One Markets Regulator or Three?

One of the debates going around in the international financial community concerns the correct degree of centralisation of regulation of markets. The regulatory structure in India features a decentralised setup, where the equity and corporate bond markets are regulated by SEBI, the foreign exchange and fixed income markets are regulated by RBI and the commodity markets come under the Forward Markets Commission (FMC). In contrast, the UK is presently moving towards a consolidation of all financial markets regulation into a single regulator. Is this a superior approach?

There are three major reasons why a unified approach towards regulation would help: (a) the commonality of knowledge, (b) the integration of markets, and (c) information sharing.

The commonality of knowledge argument is based on the fact that there is something universal about all trading in financial markets. Regardless of whether we discuss trading wheat or shares of TELCO, the basic issues of trading, clearing and settlement are remarkably similar. In this case, when a regulator develops the expertise in preventing fraud and protecting systemic integrity, there are economies of scale in deploying this expertise across many markets.

This expertise is quite difficult to acquire, in the modern environment where trading is electronic, clearing takes place through a clearing corporation, settlement is electronic wherever possible, funds move electronically to the extent possible, and spot markets are supplemented by derivatives markets. The story of badla is a reminder about how regulators need a remarkable degree of clarity, in ways which are often quite incompatible with "normal market practice", in order to make appropriate choices about how the markets should function.

A regulatory agency which oversees all financial markets in the country would be able to rapidly carry successful ideas from one style of market to another: e.g. such a regulator is likely to have chosen to replicate the success of the electronic order book market (which was born in India on the equity market) in the foreign exchange market.

Electronic funds transfer (EFT) is a situation which is likely to be viewed quite differently by the RBI as compared with the securities industry. For the banking system, and hence for RBI, EFT is a part of the drive towards bank computerisation and enhanced efficiency. For the securities industry, EFT is the lifeblood of the functioning of the clearing corporation, enabling the reliable payment of margins and hence the integrity of the market. A single regulator would move far more decisively in establishing an electronic highway, connected to numerous non-banks in the country, whereby funds move within seconds between any two points in the country.

One often hears suggestions that derivatives markets are somehow different and require a new regulatory establishment. This approach understates the tight (arbitrage) linkages that bind the spot market and the derivatives market together. Having one regulator for the spot market and one regulator for the derivatives market is bound to generate difficulties; it makes more sense to view the combination of spot and derivatives as one unified market.

The second argument favouring a single monolithic regulator concerns avoiding artificial boundaries and turf wars. Markets evolve in response to innovations and technology, and this regularly has the effect of making some institutions obsolete. In an environment where one regulator oversees institution A while another regulator oversees institution B, there is often a temptation on the part of the regulator to protect the interests of the institutional mechanism that he oversees. This often ends up being a barrier to innovation, and slows down the pace at which old institutions become defunct.

An extreme case of irrational turf conflict is seen in the US, where the political compromise in place today consists of one regulator, the SEC, being in charge of options and another regulator, the CFTC, being in charge of futures. This distinction, based on the instrument, is an outcome produced by lawyers and politicians trying to "solve" a longstanding turf war, without understanding the economics.

Turf conflicts will also inevitably arise given the sophistication of instruments which proliferate in the modern financial system. If a derivatives exchange trades futures on the dollar-rupee, will this be regulated by the RBI or by SEBI? If NSE's derivatives market comes up with an instrument which is an option based on the price of wheat expressed in dollars, will this be regulated by SEBI or RBI or FMC? If a modern futures market on the dollar-rupee comes about, then would the RBI wholeheartedly push banks to transfer their usage from the existing forward market to this new futures market, even if the futures market is not regulated by the RBI? The turf wars which surface here inevitably hurt the development of the markets.

The third reason favouring a single regulator is about information sharing and coordinated crisis-handling. The CRB crisis has shown up our regulators in poor light on their ability to share information, work together and solve problems. Things might work better with a single regulatory agency. Similarly, the Canstar problem would have worked out very differently if a single regulator dealt with Canara Bank and with Canbank Mutual Fund.

Every market crash in the world puts clearing corporations of the securities industry under stress, and one good response is to setup overnight credit for the clearing corporation. One can easily imagine a central bank being relatively unconcerned about the worst disaster which can befall the securities industry, i.e. the failure of a clearing corporation.

I have hence shown three good reasons why a single regulator in charge of all finance is a good idea: this would cover banking and the five major financial markets - equity, debt, foreign exchange, commodities and real estate. What are the problems that we would face if this were done?

The most important criticism comes from worrying about the quality of leadership that such a super-agency can obtain. There is a tremendous concentration of power into a few hands in such an agency; and this would attract power-seekers to these posts. Do we, as a country, have the methods in place to ensure that these appointments will be based on competence, integrity and technical expertise alone? The kind of damage that can be done from senior levels of this agency - whether motivated by ignorance or patronage or corruption - is frightening to contemplate. Going beyond economics, we should also think about the consequences of this concentration of power for the liberal democracy.

Innovation is too often disliked by regulators, and the international experience is that innovations which are blocked by one regulator often get the green light from another. For example, in India, while derivatives in the equity market have been interminably delayed, there is significant progress in futures markets on commodities, which is helping by way of generating skills and diminishing the "fear of derivatives" in the country. Similarly, while computerised order matching was not a priority with regulators in commodities, fixed income or foreign exchange, it was a high priority for regulators on the equity market.

In these ways, competition between regulators within a country might often yield better outcomes than the stifling impact of decisions by a single regulator. With a single regulator, the only alternative left for innovations would be to escape to exchanges overseas.

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