The Revenge of Badla: How early 2000s market shifts fuel Jane Street case

The Badla system was a hybrid cash & futures trading product. It was offered on the BSE, and had been an age-old system for trading on margin

I woke up that morning in February of year 2000, with a particularly bad attack of the ‘imposter syndrome’.

This syndrome should strike most people who make some quick riches at the casino/races/ lottery/ stock market. But it rarely does.

 
I was in my mid-30s. That’s a particularly dangerous age to get dangerously rich and I was exactly in that hot zone. All my tech stocks had been flying long and hard (back then, at the height of the tech boom, long term was defined as six months).

 
I made myself a quiet cup of coffee, lit a cigar, and ruminated on what all this lunacy meant. The only sensible answer I got from my easy-money addled brain was “Get out. Now!”.

I got out and so did all my FII clients.

But this piece is not about me or my imposter syndrome. It’s about the ease with which I managed to sell hundreds of millions of dollars and more, at the press of a button: Infosys, HFCL, Global Tele, Satyam, Zee... the entire dirty dozen. Knife through butter doesn’t even begin to describe just how effortless those exits were: my traders kept shouting “Boss, 20 million dollars sold in HFCL. The market is just swallowing whatever we can give. We can do more”. That was classic dealing room cocaine.

Impact cost is the way we measure...well... the impact of a trade on the price of that security. The impact cost of those 100s of millions of dollars in sell trades was miniscule, the screen told me: the Komodo Dragon in the terminal wasn't even belching, while ingesting our finest tech names.

And no, Ketan Parikh had no influence on prices, contrary to lore: as revealed in a Sebi report, the aggregate of his trading volume in all the tech names of the day, was around 5 per cent at the highest. Nobody can control markets doing such volumes. There was a global tech boom, Indian tech names participated in lock-step. And collapsed in the same lock-step.

Fast forward eight years later. Market peak of 2008. I woke up with the same imposter syndrome. I dialed up the FIIs.

The FIIs, with uncaged capital, and ever so willing to listen to sanity, told me to sell. But something had changed. The knife was not going through butter anymore. It was going through molasses. The impact cost was massive. Even small selling was leading to large instant falls in our blue chips of that era. We had a market collapse of 12 per cent over two days in January 2008, as a result.

 
What changed between 2000 and 2008?

The disappearance of the ‘greatest financial innovation’ ever in the history of financial innovations: Badla.

 
The Badla system was a hybrid cash & futures trading product. It was offered on the BSE, and had been an age-old system for trading on margin. But here’s where it became interesting: a typical settlement back then on the BSE ran from Monday to Friday (batch settlement). Badla was offered on the largest stocks in the market: the ITCs, Reliances, sundry hot favourites of the relevant era’s bull market (the more things change, the more they remain the same, don’t they?). They were called ‘A Group’ stocks, much like the F&O list today. The rest of gang traded only in the cash market, and were called (kinda B- Grade), B Group.

Now, you bought 100 shares of Reliance on a Monday. On Friday, you had a choice: square up, take delivery or roll it over (called “carry forward”). Assume you decided to roll it over. Every Saturday, the BSE held a “Badla Trading” session — a session to determine the badla or the interest rate (contango) at which you could roll over your Reliance (these rates varied stock to stock and if a stock was heavily shorted, there could even be the exact opposite — undha badla,or a negative interest rate where the seller, instead of receiving Badla, would have to pay Badla (backwardation). So say, the closing (hawala) rate of Reliance was 200 on Friday, and the Badla for the coming week was 25 paisa, your trade would be carried forward at 200.25 into the next settlement.

For folks wanting delivery, you would get delivery in the physical delivery session, held the same Saturday.

Now, absorb this slowly: the market had one single, unified stream of liquidity. The hybrid cash-futures or Badla stream. The stream parted only at the end of close on Friday. So the speculator and the investor, both entered, drank, swam, in the exact same stream.

What this did to market liquidity was quite astonishing. Many popular stocks, in the 1999-2000 bull market, traded between 2 and 10 per cent of their market cap. Daily! Yes, you read that right. That’s precisely why I could get the FIIs and myself, out in minutes and hours, with negligible impact cost. The market back then was an abundant Amazon (I am talking about the river not the e-commerce website) of liquidity, co-mingling the day trader with the “hold forever” tribe.

Let’s get to some data now:

The data (as in the above charts) is an Ali one two punch. Our markets today are far less liquid than what they were 25 years ago. They are far less liquid, pound for pound, than the US markets. And even for the very same stocks, we are far less liquid today than 25 years ago. Put another way, our markets were 2x-20x more liquid in 2000, than they are today! Just look at our largest company — Reliance’s - data in the table. Reliance was around 6x more liquid in the Badla era than it’s today.

And this is despite a massive growth in participation in every single segment of investors: DIIs, retail, FPI (heck, even promoters who seemed very active at least on the selling side in this bull market!).

One more thing: post abolition of Badla, we have had around seven instances of +/- 8 per cent move- days, vs just one in the Badla days (excluding aberrations like Covid falls & rallies and Harshad months moves when the market had next to no widespread retail or institutional participation).

Cancelling Badla has made our markets more volatile, because it has cut liquidity.

Let’s turn to the Jane Street imbroglio. Very simply, they figured out, presumably using Math PhDs with supercomputers, the data given in the tables, something I just did on my mobile phone: that the Indian markets are eminently game-able. So they bought up index components (the dog) in the illiquid cash markets, which drove up the index (the tail) in the ultra-liquid futures market, and then bought puts/ wrote calls, or did whatever Math PhDs on super computers do.

But Jane Street could do what they did because of the most fundamental flaw in the Indian stock market: a fragmented, fractured, fissured, fistula-ed (sorry) liquidity stream wherein the cash and futures streams, originally unified in the Badla system, became an unstable coalition, each swimming in its own dank stream.

The free flowing giant Amazon river has become a collection of rivulets.

So what happened to the Badla system? It got outlawed in 2001, following the Ketan Parikh episode. Why? Because apparently some brokers and traders abused it. This was the equivalent of banning alcohol on all domestic flights because a passenger on Damania Airways got drunk on 125 ml of weak beer and misbehaved with a flight attendant.

So out went old & musty Badla, in came factory fresh F&O.

Well, it seems Jane Street abused this super modern F&O system. So what are we going to do? Outlaw it, like we did Badla? Naah...we only outlaw desi stuff.

But the data are unequivocal: Badla lubricated the gears of our market’s trading. Understand this: India is intrinsically always going to be a lower liquidity market than most. This is because of very high promoter holdings, hence lower free float, in Indian companies in sharp contrast to most others in the developed markets.

Badla evened that out. By making the cash and futures become an inseparable, fast spinning yin-yang wheel, such that the two were indistinguishable from each other.

Thereby, Badla compensated for the lack of high free float.

And therein lies the root of the current Jane Street scandal. Our markets today are a hollow anthill of only market cap. In most part, these anthills take just a small kick to cave them. Even a kick as small as three quarters of a billion dollars, like Jane Street did.

It is completely unreasonable to expect India to become atmanirbhar in financial thinking (come to think of it, why do we still call Draft Red Herring Prospectus thus? This is a century old Wall Street term which has never had any relevance to India. But we still regulatorily use it.)

But maybe, just maybe, we could trial this on a group of “B Group” stocks? Don’t call it Badla. Call it “The Hybrid” or some such?

I don’t hold out hope though. We should have been exporting Badla to global markets. Instead, we drove a stake into Badla’s heart. Now, its apparition is sucking the blood of retail traders as they lose money to the Jane Streets in a supremely manipulable market.

I can only reminisce about the cascades of liquidity in the Badla era, while drowning my sorrows in a more liquid bottle of Domaine de la Romanée-Conti 1999 Burgundy, singing “It must have been good, but it’s over now”.

Shankar Sharma

Founder of Gquant FinXRay, an AI company

Investment Philosopher