Why track down Rooplaben?

A few months ago, when Manjunath was murdered, at first there was an uproarabout bad law and order. While concerns about bad law and order arecertainly well placed, in this case, the incentive for criminal activitiesclearly came from government-induced pricing distortions in petroleumproducts. Just as the problem of smuggling was caused by India's tradebarriers, which went on to corrode the police, the problem of Manjunath'smurder was caused by India's oil pricing policies, which went on to corrodethe police.

A similar situation has shaped up on the IPO market. The root of the rot isa pricing policy which gives supernormal returns to "individual investors".In the IPO market, a "small investor" is defined as someone applying forshares of less than Rs 50,000. In the Yes Bank IPO, the oversubscriptionfor such "small investors" was 9.96 times, while the oversubscription forthe remainder was 43.68 times. This gave "small investors" an allotment ofshares bigger by four times.

If you got shares of Yes Bank at the IPO and sold at first listing, thisgave you an instant profit of 36%. How do you think people will respond tosuch a situation? By tossing in more applications! A family of five willput in five different applications, each at Rs 49,999. A family of fivewill create five fake identities each, and thus have 25 applications. Andso on it will go, to a point where some people will muster thousands ofapplications. It is hypocritical to pour invective upon someone who puts in5,000 applications, while ignoring the ordinary household that puts in 25applications.

When the IPO market is structured in this fashion, there is endemicfalsfication, and ordinary citizens engage in fraudulent behaviour. When acertain activity endemically takes place amongst ordinary, middle-classhouseholds, no police force in the world can stop it. In a democracy, whenthere is a collision between law and mass behaviour, ultimately it is thelaw that has to budge.

In some countries, there are strong notions of citizen's identity, whichuniquely identifies each person. An enormous enforcement infrastructure hasbeen developed in those countries, to enforce stringent penalties againstpeople who have multiple identities. If such identity infrastructureexists, it becomes feasible to enforce rules such as "no more than oneapplication per citizen". But even there, it is unfair that a family of sixcan toss in six applications while a family of two can only put in twoapplications. In the Indian case, given the absence of identityinfrastructure, enforcement against multiple applications is justinfeasible.

The finance minister has promised a crackdown on the "IPO scam". Hundredsof staffpersons at the ministry of finance, the RBI, Sebi, NSDL, etc. arenow expending their energies in hunting down multiple applications inrecent IPOs. Is this an efficient use of scarce regulatory and governancecapacity?

The core problem lies elsewhere. It lies in a pricing distortion that hasbeen created by Sebi. The solution that is required is to eliminate thisdistortion.

There is no case for special allocations for "individual investors". Theultimate aim of a good IPO mechanism is that the price discovered in theIPO auction should be practically the same as the price at first listing.If an IPO takes place on Friday, and trading starts next Monday, onaverage, the Monday closing price should be the same as the IPO price.

Once this is done, there is no "special profit" in buying at the IPO, whichcan be politically allocated to "individual investors". Individualinvestors who didn't obtain shares in the auction would be able to buy themon the secondary market on Monday at essentially the same price.

The way forward, thus, consists of removing the frictions that are in ourIPO process, which are generating a gap between the IPO price and the firstlisting price. Our the IPO mechanism has made enormous progress compared tothe bad old days, when people filled out forms and sent them out with acheque attached, by post. We have started using computer technology toreduce the frictions. But partly owing to the business interests ofinvestment bankers, we have stopped short of the logical destination: IPOby pure auction through the NSE and BSE.

Here is how it would work. The investment banker would help the company towrite the prospectus, and do roadshows across India, but have no other rolein the IPO. On a Friday, the auction would take place from 9:55 to 3:30. Aswith secondary market trading, there is no need for a "price band", whichonly limits price discovery. Investors would go to a broker to place ordersin the auction. All brokers in India would be able to accept orders for theIPO, exactly as is the case with the secondary market today. Exactly aswith the secondary market, the broker would be held financially responsiblefor the orders placed by investors.

The screen would continually display the market-clearing price and demandschedule. Investors would have the ability to revise their bids if theychange their minds based on looking at the demand curve. At 3:30 PM, thecomputer would calculate the cut-off price, and apply it to all successfulbidders. By definition, there would be no oversubscription.

The greatness of India's secondary market for equity has been that allinvestors_retail or institutional_participate in a single unified pricediscovery. The success of unification of all orders in the secondary marketshows that this is feasible in the IPO auction also. A financial market isabout prices, where the highest bidder gets the securities sold in theauction, and not about the identity of the participant.

The ultimate cause of smuggling was our trade barriers. The ultimate causeof Manjunath's death is our pricing distortions on petroleum products. Theultimate cause of the "IPO scam" is mistakes in the design of the IPOmarket. Instead of expending thousands of man-hours of staff time in hotpursuit of Roopalben, we should solve the problem at the source. Thisrequires moving up to the next level: an IPO market based on pure auction.Everyone benefits in such a scheme, except for the investment banker whomakes less in fees.