20 April 2012

SEBI Policy for stock exchanges – one and half step forward

I have an opinion piece in today's Economic Times analysing the recently introduced governance and other norms for stock exchanges, depositories and clearing corporations by SEBI, the securities regulator. Here is the full piece:

SEBI came out with revised governance norms and a regulatory super-structure for stock exchanges, clearing corporations and depositories (also Market Infrastructure Institutions or MIIs). While SEBI makes a significant move forward, it does take some steps back and misses an opportunity to reverse some of the harm done by previous policy. The most significant lost opportunity was the possible roll back of the 5% ownership cap on exchanges which perversely keeps out competition and which is not followed by a single country in the world, according to a report by IOSCO, the global body of securities regulators. The most significant step forward for the policy decision was its departure from the Jalan Committee Report, which had advocated contrary to parliament’s express wish that exchanges be for profit and should list. In fact statute forced BSE to convert from a not for profit status to a for profit status. See also ET’s opinion of 4th Apr 2012.

I try to list the good the bad and the ugly from SEBI’s decision in this piece apart from the above two issues which I have discussed in my pieces in this paper (12 May 2010 and 15 Dec 2010) in more detail.

First the good part. Listing of exchanges and depositories is permitted. It was funny how those who peddled listing to other companies for accountability, disclosures, valuation and performance management, themselves did not list. That barrier is now removed. There are now explicit conflict management provisions in the regulations. Heads of broker regulation, listing regulation and surveillance will report to both the CEO and to a committee of the board headed by and majority composed of independent directors. In addition, SEBI will create a conflict resolution committee to deal with conflicts of interest. This is a welcome departure from the generic talk by regulators to manage conflict of interest. It is also recognised as a first step to the final step of having a separate regulatory body which would take charge of the regulatory aspects of the exchange through an independent body. Further, SEBI’s greater involvement in oversight of MIIs is also welcome. SEBI will vett appointment of each director and ensure that the pay of senior management is not aimed at incentivising short term performance. Similarly, there are internal checks and balances in allowing variable pay which is limited and which must meet with several internal approvals like that of a compensation committee. In addition, the MII can provide for clawback arrangements for taking back past compensation to dis-incentivise short termism. Some will see many of these as micro-regulation, but if executed well, these should not stand in the way of offering high pay to attract talent to exchanges.

Clearing corporations, which are the bearer of risk and need to have risk management in place have also got serious thought as required by parliament in 2004. Clearing corporations are required to be independent entities, which will be separately recognised and supervised by SEBI and will have an independent risk committee which will not just interact with the directors of the corporation but with SEBI directly. SEBI has also sown the seeds for making clearing corporations interoperable, creating a more unified environment for exchanges. SEBI should now depart from its current position of making exchanges being final guarantors of trades rather than the global standard of the clearing corporation alone being a guarantor.

SEBI has gone wrong with prescribing a networth of Rs. 100 crores for exchanges and Rs. 300 crores for clearing corporations. The first is too high as exchanges are merely technology platforms with no risk attached. Conversely, the latter may be too low as a clearing corporation may bear the risk of tens of thousands of crores of rupees and a flat networth may be inadequate. Though not clearly asserted, SEBI’s idea of possibly mandating a single clearing corporation, pollution from the Jalan report, is wrong. Thirdly, a provision considering warrants and convertibles towards calculating the 5 or 15% ownership limits militates against the logic of capping control. Control can never come out of non voting securities as SEBI has affirmed in its takeover regulations in all its avatars. Finally and egregiously, a rule mandating handing over of 25% of profits by an exchange to a clearing corporation’s guarantee fund suffers from being an absolutist rule. Just as 300 crore rupees may be too low, a blanket 25% may be way too high and amounts to expropriation contrary to the will of parliament to make exchanges for profit.

The part which suffers the most fatal legal challenge is that SEBI mandates that there should be no trading or clearing member on the board of directors of exchanges or clearing corporations. This amounts to overruling the parliament which has specifically provided for a maximum of 25% board seats to these members in statute. SEBI should re-look at these issues in the near future, if not immediately, to create a world leading MII ecosystem which balances efficiency with tightly controlled risk.

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