FINANCIAL MARKET REGULATORY STRUCTURE AND REFORMS Development and Growth of Financial and Capital Markets in India The history of the capital market in India dates back to the eighteenth century when East India Company securities were traded in the country. Until the end of the nineteenth century, securities trading was unorganized and the main trading centres were Bombay (now Mumbai) and Calcutta (now Kolkata). Of the two, Bombay was the chief trading centre wherein bank shares were the major trading stock. During the American Civil War (1860-61) Bombay was an important source of supply for cotton. Hence, trading activities flourished during the period, resulting in a boom in share prices. This boom, the first in the history of the Indian capital market, lasted for a half a decade. The first joint stock company was established on 1850. The bubble burst on July 1, 1865, when there was tremendous slump in share price In the post-independence period also, the size of the capital market remained small. During the first and second five-year plans, the government's emphasis was on the development of the agricultural sector and public sector undertakings. The public sector undertakings were healthier than the private undertakings in terms of paid-up capital but their shares were not listed on the stock exchanges. Moreover, the Controller of Capital Issues (CCI) closely supervised and controlled the timing composition, interest rates, pricing, allotment, and floatation costs of new issues. These strict regulations demotivated many companies from going public for almost four and a half decades. In the 1950s, Century Textiles, Tata Steel, Bombay Dyeing, National Rayon, and Kohinoor Mills were the favourite scrips of speculators. As speculation became rampant, the stock market came to be known as Satta Bazaar. Despite speculation, non-payment or defaults were not very frequent. The government enacted the Securities Contracts (Regulation) Act in 1956. Period of 1950s was also characterized by the establishment of a network for the development of financial institutions and state financial corporations. Capital Market in Pre-Reforms pre-1991) period Prior to the onset of financial sector reforms in 1991, the capital market structure in India was subject to several controls and opaque procedures, The trading and settlement system was outdated and not in tune with international practices, Raising of eapital from the market wasregulated by the capital issues act, 1947 which was administered by the controller of capital issues in the ministry of finance, Government of India. Similarly, the securities Contract Act was administered by the directorate of stock exchanges also in the Ministry of Finance. It empowered the government to recognise/derecognise stock exchanges, stipulate rules and bye-laws for their functioning, compel listing of securities by public companies etc. Such a system of regulation was fragmented and inadequate in context of liberalisation wave sweeping across the world. Prior to reforms, the Bombay Stock Exchange (BSE) was a monopoly. It was an association of brokers and imposed entry barriers, which led to increased costs of intermediation. Trading took place by ‘open outcry’ on the trading floor, which was inaccessible to users. It was usual for brokers to charge the investors a much higher price from that actually traded at. ‘A variety of manipulative practices prevailed, so that external users of a market often found themselves at the losing end of price movements. Companies Act, 1956 It deals with the issue, allotment, and transfer of securities, as well as various aspects relating to company management. It provides the standard of disclosure in public issues of capital. It also regulates underwriting, the use of premium and discounts on issues, rights, and bonus issues, the payment of interest and dividends, the supply of annual reports, and other information. Reforms in Capital Market With the objective of improving market efficiency, increasing transparency, integration of national markets and prevention of unfair practices regarding trading, a package of measures has been introduced to liberalise, regulate and develop capital markets in India. Since 1992, reforms measures have mainly been focussed on regulatory effectiveness, boosting competitive conditions, reducing information asymmetries, instigating transaction costs and controlling of speculation in securities market. Introduction of Free Pricing Raising of capital from the securities market before 1992 was regulated under the capital issues control act 1947. Companies were required to obtain the approval from the controller of capital issues for raising resources in the market. New companies were allowed to issue shares only at par. Only the existing companies with substantial reserves could issue shares at premium, which was based on prescribed formula. In 1992, the Capital Issues Act, 1947 wasrepeated and this ende ro m the market 8 ended all c4 k dled all controls related (0 raising of resources from 1 z irke' Restrictions on ri b s sont i rt ‘ghts and bonus issue have also been removed. New as well as established companies are now i ir is et “ now able to price their issues according to their assessment of market conditions, However, i capi over, issuers of capital are required to meet the guidelines of Securities and change Board of India (SE! s isclosures, including justification of the issue price and also material disclosure about the risk factors in their offer prospectus. In the interest of investors, SEBI issued Disclosure and Investor Protection (DIP) guidelines, The guidelines allow issuers, complying with the eligibility criteria to issue securities the securities at market determined rates. The market moved from merit based to disclosure-based regulation. Sereen Based Trading ‘A major developmental initiative was a nation-wide ‘on-line fully-automated Screen Based ‘Trading System (SBTS) where a member can punch into the computer quantities of securities and the prices at which he likes to transact and the transaction is executed as soon as it finds a matching sale or buy order from a counter party. Screen based trading makes on-line, electronic, anonymous and order-driven transactions possible, Iisa transparent system which provides equal access to all investors, irrespective of their geographical locations. SBTS electronically matches orders on a strict price/time priority and hence ¢ as well as on fraud resulting in improved operational efficie yut down on time, cost and risk of error, ney. It sensitive information into prevailing prices, thus allowed faster incorporation of price enabled market participants to see the increasing the informational efficiency of markets. It making the market transparent. It allowed a large number of full market on real-time, participants, irespective of their geographical locations, to trade with one another simultaneously, improving the depth and liquidity of the market — over 10,000 terminals creating waves by clicks from over 400 towns /cities in India. It provided full anonymity by accepting orders, big or small, from members without revealing their identity, thus providing, ‘equal access to everybody. It also provided a perfect audit trail, which helps to resolve disputes by logging in the trade execution process in entirety. The SBTS shifted the trading platform from the trading hall of an exchange to brokers’ premises The move to an electronic trading system has resulted in transparency in trades, better price discovery and lower transaction cost. The operational efficiency of the stock market has alsobeen strengthened through improvements in the clearing and settlement practices and the risk management process. Almost the entire delivery of securities now takes place in dematerialised form. Establishment of Securities Exchange Board of India SEBI was set up in April 1988 by an administrative order and acquired a statutory status in1992 on recommendations of the Narasimham Committee. It was enacted to empower SEBI with statutory powers for (a) protecting the interests of investors in securities, (b) promoting the development of the securities market, and (c) regulating the securities market, (d) registering and regulating the working of collective investment schemes including Mutual Funds, (e) promoting and regulating the self-regulatory organisations, (D prohibiting fraudulent and unfair trade practice, relating to securities markets, (g) promoting investors education and training of intermediaries of securities market, (4) prohibiting the insider trading of securities. Its regulatory jurisdiction extends over corporates in the issuance of rae ma ; sari jated with capital and transfer of securities, in addition to all intermediaries and persons associated . . sacnectit and the securities market. It can conduct enquiries, audits, and inspection of all concerned, adjudicate offences under the Act. It has the powers to register and regulate all market i i jolati isi ‘Act, intermediaries, as well as to penalize them in case of violations of the provisions of the Rules, and Regulations made there under. SEBI has full autonomy and the authority to regulate and develop an orderly securities market. SEBI has been vested with wide-ranging powers. Firstly, to over operations of mutual funds including presentation of accounts, following the decision to vate sector and joint sector mutual funds. Secondly, all stock ree constitution as well as allow the entry of the pr cxchanges in the country have been brought under the annual inspection regime of SEBI for ensuring orderly growth of stock markets and investors protection. Thirdly, with the repealing of the Capital Issues (control) Act, 1947, in May 1992, SEBI has been made the regulatory authority in regard to new issues of companies. National Stock Exchange of India National Stock Exchange of India (NSE) was set up in November 1992 and was owned by we un and other public sector institutions. It commenced its operations in1994. NSE is a securities exchange which marks a radical break with the past. The regime in which trading on AO oe 7 - SE operates is characterised by four key innovations (1) the physical floor was replaced by anonymous computerised order matching with stri ig With strict price time priori priority. (2) The limitati lations ofbeing in Mumbai, i i, and itati ia’ i ent the limitations of India’s public telecom network, were avoided by using mmunicati i ‘ ications. (3) NSE is not ‘owned’ by brokers. It is a limited liability company, and brokers are is (4) i 'e franchisees. (4) Traditional practices of unreliable fortnightly settlement cycle with the escape clause of badla were replaced by a str weekly settlement cycle wi Scape clause of badla were replaced by a strict weekly settlement cycle without badla. Badla was an indigenous carry-forward system invented on the Bombay Stock Exchange as a solution to the perpetual lack of liquidity in the secondary market. Badla was banned by the Securities and Exchange Board of India (SEBI) in 1993, effective March 1994, amid complaints from foreign investors, with the expectation that it would be replaced by a futures- and-options exchange. Such an exchange was not established and badla was legalized again in 1996 (with a carry-forward limit of Rs 200 million per broker) and banned again on 2 July 2001, following the introduction of futures contracts in 2000. Example The mechanism of badla finance can be explained with the following example: Suppose A wants to buy shares of a company but does not have enough money now. If A values the shares more than their current price, A can do a badla transaction. Suppose there is a badla financier B who has enough money to purchase the shares, so on A's request, B purchases the shares and gives the money to his broker. The broker gives the money to exchange and the shares are transferred to B. But the exchange keeps the shares with itself on behalf of B. Now, say one month later, when A has enough money, he gives this money to B and takes the shares. The money that A gives to B is slightly higher than the total value of the shares. This difference between the two values is the interest as badla finance is treated as a loan from B to A. The rate of interest is decided by the exchange and it changes from time to time. ‘The improvements that accompanied this regime were a follows: (a) transparency - users could look at a price on a computer screen before placing an order. (b) anonymity - electronic trading is completely transparent about price and quantities, and completely opaque about identities. (©) Competition in the brokerage industry-as a result of NSE about 1000 new brokerage firms has entered the market. This reduced the transaction cost sharply. (a) Operational efficiency-automation eliminated the vagaries of manual trading. (d) Gains outside Mumbai-NSE’s satellite-based trading gave equal access to the trading floor from all locations in India. NSE is now the world’s largest derivative exchange. It currently operateswith 10 trading engines and handles 450 million orders everyday with 50000 other messages per second for trading across asset classes. Laundering Act, 2002 ‘The primary objective of this Act is to prevent money laundering, and to allow the confiscation of property derived from or involved in money laundering. According to the definition of “money laundering,” anyone who acquires, owns, possess, or transfers any proceeds of crime, or knowingly enters into any transaction that is related to the proceeds of crime either directly or indirectly, or conceals or aids in the concealment of the proceeds or gains of crime within India or outside India commits the offence of money laundering. Besides prescribing the punishment for this offence, the Act provides other measures for the prevention of money laundering. The Act also casts an obligation on the intermediaries, the banking companies, etc. to furnish information of such prescribed transactions to the Financial Intelligence Unit-India, to appoint a principal officer, to maintain certain records, etc. National Securities Clearing Corporation (NSCC) Small counterparty risks could turn into large counterparty risks owing to cascading effects, jeopardising the functioning of the entire market. The NSE has set up @ clearing corporation which provides legal counter party guarantee to each trade and thereby eliminates counter party risk. Attempts are being made to reduce the time gap between execution of trade and its settlement through rolling settlement. To tackle this problem, National Securities Clearing Corporation was set up in 1996. Every trade that takes place is freed from the risk of the counterparty defaulting. This automatically ends the risk of cascading failures generating a payment crisis. The NSC assures the counterparty risk of each member and guarantees financial settlement. Counterparty risk is guaranteed through a fine-tuned risk management systems and an innovative method of on-line position monitoring and automatic disablement. Shortening of Settlement Cycle Before the enactment of Depository Act 1996, trades were settled by physical movement of paper. This had two aspects. First, the settlement of trade in stock exchanged by delivery of shares by the seller and payment by the purchaser. The process of physically moving the securities from the seller to the ultimate buyer through the seller’s broker and buyer’s broker took time with the risk of delay somewhere along the chain. The second aspect related to wansfer of shares in favour of the purchaser by the company. The system of transfer ofownership was grossly inefficient as every transfer i jt securities to the issuer for registration, vith eckneens a es ae _ endorsement on the security certificate. In many cast sh ne longer, and a significant proportion of vaacto ae ~ o_ .s ended up as bad delivery due to faulty compliance of paper work. Theft, forgery, mutilation of certificates and other irregularities were rampant. Risk Management ‘A number of measures were taken to manage the risks in the market so that the participants are safe and market integrity is protected. These include: Trading Cycle: The trading cycle varied form 14 days and settlement took another fortnight. Often this cycle was not adhered to. Derivatives Derivative trading took off in June 2000 on two exchanges. In India, derivative trading began in June 2000, with trading in stock index futures. The NSE has become the largest exchange in single stock futures in the world, and by June 2007, it ranked fourth globally in trading index futures, a sign of an evolving and maturing market. Settlement Guarantee A variety of measures were taken to address the risk in the market. Clearing corporations emerged to assume counter party risk. Trade and settlement guarantee funds were set up to guarantee settlement of trades irrespective of ‘default by brokers. Various measures taken over last decade or so have yielded considerable benefits to the market, as evidenced by the growth in number transactions, increasing globalization of of market participants, growth in volumes in securities ‘the Indian market, reduction in transaction costs, and compliance with international standards. In terms of number of trades, NSE is the third largest exchange in the world. Qualified Institutional Placements 2009 The Securities and Exchange Board of India (SEBI) introduced the qualified institutional placements (QIP) programme to allow companies to make offers through qualified institutional buyers (QIBs). One of the requirements of QIPs js only companies compliant with the listing agreement can make a QIP. Since many companies in the government andprivatetsectors 7 ‘ , a ee i : _ wn ms a public shareholding norms, they could not . The institutional placement programme (IPP) will help such companies make an offer to QIBs. Disclosure and Investor Protection (DIP) Guidelines Major part of the liberalisation process was the repeal of the Capital Issues (Control) Act, 1947 in May 1992. With this, Government's control over issue of capital, pricing of the issues, fixing of premia and rates of interest on debentures etc. ceased and the market was allowed to allocate resources to competing uses. In the interest of investors, SEBI issued Disclosure and Investor Protection (DIP) guidelines. The guidelines contain a substantial body of requirements for issuers/intermediaries, the broad intention being to ensure that all concerned observe high standards of integrity and fair dealing, comply with all the requirements with due skill, diligence and care, and disclose the truth, whole truth and nothing but truth. The guidelines aim to secure fuller disclosure of relevant information about the issuer and the nature of the securities to be issued so that investor can take an informed decision. For example, issuers are required to disclose any material ‘risk factors’ in their prospectus and the justification for the pricing of the securities is to be given. SEBI placed a responsibility on the lead managers to give @ due diligence certificate, stating that they have examined the prospectus, they find it in order and that it brings out all the facts and does not contain anything wrong of misleading. Though the requirement of vetting has now been dispensed with, SEBI has raised standards of disclosures in public issues to enhance the level of investor protection Investor Protection ‘The SEBI Act established SEBI with the primary investors in securities and empowers it to achieve this objes tandards of disclosure required for the protection of investors in respect objective of protecting the interests of .ctive. SEBI specifies the matters to closed and the st and issues directions to all intermediaries and other persons associated with the securities market in the interest of investors or of orderly development of the securities market, DEA, DCA, SEBI and exchanges have set up investor grievance cells for redressal of investor grievance. The exchanges maintain investor protection funds to take care of investor claims, which may arise out of non-settlement of obligations by a trading member for trades executed on the exchange. DCA has also set up an investor education and protection fund for the promotion of investors’ awareness and protection of interest of investors. All theseagencies and investor associations are organising investor education and awareness programmes. International Initiatives Principles of Securities Regulation In February 2002, The International Organization of Securities Commissions (IOSCO) released a new version of the Objectives and Principles of Securities Regulation, which supersedes the one released in September 1998. IOSCO is an association of organizations that regulate the world's securities and futures markets. Members are typically primary securities and/or futures regulators in a national jurisdiction or the main financial regulator from each country. It aims to provide advice and a yardstick against which progress towards effective regulation can be measured. IOSCO members, including SEBI, through their endorsement to these principles, intend to use their best endeavours within their jurisdiction to ensure adherence to these principles. These principles are: Regulator 1, The responsibilities of the regulator should be clear and objectively stated. This requires a clear definition of responsibilities, preferably set out by law; strong cooperation among responsible authorities through appropriate channels; and adequate legal protection of regulators and their staff acting in bonafide discharge of their functions and powers. Any division of responsibility should avoid gaps and inequities in regulation. 2. The regulator should be operationally independent and accountable in the exercise of its functions and powers. Independence is enhanced by a stable source of funding for the regulator. ‘Accountability implies: a regulator that operates independently of sectoral interests; a system of public accountability of the regulator; and a system of permitting judicial review of decisions of the regulator. 3. The regulator should have adequate powers, proper resources and the capacity to perform its function and exercise its powers. The regulator should have powers of licensing, supervision, inspection, investigation and enforcement and also access to adequate funding. 4, The regulator should adopt clear and consistent regulatory processes. The regulator should have a process for consultation with the public including the regulated, publicly disclose its policies, observe standards of procedural fairness and have regard to the cost of compliance with the regulations. It should also play an fi A os active role in the education of investors and other participants in the capital market. 5. The staff 5. al of the regulator should observe the hi lighest professional i : ; standards of confidentiality. standards, including appropriateGlobal Financial Reforms and Implications for India The objective of global regulatory reform is to build a resilient global financial system that can withstand shocks and dampen, rather than amplify, their effects on the real economy. Lessons drawn from the economic crisis caused by Global Financial Crisis (2007-9) have led to specific reform proposals with concrete implementation plans at the international level. Yet, these proposals have raised concerns of relevance to Asia's developing economies like India and hence require further attention. Global financial reform should allow for yr the enormous development challenges faced by developing countries - while ensuring that domestic financial regulatory systems keep abreast of global standards. This implies global reforms should be complemented and augmented by national and regional reforms, considering the very different characteristics of emerging economies’ financial systems from advanced economies. Key areas of development focus should be (i) balancing regulation and innovation, (ii) establishing national and cross-border crisis management and resolution mechanisms, (iii) preparing a comprehensive framework and contingency plan for financial institution failure, including consumer protection measures such as deposit insurance, (iv) supporting growth and development with particular attention to the region's financial needs for infrastructure and for small and medium-sized enterprises, and (v) reforming the international and regional financial architecture.