign investments, while the other have taken the “wait and watch policy”.

USA: In the United States, there is no separate regulatory framework for cryptocurrencies. Though cryptocurrencies are not legal tender in the United States, the trading activities are not entirely prohibited, though heavily monitored. They are regulated by different regulatory bodies under the existing legal framework. Currently, the Security and Exchange Commission (the SEC), the Commodity and Futures Trading Commission (the CFTC), the Federal Trade Commission (the FTC), and the Department of the Treasury regulate the cryptocurrency related activities. The digital assets and the tokens are considered as an “investment contract”. In 2019 The SEC also released a framework to determine when a digital token should be considered as securities.[11] A cryptocurrency exchange and the administrator who has the authority to issue and redeem the cryptocurrency is regulated by the Department of Treasury through the Financial Crimes Enforcement Network and prohibits any anonymous accounts. In 2019 a new legislation “Crypto-Currency Act of 2020” was brought into the congress aiming to create a robust regulatory framework with clear power and regulatory liability distinction.[12]

UK: Like the USA, the United Kingdom does not have any specific law to regulate the cryptocurrency. All the cryptocurrency-related activities are regulated through already existing law like Financial Services and Markets Act 2000, the Payment Services Regulation 2017, and Electronic Money Regulations 2011. The UK Crypto-assets Taskforce has defined cryptocurrency as “a cryptographically secured digital representation of value or contractual rights that uses some distributed ledger technology and can be transferred stored or traded electronically.”[13] Regulators in the country have been cautious about cryptocurrency regulations. Thought in the country, there is no blanket prohibition on activities related to cryptocurrencies, regulators have advised to restrain from cryptocurrency investments and warned about the risk involved through repetitive public notice.

Switzerland: Since the beginning, the position of the government of Switzerland has been encouraging for the cryptocurrency industry. The government of Switzerland is open to new development in this front. In December 2018, the Swiss Federal Council’s report on the regulatory framework for cryptocurrency had concluded that the existing laws provide a sufficient regulatory framework for cryptocurrencies.[14] On March 22, 2019, the Swiss Authorities proposed a new law to regulate the cryptocurrency.  Currently, the Swiss Financial Market Supervisory Authority (FINMA) does not consider cryptocurrencies as security; instead, it is a “medium of exchange” and “storage of value.” Though trading involving cryptocurrencies constitute security, and those activities are regulated as normal trading activities like dealer license requirement, platform regulation, or prospectus requirements.

Singapore: Singapore is one of the most progressive countries in terms of regulation of cryptocurrency. Due to the regulators’ balanced approach towards cryptocurrencies, the cryptocurrency market is thriving. Cryptocurrencies are not regulated in Singapore through any legislation or by the Monetary Authority of Singapore (MAS, the central bank of Singapore). In Singapore, cryptocurrencies are not considered as a means to store values; instead, they are recognised as assets and personal properties. Regulatory authorities encourage cryptocurrencies as “a mode of payment, and are a means of making payments.” However, some of the activities related to cryptocurrency are regulated as Securities by MAS. If cryptocurrency-related activities are classified as securities, then the parties engaging those activities are required to be registered. On 20 November 2019 MAS also proposed to allow payment token derivatives’ trade in Singapore.[15] The government and the monetary authority encourage this new distributed ledger technology. The MAS also has partnered with a private company R3 and a consortium of financial institutions to develop a payment platform using blockchain technology.[16]

Japan: Though the Government of Japan and the Bank of Japan do not recognise any cryptocurrency as security nor it treat it as “money,” Japan is one of the first countries to embrace cryptocurrencies. In February 2014, a Japanese company MTGOX Co, Ltd, started the cryptocurrency exchange services between the cryptocurrency and different legal tender. It quickly became the world’s largest cryptocurrency exchange, and soon more business came into existence. With the booming business environment in the country, Japan was one of the first countries to regulate the cryptocurrencies and bring specific laws specific to cryptocurrencies. According to the law of Japan, cryptocurrency is a method of payment rather than currency. Cryptocurrency is defined as “proprietary value that may be used to pay an unspecified person the price of any goods purchased or borrowed or any services provided and which may be sold to or purchased from an unspecified person and that may be transferred using an electronic data processing system.”[17] To stop financial crimes, illegal trade, and terror financing, it mandatory for any services dealing with cryptocurrencies to register with the Financial Service Agency. Through different legislation, they have been empowered to regulate cryptocurrency-related services. Failing to register is a criminal offense for any entity or individual.

The Stance of the RBI

Indian Authorities do not consider cryptocurrency a legal tender or as a coin. Due to the lack of any regulatory norms, during the mid-2010s, businesses based on crypto-currencies grew. Trading volumes in the cryptocurrency markets reached as high as about $50 million to $60 million per day by the end of March 2018.

Different regulatory bodies in India, including the Reserve Bank of India (RBI) was somewhat uncomfortable with this development. Accordingly, in December 2013, RBI issued a warning to the general population about the risk involved in dealing with the cryptocurrency. Later in December 2016, in the financial stability report, RBI mentioned the establishment of a regulatory sandbox10 and innovation hubs to understand and support the development of new financial instruments and services. The report also highlighted the risk and concerns involving “virtual currencies,” the effectiveness of the monetary policy, and financial crimes.

On February 1, 2017, the RBI again issued a notice to the public about the usage and risks involved in using the cryptocurrencies. On July 25, 2017, an Inter-Disciplinary Committee released its report on the “virtual currencies” and the measures to regulate the “virtual currencies.” The report clearly distinguishes the distributed ledger technology and cryptocurrency. Inter-Disciplinary Committee recommended an explicit prohibition on the use, hold, and trade of any cryptocurrencies. The committee also recommended positively about the underlying distributed ledger technology and its potential usage “other than that of creating or trading in crypto-currencies.” On December 5, 2017, the RBI issued a notice iterating its concerns about the usage of cryptocurrencies.

Finally, the RBI in its Statement on Developmental and Regulatory Policies of April 5 2018, talked of ring-fencing regulated entities from virtual currencies and went on to say:

“… Virtual Currencies (VCs), also variously referred to as crypto currencies and crypto assets, raise concerns of consumer protection, market integrity and money laundering, among others. Reserve Bank has repeatedly cautioned users, holders and traders of virtual currencies, including Bitcoins, regarding various risks associated in dealing with such virtual currencies. In view of the associated risks, it has been decided that, with immediate effect, entities regulated by RBI shall not deal with or provide services to any individual or business entities dealing with or settling VCs.”[18]

Accordingly the next day, i.e., on April 6, 2018 the RBI issued a circular prohibiting all entities regulated by the RBI from dealing in Virtual Currencies (VCs). Specifically, the prohibition included “maintaining accounts, registering, trading, settling, clearing, giving loans against virtual tokens, accepting them as collateral, opening accounts of exchanges dealing with them and transfer / receipt of money in accounts relating to purchase/ sale of VCs”. [19] Regulated entities which already provided such services were asked to exit the relationship within the next three months.

Though the prohibition did not extend beyond the entities regulated by the RBI, due to lack of access to capital, banking infrastructure like maintaining the accounts, trading, payment settlement, or access to credit choked the new businesses dealing with crypto-currencies.

Later on, December 5, 2019, in the Monetary Policy Press Conference, to a question on RBI’s stance on cryptocurrency, RBI Governor categorically stated:

“…. With regard to digital currency, there are two aspects. One is private digital currency. RBI is very clearly against any kind of private digital currency. And let me also add that it is not RBI which is against it, world over, the central banks and the governments are against private digital currency. Because currency issuance is a sovereign function, it has to be done by the sovereign. A private currency cannot overwrite what is in the sovereign domain. And there are huge challenges with regard to money laundering and other aspects. With regard to digital currency to be issued by a central bank, that is central bank digital currency, this is very early. Some discussions are going on. The technology has also not yet fully evolved, it is still evolving. This is still in a very incipient stage of discussion and at the RBI, we have examined it internally. And we are continuing to have internal discussions. And we do have consultations and discussions with other central banks also. But it’s too early to talk about central bank digital currency. But as and when the technologically evolves, with adequate safeguards, I think it is an area which the Reserve Bank will certainly look at seriously, at an appropriate time.[20]

It is in this context that the Supreme Court judgement of March 4, 2020 assumes critical significance.

Supreme Court Judgement of March 4 2020

On 4 March 2020, the Supreme Court of India gave the verdict on RBI’s prohibition for financial institutions to deal with any entity engaging in the cryptocurrency-related activity.[21] In the verdict, the Apex Court told that RBI in some sense had violated Article 19(1)(g) of the Indian constitution, providing fundamental right to practice any profession. As the businesses involving cryptocurrency is not illegal in India, RBI cannot deny any business dealing with cryptocurrencies access to the formal financial infrastructure. In the verdict, the Apex Court has said the arguments made by RBI on financial crimes lacks empirical evidence and that RBI has not proposed any alternative measures to mitigate those risks, though, the judgment also acknowledged that this verdict based upon article 19 (1)(g) and does not cover any individual as stated in the verdict “Persons who engage in buying and selling virtual currencies, just as a matter of hobby cannot pitch their claim on Article 19(1)(g), for what is covered therein are only profession, occupation, trade or business.”

Interestingly, it was pointed out that that multiple reports both by RBI and Inter-Ministerial Group have given conclusive evidence that the distributed ledger technology and cryptocurrency are two separate entity, and call cryptocurrency as the “by-product” of the distributed ledger technology. The Apex court has also acknowledged after going through all the definitions a significant number of regulators that though “VCs are not recognized as legal tender,” “they are capable of performing some or most of the functions of real currency.” According to the verdict, money has three primary functions; “It provides, namely (1) a medium of exchange (2) a unit of account and (3) a store of value. Finally, a fourth function, namely that of being a final discharge of debt or standard of deferred payment, was also added”. Any cryptocurrency satisfies all but the fourth functionality, which is the conferment of the legal tender status by a Government/central authority. Thus, cryptocurrency satisfies the functionality of currency, and the Reserve Bank of India has authority over any cryptocurrency to regulate it. As per the Apex court, “the users and traders of virtual currencies carry on an activity that falls squarely within the purview of the Reserve Bank of India.” [22]

The verdict stated, “anything that may pose a threat to or have an impact on the financial system of the country can be regulated or prohibited by RBI, despite the said activity not forming part of the credit system or payment system.” Hence the verdict has strengthened the regulatory authority of the Reserve Bank of India, and in case of any legislative or executive actions on the ground of financial stability, the verdict will not hold. Thus, the verdict leaves room open for the proposed bill banning any activities related to cryptocurrencies in the parliament gets enacted into law and that will not violate any clause of the verdict nor it will be a violation of the fundamental rights of any individual under Article 19 (1)(g).

Way Ahead                                                                                                                      

While accepting the RBI’s jurisdiction over the cryptocurrency market, this Judgment could trigger a spurt of activity in this now moribund market. However, lot will depend on the regulatory and legislative action / reaction in this regard. The Government of India has already prepared a Draft of the “Banning of Cryptocurrency & Regulation of Official Digital Currency Bill, 2019” in August 2019. This Bill proposed to prohibit mining, holding, selling, trade, issuance, disposal or use of cryptocurrency in India.[23] While under the draft Bill, mining, holding, selling, issuing, transferring or use of cryptocurrency is punishable with a fine or imprisonment of up to 10 years, or both, there is a provision that the central government, in consultation with the RBI, may issue digital rupee as legal tender”. However, the government refrained from introducing the draft bill in the winter session of the parliament during November – December 2019. Going forward the future of cryptocurrency in India will depend upon a number of unknown unknowns. Illustratively, we do not know whether, in the days to come, cryptocurrencies could be replaced by Central Bank Digital Money. What would be interaction between the market participants and regulators / legislative actions? What stance would international bodies like G-20 or FATF is going to take? Future of cryptocurrency, like any other financial innovation, will lie in the outcome of such a cat and mouse game between the regulators and market players.

*******

[1] Lagarde, Christine (2018): “An Even-handed Approach to Crypto-Assets”, IMF Blog, available at https://blogs.imf.org/2018/04/16/an-even-handed-approach-to-crypto-assets/

[2] The actual cryptocurrency software was released in the open source domain in January 2009.

[3] Pichl, Lukas and Taisei Kaizoji (2019): “Volatility Analysis of Bitcoin Price Time Series”, Quantitative Finance and Economics, available at https://www.researchgate.net/publication/321827427_Volatility_Analysis_of_Bitcoin_Price_Time_Series

[4] UK Parliament (2018): Crypto-assets, Twenty-Second Report of the House of Commons Treasury Committee, available at https://publications.parliament.uk/pa/cm201719/cmselect/cmtreasy/910/910.pdf

[5] UK Parliament (2018): Crypto-assets, Twenty-Second Report of the House of Commons Treasury Committee, available at https://publications.parliament.uk/pa/cm201719/cmselect/cmtreasy/910/910.pdf

[6] While over the years, number of other cryptocurrencies appeared, in terms of transactions bitcoin maintained its prime position in the cryptocurrency market. Ethereum (ETH); Ripple (XRP); Litecoin (LTC); Tether (USDT); Bitcoin Cash (BCH); Libra (LIBRA); or, Monero (XMR) all are examples of cryptocurrencies to name a few.

[7] Morten Bech and Rodney Garratt (2017): “Central bank cryptocurrencies”, BIS Quarterly Review, September 2017.

[8] Similar volatility is noticeable in other cryptocurrency market as well.

[9] FSB Chair’s letter to G20 Finance Ministers and Central Bank Governors: February 2020

[10] Global Finance, G20 Osaka Leaders’ Declaration: 28-29 June 2019, available at https://www.mofa.go.jp/policy/economy/g20_summit/osaka19/en/documents/final_g20_osaka_leaders_declaration.html

[11]  Security Exchange Commission (the USA, 2019): “Framework for “Investment Contract” Analysis” available at: https://www.sec.gov/files/dlt-framework.pdf

[12] As per the draft bill there are three types of digital assets i) cryptocurrency ii) crypto-commodity (Goods and services with substantial fungibility) iii) crypto-securities (debt, equity and derivative instruments). The draft version of “Crypto-Currency Act 2020” available at: https://www.crowdfundinsider.com/wp-content/uploads/2019/12/Draft-Crypto-Currency-Act-of-2020.pdf

[13] Cryptocurrency taskforce: Final Report available at https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/752070/cryptoassets_taskforce_final_report_final_web.pdf

[14] The Federal Council (Switzerland)(2018): “Legal Framework for distributed ledger technology and blockchain in Switzerland” available at: https://www3.unifr.ch/webnews/content/166/file/Attachments/Report%20Blockchain%20ICO.pdf

[15] Monetary Authority of Singapore (2019): “Proposed Regulatory Approach for Derivatives Contracts on Payment Tokens.” Available at: https://www.mas.gov.sg/-/media/MAS/News-and-Publications/Consultation-Papers/2019-Payment-Token-Derivatives/Consultation-Paper-on-Proposed-Regulatory-Approach-for-Derivatives-Contracts-on-Payment-Tokens.pdf

[16] Monetary Authority of Singapore (2019), Media Release, Available at: https://www.mas.gov.sg/news/media-releases/2016/mas-experimenting-with-blockchain-technology

[17] For more detail see:  https://www.globallegalinsights.com/practice-areas/blockchain-laws-and-regulations/japan

[18] For more detail see: https://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/PR264270719E5CB28249D7BCE07C5B3196C904.PDF

[19] These instructions are issued in exercise of powers conferred by section 35A (read with section 36(1)(a) of Banking Regulation Act, 1949), section 35A (read with section 36(1)(a)) and section 56 of the Banking Regulation Act, 1949, section 45JA and 45L of the Reserve Bank of India Act, 1934 and Section 10(2) read with Section 18 of Payment and Settlement Systems Act, 2007.

[20] Available at https://www.rbi.org.in/scripts/bs_viewcontent.aspx?Id=3798

[21] Two different petitioners went to court against this move: (a) the Internet and Mobile Association of India; and (b) a group of corporations that were in the business of running of crypto exchange platforms.

[22] The verdict by Supreme Court of India (2020) is available at: https://main.sci.gov.in/supremecourt/2018/19230/19230_2018_4_1501_21151_Judgement_04-Mar-2020.pdf

[23] As per this Draft Bill, cryptocurrency is defined as any information, code, or token which has a digital representation of value and has utility in a business activity, or acts as a store of value, or a unit of account.

The use of derivatives by mutual funds is closely monitored by regulators across markets. Indian market regulator, Securities and Exchange Board of India (SEBI) has recently taken measures to allow Indian mutual funds to underwrite call option contracts under certain strict conditions[1]. In general, call options refer to an agreement between two parties where the buyer gets the right to buy an underlying asset in the future at a predetermined price whereas the seller has the obligation to sell the underlying. Till recently, mutual funds were allowed only to take positions in derivative contracts but can now write option contracts. However, this is allowed under covered call strategy and also restricted to index constituents of NIFTY 50, and SENSEX. This implies that they cannot write options without being long on the underlying.

Derivative contracts, especially option contracts are a very useful tool available to mutual funds in several ways. It is a fact that mutual funds herd and Indian mutual funds are no exception. However, we don’t have concrete information on how different mutual funds employ different types of derivatives and to what extent they use them to enhance their portfolio performance. It has been discussed in the popular press that mutual funds using options have several advantages and these funds are seen as better investment funds. These funds have superior risk management ability; demonstrate superior performance. Other important arguments put forward by popular academic research which supports the above are; informed investors with their superior information find it attractive to trade in the options markets. Hence, mutual funds which use options integral to their trading strategies are informed investors that best use their superior information to attain stock specific exposure with a fraction of a cost that they have to otherwise pay for directly taking exposure in the stocks. Also, using options efficiently requires in-depth knowledge of option pricing and working of options markets. These qualities are generally beyond the orthodox skills of mutual fund managers and hence suggest that funds which use options effectively are sophisticated funds. Information on these aspects will throw light on the advantages and disadvantages of derivatives use by mutual funds and help regulators to take appropriate measures to improve the overall health of the mutual fund industry. The heterogeneous use of derivative instruments by different mutual funds impact their portfolio return and risk characteristics. In this context, I analyze some of the major Indian mutual funds in terms of assets under management to understand their use of options contracts in their portfolio strategy and their performance.

I analyze the data of 200 open-ended mutual fund schemes for a period of five years from 2015-2020 to understand their options use.[2]

Table 1 above reports the some statistics on the option positions held by our sample mutual funds. Out of the 9026 total reported option positions, 7849 positions are of equity options and the remaining 1177 relate to index positions. The call option positions represent the majority positions in equity option category whereas, put option positions are higher in the index category. The call option positions also include the written call positions as well as long call positions. The written call option positions allowed with restrictions by SEBI are mainly used by the fund houses for income generation. Long put positions are lesser than long positions and this suggests that mutual funds use them mainly for insuring their portfolios.

I examine the sample mutual funds to understand the motives behind their option positions; more specifically to see if there is information content about the future performance of the underlying stocks. For this, portfolios replicating the underlying option positions are constructed for each period separately for calls and puts and then held for a period of one to twelve months. These portfolios are rebalanced at the end of each of the holding period and their returns are benchmarked against the standard market benchmark portfolios. Table 2 reports the risk-adjusted returns of the above options portfolios.

It can be seen from the table above that all the risk-adjusted returns are insignificant. Hence, there is no evidence to support that there is a significant variation in the future prices of the underlying equities over the different buy-and-hold periods. The above results should be read with caution as the portfolios are constructed without knowing the exact date when the mutual funds bought the underlying, took long/short position in options and also we do not have reliable disclosed information.

To understand which type of mutual funds use options in their portfolios, I perform univariate analysis for the sample funds after reclassifying the sample funds into growth, income, large-cap, mid-cap, small-cap, and other types of funds. Table 3 reports the frequency of option users versus nonusers. In the options user category, growth funds with a 39% are the highest users of options followed by large-cap and mid-cap funds. The remaining funds have underrepresentation in the sample. If we look at the fund characteristics of option users versus nonusers it is seen that option users are not consistent in using the options and similarly nonusers too use them in the times of volatility to protect their portfolios.

It is also observed that most of the option users are from small fund houses with lesser assets under management. On an average, the size of option users is approximately 40% less than nonusers. One more interesting observation is that options user mutual funds charge a higher fees and their expense ratios are higher. The portfolio turnover of options users is higher compared to nonusers. Finally, option users generate lesser overall returns because of their high risk exposure than the nonusers.

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[1] Retrieved from https://www.businesstoday.in/current/economy-politics/sebi-issues-norms-for-mutual-funds-investments-in-derivatives/story/310750.html

[2] I use ACE mutual funds database to analyze the data. Funds with non-missing data is considered and please note that the ACE mutual funds data has some errors which could not be rectified.

[3] Author’s own computations.

Most universities in the US have shut down their physical offerings over the past few weeks and educators everywhere are scrambling to get their courses online. This is quite an onerous transition for everyone involved in the process because the overnight change has caught teachers, students and administrators off-guard. Nevertheless, with high-speed internet commonplace in the US, the move will be made, albeit with many hiccups.

Not all commodities in the economy are as “online moveable” as education. Movie halls, sports arenas, theme parks, stores, and a host of other venues need physical footfalls to generate revenue. As communities and cities across the world self-quarantine to contain the spread of the novel coronavirus pandemic, the big worry confronting economists is the wide-ranging effects on the economy of such an unprecedented turn.

1. Running an Economy

At the most basic level, an economy is simply a group of humans that decide to work together, because doing so is to the mutual advantage of everyone in the group. Small groups organize themselves into bigger communities, small communities band together to form bigger societies, small firms align with each other to create bigger enterprises, so on and so forth till you reach the stage of giant corporations with supply chains and consumers spread all over the world. The apple on your breakfast table might have been harvested on a farm in Costa Rica owned by a Spanish farming company, transported on a ship that docked in Amsterdam or Doha or Singapore, before it reached the shore of your country.

The real ingredients of any economic system are the expectations of the agents that volunteer to be a part of it. Modern economics provide a unifying template for the coordination of disparate enterprises spread across diverse regions of the planet – say, manufacturing in China, production in Vietnam, marketing in the US, consumption in India, and a host of other activities in different parts of the world – through the coordination of expectations. A manufacturer tries to figure out the how much to make by using the economic marketplace that allows him to gauge the strength of the demand; the consumer tries to determine the best price to pay by using the economic marketplace that allows her to gauge how much other rival sellers might charge; and so on at every step of the value chain. No individual economic agent knows for sure what the actual outcomes will be tomorrow, but by gauging the expectations of others in the system, all agents have a much better sense of what the tomorrow holds for them collectively. The crucial function of the economy is then the synchronization, and the objects that are being synchronized are expectations of agents in the economy.

2. Hermit Kingdoms

The adage of the hermit kingdom is often used to emphasize the importance of trade and exchange. A hermit kingdom has no contact with the outside world and lives and dies by its own means. Humans soured on the idea of hermit kingdoms way back in the antiquities when they discovered trade: tablets and scrolls from Indus valley and China have been found in Mesopotamia and Egypt dating back thousands of years. The fathers of modern economics like Adam Smith or David Ricardo built entire theories extolling the advantages of trade, the basic idea being that trade allowed communities to specialize – you focused on what you did best  and bought from the rest of the world for your other needs. This led to more efficient resource allocation all through the value chain, improving the productivity of all stakeholders.

A pandemic like Covid-19 turns the clock back to the era of hermit kingdoms — at least in the short run. As communities start to quarantine and isolate, they are largely confined to their own resources. Of course, the presence of worldwide internet and communications means that there is still ample flow of information. However, the physical flow of goods and services — the lifeblood of modern economies — is grinding to a standstill. Equally important, there is a pervading sense of gloom and panic among economic agents because they expect the system to fall apart. In a sense, the actual failure of the economic system is becoming a quid pro quo consequence of the expectation of failure among the agents in the economy.

3. Economic Expectations

Managing a modern market economy well is really an exercise in managing the expectations of its agents. While the functioning of the actual economic machinery is an important component, what is equally crucial—but often overlooked—is the careful calibration of expectations of the participating agents in the economic system. In the language of policymaking, economic expectations are self-fulfilling. If agents believe that the economy is on a downward trend, they cut back on their investments, and this in turn pushes the economy further down south. On the other hand, if agents believe that the economy is doing well, they spend and consume more, and this in turn boosts the economy.

Navigating one’s way out of a crisis thus often comes down to adroitly playing the expectations of the agents in the system, and all important schools of macroeconomic thought concede the centrality of economic expectations — though the precise strategy for revival differs from one school to another. Such macroeconomic strategies and tools, however, were created for more conventional economic crises — problems with debt, or price rise, or banking, or housing, etc. — and the real unknown for economists is whether they work for crises arising out of unknown phenomena such as the Covid-19 pandemic.

4. Curing Economic Infections

The economic policy response to the pandemic across most of the developed world has been to unleash the tools of macroeconomic support. The Federal Reserve has slashed interest rates close to zero this weekend and announced a massive program of bond purchase, dubbed QE4. Europe’s central bank, too, has been considering asset repurchases, while China has been preparing its own stimulus program. Despite all these measures, there is a great deal of uncertainty among policy makers, because we have little experience with crises of this variety.

In a conventional crisis, the fundamental reason for the problem is economic in character —things like excessive debt, or lax oversight, or some other inherently economic failure. In the case of a pandemic induced crisis the core reason is biological in nature, so economic policy makers have little control or understanding of the root issues. Further, for politicians across the world the first order concern is to prevent a massive outbreak of disease, and the effects on the economy are, at present, a second order worry at best.

Yet, with time, the economic strain will start to show as massive cutbacks in travel and meeting inevitably soften economy-wide production and spending. In fact, as a precursor, financial markets everywhere have already started to tank. It is not clear, however, if flooding the system with cash will revive spending and growth as it did earlier. Unlike the crisis in 2008, there is not just a deficit of trust in the system, but a very real physical reason why individuals are choosing to keep away from each other. Would it help more if businesses were encouraged to move their offerings online? For example, Disney has begun to offer online streaming of all its movies running in the halls at present. However, such a strategy involves dangers of its own — what if people decide to forego going to the movies even after the crisis winds down? Disney earns much more when people physically go to the movies than when they sit at home and stream. Is Disney digging its own grave by moving its releases online?

Questions like these do not have easy answers. At a deeper level, many of the economic questions raised by the sudden spread of a pandemic like Covid-19 are completely new to the profession. Just as the crisis in 2008 led to the growth of new lines of inquiry and research, it is likely that the Covid-19 induced breakdowns will lead to a fresh look at many of the fundamental assumptions underpinning modern economics.

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A recent news item[1] reports that when the world was in celebration mood for Christmas in December 2019, the BSE Sensex scaled a twenty-year high price-to-earnings (P/E) multiple of 29X, which is just about the same as the Sensex P/E of 30X during the peak of the tech boom in 2000. The news report further informs that much of the recent rally in the Indian stock market was not based on the fundamental performance of the underlying companies. In fact, during the whole year of 2019, while the Sensex had grown by 14%, the index underlying earnings per share (EPS) fell by 6.7%. Is this a precursor to a bubble? Is there a similar rally in the mid and small cap stocks? We attempt to address these questions in this article.

The general economic mood in India is not encouraging at present and yet popular stock indices are trading almost at their peak. The last two quarters of 2020 reported historically low GDP numbers. Economists are debating whether the present slowdown is cyclical (i.e., short-term) or structural. Some experts blamed GST (Goods and Services Tax) as the major dampener for the economy. In the first quarter of FY2017 (before the implementation of GST), India registered a spectacular GDP growth of 9.4% and when the recent quarter (Q3 FY2020) GDP growth was reported at 5%, policy makers sighed a relief that at least it was better than the previous quarter. The Finance Minister had taken several measures, in the past six months, to boost the economy. Corporate tax rates were cut, GST rates lowered on several items, massive infrastructure spending was announced, and yet the economy is not picking up. There is no contagion effect as such – the US economy is doing pretty well and China, though reported a modest GDP growth recently, is still at least one percentage higher than India. The headroom to spend money by the central government has shrunk significantly with lower GST and corporate tax collections. However, government has to spend money to generate enough domestic demand. It is now known to all that automobile and telecom sectors were worst affected in the past two years. However, the fast-moving consumer goods (FMCG) did reasonably well in FY2019. For example, two Nifty 50 FMCG companies (ITC and Hindustan Unilever) reported EBITDA margins of 38.5% and 22.5% respectively. Thus, it seems that the economic slowdown and the effect of GST have impacted the medium and small companies more than the top Nifty companies. In fact, Nifty 50 companies have performed reasonably well, despite economic turmoil. Since the popular stock indices in India are quite narrow, these do not reflect overall economic situation of the country. Companies included in the top indices are popularly called blue chip stocks and are assumed to be more stable in their returns. Therefore, it may not be entirely surprising to notice significant buoyancy in large cap stocks even when the overall economy is struggling. These companies may have greater adaptive capacity to withstand rough weather. Analysts opine that investing in large cap stocks is a safer bet at all times as these stocks are less sensitive to economic turmoil.

Flight to Quality

Large cap index (NSE Large Cap 100) grew by 48% in the past five years (2015-2019), and small cap stocks (Nifty SML 100) performed the worst ending almost at the same level where it began in early 2015. The Nifty 50 was perfectly tracking the large cap index, as expected. What is interesting to note is small cap stocks did very well till December 2017 and thereafter it nosedived and lost almost 40% of value in the next two years. The story is very similar for mid cap stocks. Around the same time (between 2017 and 2019), large cap stocks made all the gains. One possible explanation could be the adverse effect of GST[2] on mid- and small-sized companies’ profitability.

Figure 1: Five-year growth of NSE Indices. Data source: Moneycontrol.com

There could be another explanation- the flight to quality. The flight to quality phenomenon occurs when investors dispose of apparently riskier assets and buy relatively safer investments. Fund managers believe that during macroeconomic uncertainties, it is prudent to invest in safe stocks and large cap stocks are more shock resistant. If this argument were to hold, the fund flows to large cap stocks should increase during this period. We have looked at the investments by equity mutual funds in large-, mid-, and small-cap stocks (Figure 2) during the same period. We find that equity mutual funds in India (across different strategies) have held more than Rs.800, 000 crore (US$115 billion) in large cap stocks in 2019- a 2.6 folds increase in five years.

Figure 2: Investments by Equity Mutual Funds. Source: Ace Equity Mutual Fund

The share of holdings of equity mutual funds in large cap stocks has grown over the past five years at the expense of mid cap and small cap stocks. For example, large cap stocks accounted for 86% of total holdings by equity mutual funds in 2015 and that share has grown to 93% during 2019. Small cap stocks particularly account for only 2% of equity mutual fund investments in 2019.

A related question to ask at this stage is whether the relative preference for large cap stocks was driven by superior performance of large cap indices. We estimate Information Ratio of three categories of indices using total returns (TRI). It is observed (Table 1) that in the last two years, large cap indices outperformed both mid and small cap ones. Interestingly, the mid and small cap indices outperformed the large ones in the preceding three years (2015-2017) in both the markets. Thus, we find a clear linkage between funds preferences (exhibit 2) to large cap stocks and superior performance of large cap indices. Can we say that it was indeed a flight to quality?

Table 1: Performance of Indices[3]

Another possible explanation for increasing investment in large cap companies is the effect of a SEBI circular[4] on the categorization of mutual fund schemes. According to the circular, a large cap equity fund should invest at least 80% of its total assets in large cap companies (defined as 1^st to 100^th companies on full market capitalization basis). Similarly, any mid (small) cap open ended equity fund should invest at least 65% of total assets in mid (small) cap companies. Therefore, theoretically, any mid and small cap equity fund can invest the balance of their assets in large cap companies. That could be another reason for relative surge in fund flows to large cap stocks. The market performance (Table 1) indicates that large cap stocks performed particularly well post 2017. Was this performance backed by fundamental financial health of the large cap companies?

A Bubble?

The fundamental performance of the top 50 listed companies in NSE did not show any deterioration in period after 2017- post GST era (Table 2). In fact, the average EBITDA margin of the Nifty 50 firms have been maintained around 25% over the past five years. Annual growth in revenue did witness a marginal dip in 2017-18 but was followed by robust average growth of 17% in 2018-19. The earning per share (EPS) of these companies has also grown over the past five years.

Table 2: Average Performance of Nifty 50 companies

Source: Bloomberg and Money control. Authors estimates.  Each year ended in March. Thus, the year 2015 denotes the financial year 2014-15. Percentages are simple average numbers of the Nifty 50 companies. Net Capex represents capital expenditure net of depreciation.

The top companies did not cut back their capital expenditure program. The net capital expenditure registered a five-year CAGR of 6%- growing almost at the rate of wholesale price inflation. Thus, one may argue that there was no growth in real capital formation by these top fifty companies over the past five years. However, given the general economic mood of the country in the past two years, maintaining real capital is also an achievement.

We show that mutual funds are doing right in putting a greater share of their funds in large cap stocks- a safer bet. This excessive flow is pushing the P/E multiples of top stock indices high. Some of the blue-chip stocks are presently trading at very high multiples. For an economy as large as India, performance of fifty top companies are not good enough to turnaround the economic woes. In order to go anywhere near the 5 trillion-dollar GDP target, private domestic consumption should grow and for this to happen common citizens should have more money to spend.

[1] Sensex valuation nears 20-year high. The Economic Times 24 December 2019

[2] GST was introduced in July 2017

[3] We calculate Information Ratio (IR) as E (Ri-Rb)/Std.Dev (Ri-Rb). Here ‘Ri’ is index return and ‘Rb’ is benchmark return. We use daily data for calculating IR.

[4] SEBi Circular No. SEBI/HO/IMD/DF3/CIR/P/2017/114 dated October 6, 2017

Economic downturn often creates extreme barriers in day-to-day operations of the firms that are dependent on liquid assets. The situation becomes worse when new loan granting by banks reduces significantly, cost of borrowing increases considerably and liquidity dries up in asset-backed markets. This essentially demands for some solutions which may optimise the working capital management of a firm. Supply Chain Finance (SCF) is one such popular approach that optimises liquidity condition of a firm. SCF, also known as reverse factoring, is well adopted by companies like Coca-Cola, Procter & Gamble or Walmart. Instead of adopting the conventional method of directly paying to the supplier within a given timeline (say, 30 days), firms prefer SCF where they pay certain fee to a bank or a financier to ensure 100% early payment to the supplier (as soon as 10 days). Thereafter, according to the nature of contract, firms repay the amount to bank. The entire exercise creates a “win-win-win” scenario for all three parties involved. The supplier receives early payment, the customer[1] extends the formal payment term with supplier as per their desire and the bank or financier optimises their exposure of risk weighted asset portfolio. Such benefits enhances the acceptance of SCF world-wide which has been further reflected in the estimation of Aite (US research and consultancy group) about the worth of the global SCF market. According to them, the current value of this market is around US$255 billion ($376 billion).

Despite the listed advantages, there are number of concerns which may act as a deterrent for a supplier to proceed with a supply chain contract. The first and most important factor is the ‘control’ aspect which is most probably hidden on the face of the contract. If the customer is a so called “big firm” and the growth of the supplier, to some extent, depends upon the orders generated from the customer, the supplier compulsively has to follow terms and conditions put forward by the customer. Clive Isenberg, chief executive of Octet, has said that – “Once you’re supplying the big end of town and you’re so reliant on that big end of town buying from you and you’re growing with them as they buy from you, you are being constantly pressurised to follow the way they’re going. You’ve got to agree to their payment terms, and if their payment terms means it’s a reverse factoring model, you take it or leave it”. The next important factor in this entire exercise is the ‘trust’. Suppliers need to be watchful about the fact that the bank or financier only register security on their invoices rather than businesses. At the same time, the bank or financier would want to ensure a reasonable payment period as per the contract between the customer and the supplier. Very recently, the ‘big four’ accounting firms have sent a letter to the Financial Accounting Standards Board (FASB) of the US stating that few firms often try to negotiate the payment terms with the suppliers up to 180 or 210 days, whereas historically the payment term was binding from 30 to 60 days at maximum. Hence, the rating agencies, analysts and investors have started scrutinising SCF schemes as the firms (customers) may use this to camouflage problems related to cash flows and put pressure on suppliers for providing discount on invoices. Apart from these ‘control’ and ‘trust’ factors, the third and hopefully the last concern related to SCF is its ‘cost’ of development and maintenance. Since the funding is handled by the customer appointed bank, the bank may work in best interest of their own and the customers rather than in favour of the suppliers. For example – a bank may allow early payment on only a certain amount of invoices in a given month or the customer may keep an upper cap on the same. Besides, the cost related to invoice generation, recording and following-up can be huge at times.

Figure 1: Supply Chain Finance Network; Source: BSR | Sustainable Supply Chain Finance

The above mentioned three issues, i.e. control, trust and cost, can be well addressed if the level of transparency and speed of execution in the entire supply can be enhanced significantly. Blockchain technology (BCT) can act as a promising solution in this regard. The BCT helps registering all the transactions cryptographically using a shared database. These blocks of data are chained in such a manner that they become long-lasting and immutable. Furthermore, automated version of contractual agreement (e.g. smart contract) between supplier and customer or between customer and bank provides more transparency in the system. In this system, there is almost no requirement of involving a neutral third party to eliminate related counterparty risk. Even it’s possible to exchange value through BCT among peers. It also reduces cost of due diligence by facilitating KYC process digitally. Along with these improvements, new level of product and information integration would be possible due to open nature of a blockchain. Brigid McDermott, the vice president of Blockchain Business Development & Ecosystem has echoed the same –

“If you talk to supply chain experts, their three primary areas of pain are visibility, process optimization, and demand management. Blockchain provides a system of trusted records that addresses all three.”

Figure 2: Supply Chain Finance with Blockchain; Source: Capgemini Financial Services

Supplier’s benefit with BCT

As time passes, this technology will be gradually available to any small supplier. Thus BCT will make SCF available to suppliers with diversified business. Customers can easily on-board multiple suppliers in single set up. As SCF backed by BCT proliferates at different levels, competition is expected to be significantly enhanced. As marked by Hackett Group, marginal benefits will be of high importance for the suppliers in coming days. According to their analysis, even a small error in invoice processing or delay in delivery may be easily cascaded within SCF network. However, it’s expected to gain huge efficiency in booking transactions, approval of invoices and dealing with foreign currency transactions. In addition, flow of inventory and its tracking will be pretty straightforward. The speed of transactions will be fastened if the relationship between the supplier and customer is strong. For example – prepayment of purchase orders will take place and in case of delay in delivery or defects in goods automated refunds can be initiated.

Customer’s benefit with BCT

According to Mr. Robert Murphy of Forbes, the BCT allows the customers to set up a streamlined SCF with limited resources. Involving multiple suppliers on the same system, the customer will be in a better position to negotiate prices and other terms and conditions related to the agreement in its own favour. With the advent of cloud based technology and smart contracts, it’s possible for a customer to involve some alternative sources of funding, e.g. – credit unions rather than depending only on the handful of banks that offer SCF. Pooling their funds will ultimately reduce administrative costs and overall overhead. This will strengthen the cash flow of both customers as well as suppliers. Another important aspect of SCF for the customer is to obtain a favourable payment term from suppliers as suppliers are using the customer’s credit. BCT will be useful in involving the third-party payer as well in the negotiation process to keep the process more transparent.

Financier’s benefit with BCT

Along with the supplier and customer, BCT also provides banks or financier much desired reliability, speed and increased control in SCF network at a fraction of cost. Since both the original contract and the order placed by customer are on display, bank can readily verify the origin and authenticity of the same. Moreover, if the contract is of any long term events, such as manufacturing or transportation, the progress can be tracked on real time basis. Hence, an easy collaboration between financial service and supply chain activities is catalysed by BCT.

Overall, BCT provides tremendous efficiency in the system. The time of initiation of payment, verification and approval are expected to be drastically reduced. Even due to less manual activity bank fees would be reduced. Therefore, compared to existing practices of SCF, BCT backed SCF would be much cheaper and efficient.

Development and adoption of BCT

Trade finance, now a days, is gradually shifting from a traditional paper based manual model towards a paperless digitized model. In order to achieve this, manual processes are largely replaced with automated transactions. For example, in 2016, export letter of credit has been launched in electronic form for the first time by Wells Fargo and Cargill (commodity trader). Thereafter, since last two years, firms have started implementing BCT in order to support SCF. The CEO of Hugo Boss, Andrea Redaelli, shared with the delegates of SCF forum in 2017 how their company has started implementing BCT to track inventories through a supply chain on experimental basis. Since then, number of start-ups have been coming up with as a provider of BCT in the domain of SCF. Few names among them which are becoming more popular are – Eximchain, Zero1 Capital, Tango Trade, Hijro etc. Some pilot projects on adoption of BCT have already been launched and completed. HSBC has performed financing of soybeans last May using BCT. This is their first transaction in trade finance using this sophisticated technology. Last year, Commerzbank in Germany had also propelled a pilot project on BCT, where their existing business process designed by SAP is integrated with Corda blockchain platform end-to-end.

Challenges in adoption of BCT

The popularity of BCT obviously brings number of questions on board asked by the critics. The most prominent among them is whether BCT can bring a long-lasting and real value in SCF network. In September 2018, the consultancy service firm Deloitte has reported that the technology is yet to come out of the notion of a brilliant idea and being actually implemented in real life. For most of the companies, the adoption of this cloud based technology is still limited for commercial use. According to this report, only nine percent of Chief Information Officers (CIOs) have declared that they are either planning to set up a blockchain project within a year or have already started with one of these. Deloitte has identified some complexities in adoption of this technology. One such complexity is to set up distributed ledger technology (DLT). Besides, processing speed of transactions by the existing systems is also a concern. Another important issue pointed out here is the lack of standards on front.

Apart from operational concerns as discussed above there are also regulatory and legal issues which may crop in. For example, privacy of data is always an important aspect which over the years becoming a major threat. Customers often become conscious when they have to share sensitive financial information (such as cost related information) in the supply chain. But, the main purpose of DLT is to bring transparency among the parties present in the network. This purpose will be completely defeated if the firms hesitate to share information.

Given the potential of BCT in enhancing efficiency of the entire system of SCF some effective planning is required to extract the best results. For example, one can differentiate private blockchains from the public ones. The barrier of transparency created for sensitive information can be somehow controlled by using private blockchain instead of public blockchain. Here, it’s required to grant certain rights to access to certain members of the chain only. One can sincerely hope that with such type of innovative steps, corporates will turn their heads towards this highly efficient technology and avail maximum benefit of SCF.

[1] The terms ‘customer’ and ‘buyer’ have been used interchangeably

The Reserve Bank of India sits at the apex of the financial system. It is the banker and debt manager to the Government of India, banker to banks, regulator, licensor and supervisor of banks, regulator of payment and settlement systems and manager of foreign exchange of the country. It has an important role to play in monetary policy formulation and subsequent modulation of liquidity conditions to ensure transmission of monetary policy to the financial system. It is the issuer of paper currency and can also create electronic money “out of thin air”, when it pays banks for the securities it purchases from them.

Any action of RBI therefore attracts a flurry of attention in the financial media, even if it is something as mundane as the publication of a report on financial stability. The latest such report published in December 2019, has the usual platitudes like “India’s financial system remains stable notwithstanding weakening domestic growth” and “risks arising out of global/domestic economic uncertainties and geopolitical developments persist”. The report also provides many interesting insights into the state of the economy and the banking system. While underscoring the slowdown in aggregate demand, it has understandably kept away from touching upon sensitive issues like demonetization and GST implementation.

The cobra effect

Shunning the usual conservative language and adding a dash of spice to an otherwise routine report, the central bank governor, in the preface to the report, warns of a “cobra effect”, alluding to the unintended consequence of ultra-low/negative interest rates in some economies, which can lead to asset bubbles, rather than bringing back growth and inflation to acceptable levels.

NPA’s, a bottomless pit

The report anticipates that the Gross NPA (GNPA) ratio, based on stress tests, may increase from 9.3 per cent in September 2019 to 9.9 per cent by September 2020. This is surprising given the significant Rs 42,000 recovery expected by banks from Essar Steel in this period and the recognition of many large ticket corporate NPA’s having taken place already in the last few quarters. Yet to be recognized NPA’s like a defaulting non-banking finance company with a Rs 1 lakh crore balance sheet, may be a contributing factor, among others. If a forensic audit indicates a fraud, banks would need to provide 100% of their outstanding with more stringent timelines compared to a default due to a “genuine” business failure. The industrial sector’s GNPA ratio is by far the highest compared to agriculture and services, with the least being that of the retail sector.

NPA’s merit categorization after 90 day default. This is the tip of the iceberg. While the extent of stressed assets in the 1-90 day default range (known as Special Mention accounts i.e. SMA’s) is available with the central bank, strangely this information is not disclosed for all SMA accounts viz. 0,1,2. The only information available from the financial stability report is that SMA-2 loans increased by about 143 per cent between March 2019 and September 2019, with the SMA 2 ratio at 2.2%. This alarming but significant piece of information is buried somewhere deep in the report. SMA’s are the immediate precursor to NPA’s and an increase in SMA2 ratio is a harbinger of higher Gross NPA’s at banks.

Current account deficit

The report, released in the last week of December 2019 has forecast that current account deficit is likely to be under control “reflecting muted energy price outlook”. In just a week since then, the geopolitical situation has taken a turn for the worse in the Middle East, with the clash between the US and Iran, resulting in higher oil prices. Though the price quickly corrected, the Middle East situation continues to be volatile as always, putting India’s current account deficit in a similar situation. Overall, the report appears to support a bearish view on energy prices, which is good news for a huge oil importer like India.

Foreign exchange reserves

In Q1:2019-20, current account deficit widened to 2.0 per cent of GDP from 0.7 per cent in the preceding quarter, but this was more than offset by net capital flows. Foreign direct investment (FDI) recorded net inflows of USD 13.9 billion in Q1:2019-20 as compared to USD 9.6 billion in the corresponding quarter of the previous year, along with increase in external commercial borrowings (ECB’s). This has led to increase in foreign exchange reserves which now stand at a significant USD 454.49 billion. The RBI’s intervention in the foreign exchange market “to curb rupee volatility” (perhaps a euphemism for preventing rupee appreciation and its impact on exports) would have helped in building the FX reserve war chest to face sudden outflows or speculative attacks on the rupee in the offshore non deliverable forward markets.

The report opines that as US monetary easing takes a breather, the exchange rate outlook for emerging market (EM) currencies will be a large determinant of EM local currency bond flows.

Worries on credit growth highlighted

The aggregate growth (y-o-y) in banking sector’s gross loans and advances noticeably slowed from 13.2 per cent in March 2019 to 8.7 per cent in September 2019. This raises the issue of causality. Did the slowdown in the economy result in lower credit offtake or did banks’ aversion to lend to the fraud prone industrial sector, lead to economic slowdown? Perhaps, the truth lies in between, with each feeding off the other.

Rating shopping, RBI calls it out

It’s been an open secret until now, that issuers shop around for the best credit rating and rating agencies fall into this competitive trap to secure business by providing rosy ratings, which therefore are of no value to the lender/investor. The central banks concludes, using data, that for ratings that are withdrawn, the new ratings assigned are either the same or an improvement over the earlier ratings. Although replacement of withdrawn ratings by better or similar ratings by a different rating agency is visible across all rating grades, such instances are particularly pronounced at BBB and below. The issue of possible rating shopping behavior on the part of obligors clearly requires serious attention, says the central bank. Whose attention?! That of the market regulator, which regulates rating agencies?

Equity market, a better harbinger of defaults?

The report, while hesitating to spell out that rating agencies are behind the curve in recognizing defaults, makes no bones of its opinion that a relatively vibrant and active equity price is the only source of emerging information for all stakeholders including rating agencies. In other words, equity markets can predict defaults better than credit rating agencies.

Enforcement, a weak link

During July 2019 to December 15, 2019, RBI’s Enforcement Department undertook enforcement action against 29 banks and one NBFC, and imposed an aggregate penalty of ₹47.92 crore for non-compliance with/ contravention of directions on fraud classifications and reporting by the banks, reporting of fraud on the CRILC platform, fraud monitoring in NBFCs, discipline to be maintained while opening current accounts, discounting/ rediscounting of bills by the banks, monitoring the end use of the funds, violations of directions/ guidelines issued by the Reserve Bank on know your customer (KYC) norms, Income Recognition and Asset Classification (IRAC) norms etc.

Even discounting for the size of India’s banks versus those in the US/EU, the circa USD 7 million penalty by the banking regulator in India, is an abject figure compared to the multibillion dollar penalties on banks in the US and Europe for violations. The Indian market regulator’s similarly modest penalties on errant credit rating agencies, led to a rally in their share prices when the penalty figures were announced recently.  The timid response of our banking and market regulators cannot act as a deterrent to the banking and market players from ever more egregious violations.

Good news for real economies is bad news for the markets

The drafters of the Financial Stability Report appear to have taken pot shots at traders chasing negative yielding bonds. The report highlights that the extraordinary monetary expansion in the wake of persistent economic weakness has distorted global yields and that about a quarter of investments is in negative yielding bonds. Investors are betting on negative yielding bonds for capital gains for which yields need to go down even further.  However, when the tide turns, bringing in good news for the real economies, it turns out to be bad news for the markets.

To conclude, the latest edition of the Financial Stability Report by the Reserve Bank of India is rich in data and analysis, provides several meaningful insights, even appears to pontificate to its peer market regulator, but stays away from political hot potatoes like the impact of GST rollout and demonetization.

Nowadays, any discussion among economists with an India connection invariably gravitates towards a familiar topic: the slow and painful unraveling of the Indian economic juggernaut. This quarter the inflation rose to 7.35%, far above the 2-6% band targeted by the central bank. Such huge rise in prices limits the future wiggle room for monetary policy. Meanwhile, credit growth remains low, new mounds of bad loans keep hobbling the system, tax revenues are stagnant, consumer spending is slowing, there are few takers for public sector firms on the block, and the fiscal deficit targets keep getting breached many months in advance. Policies that should normally give a big fillip – like the cut in corporate tax rates, or a large infrastructure spending plan announced last month – seem to have barely made a dent. It is as if the economy has decided on an autopilot course down into the ground, and no amount of cajoling and coaxing can bring it back to its senses.

While there are many details that are specific to the Indian system, economists have for long tried to understand better the broader phenomenon of foreboding that grips the economic climate at such times. In fact, the most well-known economist of the last century, John Maynard Keynes, earned his stripes by proposing what was then a radical solution to the depression that was holding back the western economies in the 1920s and 30s. Keynesianism, as his macroeconomic school of thought came to be known, is one of the many prescriptions that economists nowadays bring to the policy table when conjuring up new ways to treat a failing economy. Just like doctors, economists don’t always agree on the best course of treatment. However, almost all economists agree that at this stage, all the myriad policy prescriptions have a simple underlying agenda: reviving the flagging expectations of economic agents.

1. Economic Expectations

Come to think of it, the real ingredients of any economic system are the expectations of the agents that volunteer to be a part of it. Economics does not dictate how the manufacturing process should operate, that is the subject matter of manufacturing. Neither does economics impose restrictions on the production process, optimizing supply chains is domain of operations. Nor does economics lay down strictures on how products must be marketed, or for that matter, how people must consume the multitude of goods and services that are peddled to them. What economics does, however, is to provide a template for the coordination of these disparate enterprises – manufacturing, production, marketing, consumption, and a host of other activities – that brings everything together and then moves it all forward in the best possible way. A manufacturer tries to figure out the how much to make by using the economic marketplace that allows him to gauge the strength of the demand. The consumer tries to determine the best price to pay by using the economic marketplace that allows her to gauge how much other rival sellers might charge. And so on and so forth. No individual economic agent knows for sure what the actual outcomes will be tomorrow, but by gauging the expectations of others in the system, all agents have a much better sense of what the tomorrow holds for them collectively. The crucial function of the economy is this synchronization, and the actual objects that are being synchronized are expectations of agents in the economy.

In a modern market economy, different marketplaces throw up prices for a diverse array of goods and services. You have price of onions, price of cars, price of homes, price of electricity, price for the cable and internet, price of medicine, and even price of entertainment in the form of a tickets at movie and concert halls. The price of any asset, whether it is a physical object or an intangible service, is the value that a buyer hopes to derive from its possession in the future. This value is all about expectations, because the future is yet to unfold when the transaction is sealed. Different people may expect to derive different value from possession, or they may expect the future to unfold differently—thus they bargain and trade. In the end, though, what they are negotiating about, is competing versions of expectations about the future that is inbuilt into the price. Thus, in a very concrete sense, a market system generates the best expectations of its agents for the future.

By this token, when an economy begins to disappoint, it fails because its agents expect it to fail. The actual failure is a consequence of the expectation of failure among the agents.

2. Managing Expectations

Running a modern market economy well is really an exercise in managing diverse expectations. While the functioning of the actual economic machinery is an important component of this exercise, what is equally crucial—but often overlooked—is the careful calibration of expectations of the participating agents in the economic system. In a way, economic expectations are self-fulfilling. If agents believe that the economy is on a downward trend, they cut back on their investments, and this in turn pushes the economy further down south. On the other hand, if agents believe that the economy is doing well, they spend and consume more, and this in turn boosts the economy. This is the reason top economic managers in a country need to have strong credibility with markets—the markets need to believe in the pronouncements of the economic managers for the pronouncements to have actual effect on the ground.

Building credibility with markets is a long and arduous exercise. Markets need to be convinced that the economic managers know what they are saying, and further, that pronouncements made on paper will be backed by concrete action in the field. This is where reputation matters. For years the Turkish Central bank has been trying to bring its inflation under control through raising interest rates. However, the political leadership in the country has been at loggerheads with the Central bank, insisting on low interest rates to boost growth. The markets think the political leadership is more powerful than the economic leadership in setting the agenda in Turkey, so any pronouncement on interest rates by the Central bank is taken with a huge grain of salt, leading to limited effect on inflation expectations.

In India, too, there is a complicated relationship between economic and political imperatives. On the one hand the economic managers are urged to fight the menace of bad loans, on the other hand political leaders compete with each other in forgiving massive farm loans. On the one hand economic managers try to get bankruptcy proceedings done quickly, on the other hand legal challenges to the process drag on in courts for years. On the one hand the Central bank is promised a free run in its domain, on the other hand through periodic appointments and strictures, its powers are circumscribed. In the past, the Planning Commission was intimately involved in management of the economy and disbursement of central funds, thus announcements by the Commission were a credible signal. Its successor, the NITI Aayog is only an advisory body—their suggestions often overlooked—thus, the Aayog’s proclamations carry limited credibility for markets. In other words, there seem to be very few sources for credible forward-looking signals in the Indian establishment today. This is one reason why forward- looking policy guidelines, that should normally give a fillip, are having little effect on the Indian economy.

3. Reviving Credibility

For reviving an economy that is faltering, the first step is to establish credibility with the markets. When this happens, agent expectations can be altered easily through forward-looking policy announcements, and this sets in motion a virtuous cycle that lifts activity economic activity. In fact, not just the economy, this maxim holds true in other domains, too. For a long time, Indian elections were a murky affair, till T. N. Seshan introduced and implemented a series of electoral reforms. More than the actual reforms, what mattered was the credibility that this exercise established for election commissioners. If the commissioners made an announcement, it got deviant candidates worried, and they therefore desisted from going against the expected norm. In effect, a virtuous cycle was put in motion, the benefits of which Indians are reaping even today.

Keynes was among the first economists to realize the potency of credibility and expectations. The Bretton Woods agreement that he engineered was as much about expectations as it was about actual policy. By getting the governments to commit themselves to far-ranging reform, and bringing in well-known policy makers to helm economic activity, the agreement provided a credible template for sustainable economic recovery after the Second World War as India battles its own economic demons, hopefully the powers that be will heed the lessons of credibility and expectations.

The Hon’ble Finance Minister, in her July 2019 Budget speech, announced that India would soon have a social stock exchange (SSE). The proposed exchange would follow SEBI regulation and allow listing of social enterprises and voluntary organisations. In September 2019 SEBI, the capital market regulator, has constituted a working group to study and recommend a framework for the launch of an SSE in India.  The concept of a social stock exchange is innovative, but not new. SSEs operate in some form in countries like Canada, UK, Singapore, and Kenya. The formats may vary. For example, the Social Stock Exchange in the UK, which was set up in 2013, functions as a platform connecting social enterprises and potential investors. On the other hand, the SVX, an online impact investing platform, set up by the Ontario government in Canada about ten years ago is aimed for ventures, funds and investors seeking social and/or environmental impact alongside the potential for financial return.

Social enterprise is not defined in the Indian Companies Act, 2013. Section 8 of the Companies Act defines a non-profit company as one established for promoting commerce, art, science, religion, charity or any other useful object, provided the profits, if any, or other income is applied for promoting only the objects of the Company and no dividend is paid to its members. Social enterprises are defined by the UK government as “a business with primarily social objectives whose surpluses are principally reinvested for that purpose in the business or in the community, rather than being driven by the need to maximise profit for shareholders and owners.”[1] Nobel Laureate Yunus has preferred to use the expression social business[2] and defined it as a business to address one or more social problems and is run as a non-loss and non-dividend company. The majority of social enterprises in India are incorporated either as a section 8 (earlier section 25) company or a charitable trust. However, law does not preclude formation of for-profit entities with social purpose. In that sense, a social enterprise should be distinguished from non-profit organisations (NPO). All NPOs are social enterprises, but the reverse is not necessarily true.

It seems that the Hon’ble Finance Minister had in her mind NPO form of social enterprises (the non-dividend type) while announcing the need of a SSE. It sounds quite logical as dividend paying companies can always tap the main stock exchange for fund raising. Since the NPOs do not follow any profitability matrix, it is difficult for the promoters to raise finances through traditional channels (e.g., bank finance). Therefore, the main hurdles that such enterprises faces are (a) lack of funding; (b) inability to sustain focus on performance; and (c) a reluctance to take on the risk of failure.[3] Global markets have already backed issuance of bonds for social purposes. For example, the green bonds are debt instruments designed to raise funds for projects and businesses that have a positive environmental or social impact. A report[4] shows that globally green bond issuance reached about US$48 billion in the first quarter of 2019. It shows that investors have supported bonds that were issued for a social cause, particularly environment-related. Therefore, it is believed that NPOs would get similar response from the investors in the SSE.

Nearly 75% of impact investments in India in 2018 were equity investments in portfolio companies (early stage, series A, and series B) and about two-thirds of the impact investors have earned a return of above 15% in 2018.[5] Thus, impact investments do generate handsome returns in the private market and hence an exchange dedicated for the impact investors should be able to encourage greater participation of impact investors.

Structure of the SSE

The proposed social stock exchange should be able to address the challenges presently faced by NPOs and the impact investors. NPOs face the challenge of access to capital; the investors face the challenge of suitable exit; and the regulator or policy makers lack a credible impact assessment tool. While the SSE would definitely address the first two challenges, the exchange may create a framework for impact assessment.

The social stock exchange could be structured as an online exchange which will connect NPOs with the impact and other investors. In order to discourage retail investors to invest in the instruments issued by the NPOs in the initial stage, the minimum investment size could be set at a higher level (e.g., Rs. 1 million). The exchange could offer three types of services- level 1, level 2, and level 3. The compliance norms would vary with the levels. Level 1 allows an NPO to privately place financial instruments (e.g., equity, bonds) with one or more institutional investors (including impact investors). Level 2 allows an NPO to list the fixed-income instruments issued in Level 1 for trading purposes. It may be noted that there will be no fresh issuance of bonds in level 2. This level allows better liquidity for the instruments and also exit options to the level 1 investors. Level 3 allows an NPO to issue fresh instruments (public issue) to investors- both institutional and high net worth individuals (HNIs). Level 1 offerings would have minimum disclosure requirements and may include quarterly reporting of social impact following a standard reporting matrix. Level 2 requires more disclosure in addition to the ones prescribed in level 1. For example, the rating of the issuer, annual financial statements, audit report once a year on impact assessment. Issuers in level 3 can raise fresh capital from the market at a better price from a large number of investors. Therefore, the compliance norms would be more stringent at this level. In addition to the requirements for level 2, a level 3 issuer has to submit quarterly (unaudited) financial results along with a report on social impact.

In order to ensure that the market players do not abuse the market quality, it is important that only reliable and accredited institutions are allowed to participate in the market.  The SSE would formulate an easy-to-implement accreditation process for both the issuer and institutional investors.

Level 1 issuers would be able to meet their financing requirements from select set of impact investors whose objects are aligned with those of the issuers. At level 1, the SSE would disseminate information on NPOs and impact investors and create a mechanism for the interested parties (issuer and investors) to clinch a deal in a transparent manner. Once a deal is consummated, the exchange will widely disseminate the details of the deal in a prescribed format.  Registered members should be allowed to view the post-issuance quarterly reports submitted by the issuers.

It may be noted that trades in level 2 are to facilitate exit for level 1 investors and not to allow NPOs to raise funds. Impact investors include endowments funds, insurance companies and domestic financial institutions. Endowment funds may not face near or medium-term liquidity demand; however the other types of investors may need to churn their portfolio in medium term. Level 2 is designed to cater primarily to those investors. Retail investors can be allowed to trade in bonds in level 2 and the institutional investors (including fund of funds) in both types of instruments. The minimum trading size in level 2 should be Rs. 25 lakhs so that small investors do not participate in this level. The SSE would disseminate market activity in level 2 every day after market hours.

Level 3 activities would be very similar to any other market platform. Since the NPOs are allowed to raise money from a large pool of investors at this level, market regulations and risk management should be of highest order. In order to encourage high net worth individuals who would like to contribute to social cause, the minimum lot size could be fixed at Rs. 1 million. Once the market matures and investors’ interest ascertained, the lot size can be lowered. The SSE would disseminate market activity in level 3 every day after market hours.

Types of Instruments

Apart from equity, the SSE may allow issuance of impact bonds – social impact bond (SIB) and development impact bond (DIB). Impact bonds are specific type of outcome based bonds with financial returns. The promise of financial returns is important to make such bonds attractive to impact investors. In case of impact bonds, the financial risk is borne by the investors who provide the upfront capital and hence these investors would look for appropriate return.  Social Impact Bonds (SIBs)—also known as “social innovation financing” or “pay for success”—offer governments a risk-free way of pursuing creative social programs that may take years to yield results. Usually, governments decide what problems they want to address and then enter into a contractual agreement with an intermediary (or bond-issuing organization) that is responsible for raising capital from independent investors including banks, foundations, and individuals, and for hiring and managing nonprofit service providers. If the project achieves its stated objectives, the government repays the investors with returns based on the savings the government achieves as a result of the program’s success.  In case of Development Impact Bonds (DIBs), the payment is made to the investors by a third party (e.g., a corporate entity). Payment is based on what the project or service has achieved and not on the processes or work that has been done. If any project fails to deliver desirable outcome, the government or the third party would not compensate the investors and hence the investors in that case stand to lose their entire capital. Generally, for both SIB and DIB, a service provider is involved. The service provider is obliged to deliver service to the target population (called beneficiaries) and would thus be compensated once the desirable outcome is achieved. The service provider can be structured as an NPO and can approach SSE for raising upfront capital to fund their need.

In a private market, a fund manager (social impact bond issuer) has a critical role to pay. She has to identify and approach high net worth individuals, foundations and even some corporate to subscribe to the SIBs. Next, she needs to know the service providers (NGOs and/or social enterprises) who have access to the beneficiaries and have organizational set up and programmes to deliver results. The fund manager also has to liaise with the government and finalise terms of repayment. The structure of SIBs is such that investors do not consider their investments as charity and assurance from government on repayment of the bonds actually enhance the creditworthiness of issuers.  While the SIB at the outset specifies that its goal is to bring about change in society, yet it would need to be competitive with other instruments in the market for people other than philanthropists to be interested.

In a public market (the SSE), much of the information on the service provider and investors would be available on the platform and hence it would become easier for the NPOs to find out appropriate investors. Similarly, investors would also have access to a variety of social enterprises to choose from.

Companies in India, who are required to spend 2% of their three-year average after-tax profits on CSR (Corporate Social Responsibility) can avail this route to ensure that they pay for results. This way impact assessment of social investments can be ensured. The CSR mandates that the funds collected would not be used for infrastructural developments under any category. This implies that for education outcomes, construction of school buildings, purchase of school equipment like chairs, tables cannot be accounted as CSR spends. Similarly, for environment sustainability, setting up of solar panels is not a CSR activity. Therefore, CSR expenditure should create impact and the corporates spending the hard earned money should be happy doing so if the investment creates impact in the society. SIB may help achieve the impact. The corporate sector can play the government’s role in a SIB structure or ‘buy out’ the contribution of initial donors in DIBs.

In order to ensure that a SSE functions as an efficient platform, the role of the regulator, and the impact assessors cannot be undermined. It is very important that the SEBI, while launching the SSE, also comes out with the guidelines of enlisting competent impact assessors. Assessment of impact is crucial for the success of any impact funds. The financial returns attached to impact bonds directly depend on the impact created by the fund and hence a reliable measurement of the impact would be necessary to make the SSE dependable and sustainable.

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[1] https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/31677/11-1400-guide-legal-forms-for-social-enterprise.pdf

[2]  Yunus, Muhammad (2011). Building Social Business: The New Kind of Capitalism that Serves Humanity’s Most Pressing Needs. PublicAffairs. p. 256.

[3] Ravi, Shamika; Gustafsson-Wright, Emily; Sharma, Prerna; Boggild-Jones, Izzy (2009). The Promise of Impact Investing in India. Brookings India Research Paper No. 072019.

[4] https://www.climatebonds.net/files/reports/global_q1_2019_highlights_0.pdf

[5] Ravi, Shamika ibid