The regulatory puzzle of MIIs

Market infrastructure institutions are being turned into de facto PSUs. Have we failed to find the right balance in their operations?

The committee constituted by the Securities and Exchange Board of India (Sebi) to review the governance framework for market infrastructure institutions (MIIs) — such as exchanges — recently released its draft report for public comments.
 

MIIs are unique institutions providing vital infrastructure for trading, settlement and record-keeping. They are vested with regulatory responsibilities while also pursuing commercial interests like other profit-oriented entities. In view of the conflicting nature of these different roles of MIIs, the governance standards of MIIs need to be robust to engender market confidence and deter malpractice.
 

Let us first summarise the views of the committee. The report emphasises that the regulatory framework should ensure that MIIs, in pursuance of their business objectives, should not lose sight of the regulatory roles vested in them as the first-line regulators. At the same time, tightening the norms should not deter innovation or customer focused service provision by MIIs. Accordingly, the report calls for a review of the requirements related to the appointment and the role and responsibility of directors on the board and key managerial personnel (KMPs). In addition, it proposes steps to improve the transparency and accountability in the functioning of MIIs, metrics for the monitoring of their performance and measures for safekeeping and sharing of information held by them.
 

On MII structure, it recommends that independent directors must constitute two-thirds of the total strength of the board. It further says that the roles and responsibilities of the directors should be clearly defined, and the board should play an active role in the risk management framework of MIIs. The report notes that operational matters take up a significant time of the board whereas the board should focus on broader strategy, policy and other important matters.
 

Other recommendations include periodical assessment of the performance of the board and its members by an external agency; reports (to Sebi) of meetings of independent directors to discuss themes specified by Sebi. Additionally, it also proposes Sebi meetings with independent and non-independent directors (without the presence of executive directors and the managing director) once a year. The report notes that MIIs need to have independent directors with technology, law or finance skill sets.

Illustration: Binay Sinha

 

MIIs are complex because there are two objectives: To make profit for the shareholders and to perform regulatory functions. These two can be in conflict. Being a service provider, factors such as customer focus, innovation, complex IT operations, and business development are important for an MII and its owners. At the same time, enforcing against market abuse, and ensuring fair play in the market, are important objectives of the MII. Reconciling these seemingly irreconcilable objectives is the MII design challenge.
 

Let’s look back into the Indian history of these questions. Most of the experience is with exchanges as they are the original MII. Though among the oldest exchanges in the world, the BSE had a record of several governance failures by late 1980s. The owners blocked every proposal to make things better. Exchanges opposed every reform. Brokers went on strike. Then a government expert committee recommended creation of the National Stock Exchange (NSE). The dominant expert view of the time was that these problems were caused by control by owners (that is, broking firms) over the managers whose duty was to regulate the owners (the broking firms). In the newly created NSE the three groups — ownership, management and trading — were kept separate.
 

By and large, this strategy worked. What the NSE did in the next two decades is nothing short of a miracle. It is important to remember that in its dynamic years, the NSE had the freedom of a private organisation, though its entire ownership was with public sector units. However, the MII problem did not go away. While the NSE chose to go with the three-way separation between ownership, management and trading, this was not formalised into regulations till much later. Entities that did not follow this practice went the predictable way. Then came demutualisation, whereby all exchanges were demutualised.
 

Is government control the answer?
 

The danger is that government control robs the exchange of dynamism. In the recent period, de facto management control of exchanges seems to be slipping away to the regulator. Every key management person appointment decision of exchanges is controlled by the regulator, as is every detail of products and processes on the exchange. This is a level of control over a private entity which was quite absent in the so-called “pre-reforms period” before 1991 for any private firm. Yet misgovernance continues to be a perennial feature! There is not yet adequate evidence to show that the presence of public interest directors has contributed to better governance that justifies an increase to two-thirds of the governing board.
 

As a consequence of the recent developments, personnel at MIIs have begun to behave like civil servants: Not take decisions and push every small question up through the hierarchy and get multiple signatures. This has hampered operational capability. Exchanges (and MIIs) in India can no longer be described as autonomous organisations that rapidly take decisions. The approach of various agencies looking into the exchange functioning appears to hold the exchange to government department procedures on issues such as procurement, contracting, and decision-making. These standards are not how private organisations behave, and are not compatible with a high performance exchange. Many of the difficulties of recent years, such as outages and payments failure, can be traced to this evolution of exchanges from private organisations to de facto PSUs.
 

More importantly, the process of innovation and progress in Indian finance has slowed. Finance is the brain of the economy, and exchanges are the most important institutional apparatus of the financial system. There is a need to get back to the journey of establishing capable exchanges, to a period where India was the envy of the world with the capabilities of NSE and BSE. There is no advanced economy where an exchange is a de facto PSU. We need to question the process of turning MIIs into de facto PSUs in India. In this setting, the Sebi report emphasises increased government control of exchanges.
This may not help matters.


The writer is an honorary professor at the Centre for Policy Research, member of a few for-profit and not-for-profit boards, and a former civil servant