Future-ready market regulation needs expertise, credibility, consultation

Effective regulation requires consultation, expertise, incentives, and institutional credibility

The draft Securities Market Code (SMC) consolidates and modernises the Securities Contracts (Regulation) Act, the Securities and Exchange Board of India (Sebi) Act, and the Depositories Act.

 

An ideal regulatory framework must mitigate Type I errors of market failures, while avoiding Type II errors of onerous regulations that constrain innovation and capital formation.

 

Balancing both objectives in increasingly complex markets requires transparent consultation, deep expertise, the right incentives, and institutional credibility.

 

Dialogue before regulation

 

Transparent consultation is essential for balanced regulation. To Sebi’s credit, its current process already sets a high bar. Its consultation papers identify issues, articulate the context and objectives, lay out alternatives, and evaluate trade-offs. Regulatory proposals have materially improved through transparent public consultations. The draft SMC further reinforces consultation and transparency in regulation-making.

 

This requirement should also extend to government policies that impact capital markets. In a complex interconnected world, for instance, market-related taxation can influence savings behaviour, capital flows, and long-term capital formation in unexpected ways.

 

Authorities do engage with stakeholders. But that is not the same as transparent consultation on specific proposals. While secrecy may be necessary in some areas, policy outcomes are dramatically improved when objectives, context, and proposals are clearly articulated, publicly debated, and refined beforehand rather than only defended post facto.

 

Building domain expertise

 

Sebi oversees multiple areas that are each extraordinarily complicated. These include primary and secondary markets across asset classes, funds, intermediaries, market infrastructure institutions, governance, cybersecurity, and more.

 

It is crucial that regulatory capability and expertise evolve in step with the ecosystem. In any consultation around regulation-making, stakeholders have their own diverse and divergent interests. Some voices are invariably louder than others. Smaller investors and firms often lack representation. In all, regulators have their job cut out. They must objectively evaluate all viewpoints, including those of the unseen and unheard, and strike the right balance between risk containment and ease of doing business. This requires deep domain expertise.

 

Similarly, for effective enforcement, regulators must assess the materiality of each case and differentiate between jaywalking and murder. This again requires deep domain knowledge.

 

The case for specialisation

 

Sebi has exceptionally capable and committed officers, most of whom are generalists. In an interconnected world, generalists are invaluable. To deepen institutional expertise, however, some officers should be encouraged to specialise by spending 12-15 years across different facets of a single domain.

 

To understand the perspective of the regulated, specialists should also be encouraged to undertake industry sabbaticals, alongside relevant advanced education and international exposure. Potential conflicts of interest can be transparently addressed.

 

Balancing caution and risk

 

Regulatory officers disproportionately bear the consequences of Type I errors of failing to address market failures, since these are visible and attributable. By contrast, the costs of Type II errors, such as stifling legitimate activity, innovation, and capital formation, can be diffused and less visible. This can bias regulators towards caution, willing to risk Type II errors rather than Type I.

 

To address this, senior-level promotions at Sebi should objectively identify officers who have consistently demonstrated the professional judgement required to balance effective risk management with facilitation of legitimate capital formation.

 

Developing the right mix of expertise, judgement, and regulatory balance is itself a long institutional apprenticeship. A majority of Sebi’s whole-time members should, therefore, emerge from within Sebi’s own ranks.  

 

Board structure and expertise

 

The proposed Sebi board structure under the SMC remains unusual by global standards. In major jurisdictions, securities regulators operate through relatively compact, executive-led boards or commissions, appointed by the government, but without ex-officio government representation.

 

In contrast, the SMC proposes a 15-member Sebi board comprising the chairperson, at least five whole-time members, two ex-officio central government officials, one Reserve Bank of India (RBI) representative, and other part-time members.

 

Every securities market regulation requires Sebi board approval. By comparison, the RBI board has a limited role in regulatory decisions, with day-to-day policy run by the executive.

 

Beyond the power of appointment, the government also has direct representation on the Sebi board. This was perhaps understandable when Sebi was a fledgling regulator. However, both markets and Sebi have since matured significantly.

 

Autonomy is often debated in the context of central banks. For securities market regulators as well, given the sensitivity of regulatory, supervisory, and enforcement decisions, institutional credibility depends on actual and perceived independence. In addition, markets are complex and fast-moving, requiring specialist regulatory and domain expertise.

 

As with other global securities market regulators, Sebi could, therefore, be given greater operational autonomy, with the executive empowered to handle day-to-day regulatory decisions. After all, Sebi’s regulation-making is already subject to transparent consultation requirements, while the Securities Appellate Tribunal (SAT) hears appeals against its enforcement actions. The broader board could then focus on governance and oversight.

 

Of course, the appointment of the Sebi chairperson and whole-time members, and their removal for cause, will remain the government’s prerogative.

 

If the SMC’s proposed structure is retained, to ensure institutional credibility, the emphasis on expertise and balanced judgement must also apply to all other board members. The relevant arms of the government (and SAT) should also further develop deep domain expertise and market understanding, even at the cost of institutional overlap.

 

For better governance, there is also merit in limiting external board appointments to a single term, akin to the framework governing external members of the Monetary Policy Committee.

 

MIIs and conflicts of interest

 

A final issue concerns market infrastructure institutions (MIIs), viz. exchanges, clearing corporations, and depositories.

 

MIIs are commercial entities that actively compete among themselves for business. At the same time, they also regulate, supervise, and conduct surveillance over their paying members. This leaves room for perceived conflicts of interest.

 

To enhance trust and credibility, there is merit in considering moving the regulatory functions of MIIs into a separate non-commercial entity, akin to the Financial Industry Regulatory Authority (FINRA) in the United States.

 

Conclusion

 

India’s securities markets have achieved enormous depth and sophistication. The next phase of reform should focus on strengthening institutions through transparent consultation, deeper expertise, balanced incentives, and greater institutional credibility.

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The writer is a former whole-time member, Sebi.

The views are personal