Law and regulation shape the character of the regulated industry

Financial Express, 4 February 2009

In the areas of the economy where regulation is necessary, a careful configuration of legal foundations, regulator, corporate governance of regulated entities and public discourse is required. When these ingredients are lacking, `regulatory capture' comes about, where the actions of regulators favour one player over another. The recent episode of FMC preventing NCDEX from cutting prices is an example: the only beneficiary of FMC's action is the incumbent, MCX, which aspires to do an IPO. Making progress requires laying sound legal foundations, setting up high quality regulators, requiring good corporate governance practices, and having open discussion of these difficult issues.

The classic argument in favour of regulation is to prevent monopolistic pricing by large players. Overlayed on this broad theme are a series of industry-specific issues. In telecom, a natural resource (spectrum) needs to be shared between players and technologies in a way that maximises the interests of the economy. In finance, regulators worry about fraud.

Financial markets are at the centre of finance, and the most important financial markets are organised on exchanges. In recent years, a new animal has come about: the for-profit exchange. This raises difficult problems for regulators, for the incentives of a for-profit exchange often run contrary to the interests of the economy. These conflicts are particularly accentuated when a for-profit exchange becomes focused on getting a high valuation for its shares. In India, "MCX" is a for-profit exchange. It is owned by a software company named "FT". Unlike most Indian software companies, FT does little by way of software exports; it derives its primary revenues from business related to exchanges.

With a strong legal system and sound regulation, for-profit exchanges work well. The threat of imprisonment through a fair regulator and efficient courts contains the conflicts of interest. MCX operates in an area - commodity futures - where the legal foundations and the regulator are weak. The legal foundations consist of an obsolete law, drafted in 1952. FMC is a small agency, which lacks independence from the political system. It is unlike SEBI in three respects: SEBI has benefited from extensive work in amending the SC(R)A, it is a creature of the new SEBI Act, and it is an independent regulator.

MCX competes with an exchange named NCDEX. The smaller exchange, NCDEX, cut prices in trying to gain market share. Ordinarily, in a duopoly, when one player cuts prices, the other is likely to follow resulting in benefits for customers. In this case, the special twist lies in the fact that MCX has long planned to do an IPO. The valuation that MCX can obtain in the IPO will reflect the net present value of the profit that it can make in coming years. MCX is probably keen to stave off a price reduction.

Normally, a regulator would applaud a price cut, since elevated prices are precisely what regulation seeks to prevent. In this case, FMC went beyond its legal brief and ordered NCDEX to raise prices. NCDEX has taken FMC to court.

In the best of times, financial regulation is difficult when faced with for-profit exchanges. In India, we have an unfortunate juxtaposition of MCX operating in an area with weak legal and regulatory foundations. Cynics would argue that MCX sprang up in that area precisely because the legal and regulatory foundations there were weak.

When regulation is weak, this encourages the players who have strengths in fixing the regulatory system to their own advantage. The firms that have risen to prominence in such areas in India tend to be those who were unable to compete in global markets under fair competition. Even a few years of faulty regulation can do long-term damage to an industry, by killing off firms with high ethical standards and endowed with skills in running a business as opposed to skills in fixing the system.

Looking forward, there are four areas for work. First, the development of a proper financial system requires sound foundations of law; this requires getting away from laws like the FC(R)A. The second front is regulation: we require agencies to match the capabilities and institutional depth of SEBI.

The third front is the corporate governance of exchanges. In the West, for-profit exchanges work well. When the regulatory and legal system is weak, for-profit exchanges present unique problems. It is important to insist on a three-way separation between owners, managers and members of exchanges. Ownership and management of the exchange business must be separated from other financial businesses.

Finally, there is the public discourse. Whether it is TRAI, CERC, SEBI, RBI or FMC: the actions of regulators often impinge on the profitability of regulated entities. Economists and journalists avoid `taking sides', and avoid criticising the government. This problem has been exacerbated by conflicts of interest in the media with shareholding in firms such as FT. An uninhibited public discourse is essential.

Back up to Ajay Shah's 2009 media page
Back up to Ajay Shah's home page