Regulation in Financial Markets in India

Submitted By: Ridhi Dandona

Table of Contents
Table of Contents......................................................................................................... Introduction..................................................................................................................! "b#ecti$es%&ur'ose of Financial Regulation...........................................................! Indian Regulatory (n$ironment..................................................................................! Reser$e Bank of India.............................................................................................! There is no) an international consensus about the need to focus the tasks of a central bank u'on central banking. RBI is far out of touch )ith such a 'rinci'le* o)ing to the s'ra)ling mandate described abo$e...................................................+ Securities and (,change Board of India -S(BI....................................................../ For)ard Markets Commission -FMC.....................................................................0 1nified Regulation: Is it the Future2...........................................................................0 Roadblocks............................................................................................................3

Introduction
4Financial stability is crucial for sustained economic gro)th but this cannot be achie$ed )ithout strong financial systems. ($en )ith sound macroeconomic management* )eak financial systems can destabili5e local economies* making them more $ulnerable to e,ternal shocks* and may threaten global financial markets.6 (Financial Stability Institute) "ne of the fundamental res'onsibilities of the go$ernment of any country is to foster economic gro)th and social )elfare. 7ence the need for a mechanism -regulatory frame)ork. to ensure the strength* stability and soundness of the financial system%markets Objectives/Purpose of Financial Regulation Maintaining the stability of and confidence in the financial system by ensuring the sol$ency and financial soundness of financial institutions (nsuring the smooth o'eration of 'ayments mechanisms. -&re$ention of systemic risk. &rotecting in$estors* borro)ers and other users of the financial system against undue risks of losses and other damage that may arise from failures* fraud* mal'ractice* mani'ulation and other misconduct on the 'art of 'ro$iders of financial ser$ices. -&re$ention of indi$idual risk. (nsuring a smooth* efficient* reliable and effecti$e functioning of financial markets* including a 'ro'er )orking of com'etiti$e market forces.

Indian Regulatory Environment

The regulatory structure in India features a decentralised setu'* )here the e8uity and cor'orate bond markets are regulated by S(BI* the foreign e,change and fi,ed income markets are regulated by RBI and the commodity markets come under the For)ard Markets Commission -FMC.. 9i$en belo) is a discussion on the $arious regulators. Reserve Bank of India The Reserve Bank of India -RBI. is the central bank of India* and )as established on :'ril 3* 30!+ in accordance )ith the 'ro$isions of the Reser$e Bank of India :ct* 30!;. Since its ince'tion* it has been head8uartered in Mumbai. Though

originally 'ri$ately o)ned* RBI has been fully o)ned by the 9o$ernment of India since nationali5ation in 30;0. RBI is go$erned by a central board -headed by a 9o$ernor. a''ointed by the Central 9o$ernment. The current go$ernor of RBI is Dr.<.=enugo'al Reddy -)ho succeeded Dr. Bimal >alan on Se'tember /* ??!.. RBI has regional offices across India. The Reser$e Bank of India )as set u' on the recommendations of the 7ilton <oung Commission. The commission submitted its re'ort in the year 30 /* though the bank )as not set u' for nine years. Main objectives Monetary :uthority: o Formulates* im'lements and monitors the monetary 'olicy. o "b#ecti$e: maintaining 'rice stability and ensuring ade8uate flo) of credit to 'roducti$e sectors.

Regulator and su'er$isor of the financial system: o &rescribes broad 'arameters of banking o'erations )ithin )hich the country@s banking and financial system functions. o "b#ecti$e: maintain 'ublic confidence in the system* 'rotect de'ositors@ interest and 'ro$ide costAeffecti$e banking ser$ices to the 'ublic. Manager of (,change Control: o Manages the Foreign (,change Management :ct* 3000. o "b#ecti$e: to facilitate e,ternal trade and 'ayment and 'romote orderly de$elo'ment and maintenance of foreign e,change market in India. Issuer of currency: o Issues and e,changes or destroys currency and coins not fit for circulation. o "b#ecti$e: to gi$e the 'ublic ade8uate 8uantity of su''lies of currency notes and coins and in good 8uality. De$elo'mental role o &erforms a )ide range of 'romotional functions to su''ort national ob#ecti$es. Related Functions o Banker to the 9o$ernment: 'erforms merchant banking function for the central and the state go$ernmentsB also acts as their banker.

o o

Banker to banks: maintains banking accounts of all scheduled banks. ")ner and o'erator of the de'ository -S9C. and e,change -DDS. for go$ernment bonds.

There is no) an international consensus about the need to focus the tasks of a central bank u'on central banking. RBI is far out of touch )ith such a 'rinci'le* o)ing to the s'ra)ling mandate described abo$e.

Securities and Exchange Board of India SEBI! In 30EE the Securities and (,change Board of India -S(BI. )as established by the 9o$ernment of India through an e,ecuti$e resolution* and )as subse8uently u'graded as a fully autonomous body -a statutory Board. in the year 300 )ith the 'assing of the Securities and (,change Board of India :ct -S(BI :ct. on !?th >anuary 300 . In 'lace of 9o$ernment Control* a statutory and autonomous regulatory board )ith defined res'onsibilities* to co$er both de$elo'ment F regulation of the market* and inde'endent 'o)ers ha$e been set u'. &arado,ically this is a 'ositi$e outcome of the Securities Scam of 300?A03. The basic ob#ecti$es of the Board )ere identified as: To 'rotect the interests of in$estors in securities To 'romote the de$elo'ment of Securities Market To regulate the securities market

Since its ince'tion S(BI has been )orking targetting the securities and is attending to the fulfillment of its ob#ecti$es )ith commendable 5eal and de,terity. The im'ro$ements in the securities markets like ca'itali5ation re8uirements* margining* establishment of clearing cor'orations etc. reduced the risk of credit and also reduced the market. S(BI has introduced the com'rehensi$e regulatory measures* 'rescribed registration norms* the eligibility criteria* the code of obligations and the code of conduct for different intermediaries like* bankers to issue* merchant bankers* brokers and subA brokers* registrars* 'ortfolio managers* credit rating agencies* under)riters and others. It has framed byeAla)s* risk identification and risk management systems for Clearing houses of stock e,changes* sur$eillance system etc. )hich has made dealing in securities both safe and trans'arent to the end in$estor. :nother significant e$ent is the a''ro$al of trading in stock indices -like SF& CDG Difty F Sense,. in ???. : market Inde, is a con$enient and effecti$e 'roduct because of the follo)ing reasons: It acts as a barometer for market beha$ior It is used to benchmark 'ortfolio 'erformance It is used in deri$ati$e instruments like inde, futures and inde, o'tions It can be used for 'assi$e fund management as in case of Inde, Funds.

T)o broad a''roaches of S(BI is to integrate the securities market at the national le$el* and also to di$ersify the trading 'roducts* so that there is an increase in number of traders including banks* financial institutions* insurance com'anies* mutual funds* 'rimary dealers etc. to transact through the (,changes. In this conte,t the introduction of deri$ati$es trading through Indian Stock (,changes 'ermitted by S(BI in ??? :D is a real landmark. S(BI a''ointed the C. C. 9u'ta Committee in 300E to recommend the regulatory frame)ork for deri$ati$es trading and suggest byeAla)s for Regulation and Control of Trading and Settlement of Deri$ati$es Contracts. The Board of S(BI in its meeting held on May 33* 300E acce'ted the recommendations of the committee and a''ro$ed the 'hased introduction of deri$ati$es trading in India beginning )ith Stock Inde, Futures. The Board also a''ro$ed the HSuggesti$e ByeAla)sH as recommended by the Dr CC 9u'ta Committee for Regulation and Control of Trading and Settlement of Deri$ati$es Contracts. S(BI then a''ointed the >. R. =erma Committee to recommend Risk Containment Measures -RCM. in the Indian Stock Inde, Futures Market. The re'ort )as submitted in no$ember 300E. 7o)e$er the Securities Contracts -Regulation. :ct* 30+/ -SCR:. re8uired amendment to include Hderi$ati$esH in the definition of securities to enable S(BI to introduce trading in deri$ati$es. The necessary amendment )as then carried out by the 9o$ernment in 3000. The Securities Ca)s -:mendment. Bill* 3000 )as introduced. In December 3000 the ne) frame)ork )as a''ro$ed. Deri$ati$es ha$e been accorded the status of ISecurities@. The ban im'osed on trading in deri$ati$es in 30/0 under a notification issued by the Central 9o$ernment )as re$oked. Thereafter S(BI formulated the necessary regulations%byeAla)s and intimated the Stock (,changes in ???. The deri$ati$e trading started in India at DS( in ??? and BS( started trading in the year ??3. S(BIJs main functions are 'ro$iding for

Regulating the business in stock e,changes and any other securities markets Registering and regulating the )orking of stock brokers* subAbrokers* share transfer agents* bankers to an issue* trustees of trust deeds* registrars to an issue* merchant bankers* under)riters* 'ortfolio managers* in$estment ad$isers and such other intermediaries )ho may be associated )ith securities markets in any manner.

Registering and regulating the )orking of the de'ositories* 'artici'ants* custodians of securities* foreign institutional in$estors* credit rating agencies and such other intermediaries as the Board may* by notification* s'ecify in this behalf. Registering and regulating the )orking of $enture ca'ital funds and collecti$e in$estment schemes including mutual fundsB &romoting and regulating selfAregulatory organisationsB &rohibiting fraudulent and unfair trade 'ractices relating to securities marketsB &romoting in$estors@ education and training of intermediaries of securities marketsB &rohibiting insider trading in securitiesB Regulating substantial ac8uisition of shares and takeo$er of com'aniesB Calling for information from* undertaking ins'ection* conducting in8uiries and audits of the stock e,changes* mutual funds and other 'ersons associated )ith the securities market and intermediaries and selfA regulatory organisations in the securities marketB Calling for information and record from any bank or any other authority or board or cor'oration established or constituted by or under any Central* State or &ro$incial :ct in res'ect of any transaction in securities )hich is under in$estigation or in8uiry by the BoardB30 &erforming such functions and e,ercising such 'o)ers under the 'ro$isions of K...L ? Securities Contracts -Regulation. :ct* 30+/* as may be delegated to it by the Central 9o$ernmentB Ce$ying fees or other charges for carrying out the 'ur'ose of this sectionB Conducting research for the abo$e 'ur'osesB Calling from or furnishing to any such agencies* as may be s'ecified by the Board* such information as may be considered necessary by it for the efficient discharge of its functionsB 3 &erforming such other functions as may be 'rescribed.

For"ard #arkets $o%%ission F#$! Forward Markets Commission FMC! head8uartered at Mumbai* is a regulatory authority )hich is o$erseen by the Ministry of Consumer "ffairs and #ublic $istribution% &ovt' of India. It is a statutory body set u' in 30+! under the For)ard Contracts -Regulation. :ct* 30+ . H The :ct 'ro$ides that the Commission shall consist of not less than t)o but not e,ceeding four members a''ointed by the Central 9o$ernment out of them being nominated by the Central 9o$ernment to be the Chairman thereof. Currently Commission com'rises four members among )hom Shri S. Sundareshan* I:S* is the Chairman and Dr. Me)al Ram* I(S* Dr. -Smt. >ayashree 9u'ta* CSS* and Shri Ra#ee$ kumar :gar)al* IRS* are the Members of the Commission.H The functions of the For)ard Markets Commission are as follo)s: -a. To ad$ise the Central 9o$ernment in res'ect of the recognition or the )ithdra)al of recognition from any association or in res'ect of any other matter arising out of the administration of the For)ard Contracts -Regulation. :ct 30+ . -b. To kee' for)ard markets under obser$ation and to take such action in relation to them* as it may consider necessary* in e,ercise of the 'o)ers assigned to it by or under the :ct. -c. To collect and )hene$er the Commission thinks it necessary* to 'ublish information regarding the trading conditions in res'ect of goods to )hich any of the 'ro$isions of the act is made a''licable* including information regarding su''ly* demand and 'rices* and to submit to the Central 9o$ernment* 'eriodical re'orts on the )orking of for)ard markets relating to such goodsB -d. To make recommendations generally )ith a $ie) to im'ro$ing the organi5ation and )orking of for)ard marketsB -e. To undertake the ins'ection of the accounts and other documents of any recogni5ed association or registered association or any member of such association )hene$er it considerers it necessary.

(nified Regulation) Is it t*e Future+

The structure* systems and 'rocesses of financial regulation in any economy are determined by the countryJs social* 'olitical and economic forces. In a dynamic socioAeconomic en$ironment* the regulatory frame)ork has to be res'onsi$e to changes in the financial market in terms of its si5e* com'le,ity* 'rocyclicality and $olatility* and hence* to remain effecti$e it needs to be a function of time and s'ace. Nhile being sensiti$e to local needs* regulation has to align itself to global concerns

and maintain a balance on an ongoing basis. The sco'e and co$erage of financial regulation e,'ands along )ith the le$el of integration in the financial market. The instruments and mechanisms of regulation are designed in res'onse to the changes in the beha$iour of financial market and its 'artici'ants. :s the financial market o'erations are information intensi$e* asymmetric a$ailability of information creates distortions )hich need to be counterAbalanced through a''ro'riate regulatory mandates. In recent times a need has been felt for a single unified regulator )ho can o$ersee the entire financial ser$ices markets. There are three ma#or reasons )hy a unified a''roach to)ards regulation )ould hel': -a. the commonality of kno)ledge* -b. the integration of markets* and -c. information sharing. The commonality of knowledge argument is based on the fact that there is something uni$ersal about all trading in financial markets. Regardless of )hether )e discuss trading )heat or shares of T(CC"* the basic issues of trading* clearing and settlement are remarkably similar. In this case* )hen a regulator de$elo's the e,'ertise in 're$enting fraud and 'rotecting systemic integrity* there are economies of scale in de'loying this e,'ertise across many markets. This e,'ertise is 8uite difficult to ac8uire* in the modern en$ironment )here trading is electronic* clearing takes 'lace through a clearing cor'oration* settlement is electronic )here$er 'ossible* funds mo$e electronically to the e,tent 'ossible* and s'ot markets are su''lemented by deri$ati$es markets. The story of badla is a reminder about ho) regulators need a remarkable degree of clarity* in )ays )hich are often 8uite incom'atible )ith Hnormal market 'racticeH* in order to make a''ro'riate choices about ho) the markets should function. : regulatory agency )hich o$ersees all financial markets in the country )ould be able to ra'idly carry successful ideas from one style of market to another: e.g. such a regulator is likely to ha$e chosen to re'licate the success of the electronic order book market -)hich )as born in India on the e8uity market. in the foreign e,change market. (lectronic funds transfer -(FT. is a situation )hich is likely to be $ie)ed 8uite differently by the RBI as com'ared )ith the securities industry. For the banking system* and hence for RBI* (FT is a 'art of the dri$e to)ards bank com'uterisation and enhanced efficiency. For the securities industry* (FT is the lifeblood of the functioning of the clearing cor'oration* enabling the reliable 'ayment of margins and hence the integrity of the market. : single regulator )ould mo$e far more decisi$ely in establishing an electronic high)ay* connected to numerous nonAbanks in the country* )hereby funds mo$e )ithin seconds bet)een any t)o 'oints in the country.

"ne often hears suggestions that deri$ati$es markets are someho) different and re8uire a ne) regulatory establishment. This a''roach understates the tight -arbitrage. linkages that bind the s'ot market and the deri$ati$es market together. 7a$ing one regulator for the s'ot market and one regulator for the deri$ati$es market is bound to generate difficultiesB it makes more sense to $ie) the combination of s'ot and deri$ati$es as one unified market. The second argument fa$ouring a single monolithic regulator concerns avoiding artificial boundaries and turf wars. Markets e$ol$e in res'onse to inno$ations and technology* and this regularly has the effect of making some institutions obsolete. In an en$ironment )here one regulator o$ersees institution : )hile another regulator o$ersees institution B* there is often a tem'tation on the 'art of the regulator to 'rotect the interests of the institutional mechanism that he o$ersees. This often ends u' being a barrier to inno$ation* and slo)s do)n the 'ace at )hich old institutions become defunct. :n e,treme case of irrational turf conflict is seen in the 1S* )here the 'olitical com'romise in 'lace today consists of one regulator* the S(C* being in charge of o'tions and another regulator* the CFTC* being in charge of futures. This distinction* based on the instrument* is an outcome 'roduced by la)yers and 'oliticians trying to Hsol$eH a longstanding turf )ar* )ithout understanding the economics. Turf conflicts )ill also ine$itably arise gi$en the so'histication of instruments )hich 'roliferate in the modern financial system. If a deri$ati$es e,change trades futures on the dollarAru'ee* )ill this be regulated by the RBI or by S(BI2 If DS(@s deri$ati$es market comes u' )ith an instrument )hich is an o'tion based on the 'rice of )heat e,'ressed in dollars* )ill this be regulated by S(BI or RBI or FMC2 If a modern futures market on the dollarAru'ee comes about* then )ould the RBI )holeheartedly 'ush banks to transfer their usage from the e,isting for)ard market to this ne) futures market* e$en if the futures market is not regulated by the RBI2 The turf )ars )hich surface here ine$itably hurt the de$elo'ment of the markets. The third reason fa$ouring a single regulator is about information sharing and coordinated crisis-handling. The CRB crisis has sho)n u' our regulators in 'oor light on their ability to share information* )ork together and sol$e 'roblems. Things might )ork better )ith a single regulatory agency. Similarly* the Canstar 'roblem )ould ha$e )orked out $ery differently if a single regulator dealt )ith Canara Bank and )ith Canbank Mutual Fund. ($ery market crash in the )orld 'uts clearing cor'orations of the securities industry under stress* and one good res'onse is to setu' o$ernight credit for the clearing cor'oration. "ne can easily imagine a central bank being relati$ely unconcerned about the )orst disaster )hich can befall the securities industry* i.e. the failure of a clearing cor'oration.

Roadblocks The most im'ortant criticism comes from )orrying about the 8uality of leadershi' that such a su'erAagency can obtain. There is a tremendous concentration of 'o)er into a fe) hands in such an agencyB and this )ould attract 'o)erAseekers to these 'osts. Do )e* as a country* ha$e the methods in 'lace to ensure that these a''ointments )ill be based on com'etence* integrity and technical e,'ertise alone2 The kind of damage that can be done from senior le$els of this agency A )hether moti$ated by ignorance or 'atronage or corru'tion A is frightening to contem'late. 9oing beyond economics* )e should also think about the conse8uences of this concentration of 'o)er for the liberal democracy. Inno$ation is too often disliked by regulators* and the international e,'erience is that inno$ations )hich are blocked by one regulator often get the green light from another. For e,am'le* in India* )hile deri$ati$es in the e8uity market ha$e been interminably delayed* there is significant 'rogress in futures markets on commodities* )hich is hel'ing by )ay of generating skills and diminishing the Hfear of deri$ati$esH in the country. Similarly* )hile com'uterised order matching )as not a 'riority )ith regulators in commodities* fi,ed income or foreign e,change* it )as a high 'riority for regulators on the e8uity market. In these )ays* competition between regulators )ithin a country might often yield better outcomes than the stifling im'act of decisions by a single regulator. Nith a single regulator* the only alternati$e left for inno$ations )ould be to esca'e to e,changes o$erseas.