Making sense of SEBI and BSE
Heads have rolled at the BSE in recent months. SEBI has forced the departure of the treasurer, president, and executive director of BSE, for their actions in the payments crisis of Summer 1998. The debate on these actions has ranged from the specific -- "Were SEBI's actions appropriate?" -- to the abstract -- "How can governance at BSE be improved to make it a well run exchange?". The analysis of Crisis '98 can flow at three levels:
- Who were the wrong-doers, and what punishment is appropriate?
- What were the defects in market design at the BSE which led to the crisis?
- Why do the clever brokers at BSE run a market which experiences one crisis every two years?
The second question - about failures in market design - is the most relevant one. The objectives of prudential regulation and systemic integrity, that SEBI is charged with, mean that SEBI should constrain market design on BSE and require minimum standards of safety. Most of the defects in market design which led to the crisis are intact today.
What were the elements of market design which led to Crisis '98? The most important factor which led up to it was the resuscitation of badla in 1997. At the time, SEBI and BSE said that badla was a perfectly normal market mechanism, and did not require any special risk containment efforts. I was present at one of these debates, at the finance ministry in late 1997, where I said that if the proposals were implemented, they would yield one payments crisis every two years. In the event, after badla was resuscitated in October 1997, the crisis only took a few months to surface.
Even if there were no badla at BSE, there is an anomaly in capital adequacy norms. NSE requires upfront capital from brokers of 12%, and BSE requires upfront capital of 5%. This state of affairs - where BSE uses much weaker capital adequacy norms than NSE - has persisted for years. This state of affairs is as unsatisfactory as one where RBI might ask certain banks to have a 9% capital adequacy norm but allow others to get away with 3.75%. A bank which used 3.75% capital adequacy would be fragile indeed, and it is no surprise that BSE is fragile. Matters are worsened when we consider that margin enforcement at BSE is reputed to be quite spotty.
This is the first order failure of the BSE - the use of badla without an adequate knowledge or understanding of risk containment, as examplified by their being comfortable with 5% collateral while NSE used 12%. Collateral is not the only issue - badla would yield crises even at NSE with 12% upfront capital. Many other elements of market design need to be put into place to cope with badla.
This is the first order question which should be addressed today - how the secondary market at BSE can be cleaned up so that crises do not recur. Sacking the BSE president does not achieve this cleanup. There are two directions which we can adopt:
- The first is to try to apply modern knowledge of risk containment to redesign badla so as to make it safe. In principle, this can be done; modern risk management does offer the tools required to build a market with badla that works.
- However, this would be a misguided effort, since the really important opportunity in India's equity market today is the full transition to "rolling settlement". With rolling settlement, the equity market would become intrinsically safer, and exchanges with poor knowledge or enforcement of risk containment would still be able to function with fewer crises. Rolling settlement is the international minimum standard. There is no reason why we cannot migrate our markets to rolling settlement today.
The next set of questions concerns failures of enforcement. The actions of BSE's top brass in Crisis '98 deserve a response on the part of the State in terms of setting standards for punishment when laws are violated. Eliminating eight days from the term of the BSE president is not an adequate punishment.
Internationally, the enforcement strategy that a regulator would adopt is three fold: prosecution of individuals (which could lead to imprisonment), monetary penalties upon the exchange membership, and restrictions upon activities that the exchange can undertake.
In this context, it was surprising to observe that while SEBI's enforcement department was uncovering a hair-raising tale of violations on the part of BSE's administration, other departments of SEBI went ahead and allowed BSE to start a depository. SEBI's level of cooperation for BSE's depository proposal was such that it was done in violation of SEBI's own regulations concerning depositories. This is remarkable, for the potential for damage in a depository actually exceeds that in an exchange.
A similar question is going to arise when BSE's derivatives trading proposal is evaluated by SEBI. The L. C. Gupta committee report says that "well-run exchanges, with a good record for compliance and enforcement" should be given permission to engage in derivatives trading. Will SEBI take the view that BSE is a "well run exchange" which can produce a sound functioning for derivatives?
When Mr. M. G. Damani was president of the BSE, he famously commented that "SEBI equals BSE plus I". Such closeness is damaging for the regulator and even more damaging for the regulated. BSE has exhibited a lax attitude in their operations for many reasons, but one of these could be a hope that when problems arose, SEBI would interpret events and regulations in a sympathetic manner. This moral hazard is one source of BSE's enforcement failures.
Anand Rathi, the new BSE president, has repeatedly spoken about the need to rebuild the relationship between SEBI and BSE. I disagree. In recent years, NSE became India's main equity market, even though BSE has had a pleasant relationship with SEBI. I think the best thing that BSE could ask for, today, is a regulator who will be unrelenting in expecting compliance, and intolerant of murky market design. This will channel the energies of the BSE towards competing through building better markets, instead of skirting at the edges of the law.
This could be easier done than said. Most BSE members have been trading actively on NSE for years, where they submit to NSE's well-designed and well-enforced regulatory framework. These experiences on NSE have helped them internalise regulatory requirements. This is an asset for BSE: it reduces the policing costs and the resistance to enforcement. The fastest way for BSE to go forward is to have NSCC do its clearing. For members of both exchanges (i.e. the bulk of BSE), this will cut back-office costs and capital requirements through unified obligation and cross-margining.
Such outsourcing has precedents: already two exchanges do clearing through NSCC, and eight exchanges do settlement through NSDL. In contrast, if BSE tries to do clearing itself, it will have to overcome the mistrust that flows from memories of the steady stream of crises at the BSE through the 1990s.
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