The central purpose of any economic regulation is the protection of public interest and, in that sense, it serves public good. There are benefits as well as costs attached to every regulation, and it is important for society to know who are the beneficiaries of the regulation and who bears the burden of the costs, so that the regulation can enhance efficiency of resource allocation. But the securities market regulation must also contend with the other competing concerns of investor confidence, investor protection and market development. In advanced markets, market development and innovation are often left to the market itself, and the regulators are responsible for investor protection and balancing the costs and benefits of regulation so that these are appropriately allocated. Unlike those markets, Sebi's role included market development, besides investor protection and market regulation. Indeed, this was inevitable; at the beginning of the 1980s, the securities market was for all practical purposes in the backwater of the financial system, suffering from manifold weaknesses and severe economic inefficiencies.
Sebi's developmental role involved putting in place a whole new regulatory framework. In some places, the extant regulatory structure needed redesigning, but in most places, a new architecture had to be crafted. This meant making new regulations where none existed. Change processes threaten status quo and affect the economic rents of the beneficiaries of systemic inefficiencies. They were unlikely to make it easy for the regulator to move forward. One example was the nationwide broker strike leading to a shutdown of all the stock exchanges and their recalcitrance to welcome market automation. It had several unintended positive consequences for the market.
Sebi had to develop strategies to support change. Analysed in hindsight, these strategies would fall into the following steps:
- Identifying the stakeholders and potential supporters of the regulatory architecture;
- Recognising possible pockets of resistance;
- Making the principal stakeholders a part of the change process and co-creating the changes with them;
- Establishing co-creating platforms for mutual exchange of ideas between the regulator and the stakeholders, and getting feedback.
It was this attempt to co-create the changes along with the market participants, through a process of active deliberations and consultations (which even included consultations on the drafts of the regulatory changes), that allowed Sebi to - gradually put in place changes in a disclosure regime; help establish the National Stock Exchange; make the market attractive to foreign institutional investors; introduce nationwide electronic trading; dematerialisation of securities; changeover to rolling settlement and shorten the settlement cycles to T+2 in less than three years; institute the risk-management system with counterparty risk and margins; set up clearing corporations; abolish badla; establish derivatives and currency derivatives; raise the standards of exchange governance; demutualise the exchanges; proliferate mutual funds; regulate the market for takeovers; raise accounting standards; and lay down the norms for corporate governance.
Five features about these reforms are worth noticing - the comprehensive scope, wide reach and range, deliberate gradualism in implementation, the sequencing of the changes (one change dovetailing into the next) and effecting the changes without market disruption.
Serious episodes of market misconduct have occurred during the past 25 years, and in all such occurrences, as is wont, fingers were pointed (often unfairly) at Sebi's failure to detect and prevent them. This is, in any case, the regulators' burden globally. The only way Sebi can address this burden is to put all its efforts behind market surveillance, monitoring and enforcement. It is as necessary a measure of regulatory efficiency as capital formation and market development.
A strong enforcement system entails an equally strong surveillance regime. Sebi may determine how best to share the surveillance burden with the stock exchanges and make more effective use of the Intermarket Surveillance Information System (which requires a strong complement of analysts and statisticians). It will also have to choose the investigation cases of market manipulation and insider trading efficaciously, imbued with a deep understanding and sensitivity of the likely implications a strong deterrent punishment will have on the market. It will need to improve the quality and speed of investigations and bring about uniformity of the regulatory actions, including its consent orders.
Globally, the markets are undergoing structural changes; the Indian markets are unlikely to be insulated from them. These changes are driven more by market demand, and less by the regulator, unlike in the past. In addition, there will be innovation-driven complexity in three areas: products and distribution, markets and technology. Added to this would be the complexity in global markets - the rise of dark pools and high-frequency trading - the impact of which will, willy-nilly, fall on the Indian markets, too, and complexity in technology resulting in the rise of cyber crime in the financial system globally.
All this makes the task of the regulator complex. But it is critical for Sebi to be aware of these challenges. To deal with these will, perhaps, require more use of technology; training of internal manpower and capacity-building; and intelligent use of the existing powers. An equally worthwhile exercise at this stage would be to undertake a cost-benefit analysis of the regulatory framework that could also throw up the impact of its policies on market efficiency. This exercise will enable Sebi to make course corrections wherever needed.
The author joined Sebi at its inception on April 12, 1988, worked closely with the first six chairmen and was its longest-serving Executive Director (1992-2006). He is currently a consultant with the World Bank and Deloitte Touche and Tohmatsu (India) Pvt Ltd