Time for SEBI to double-check its well intentioned reforms

I have a piece in today's Economic Times on the SEBI Board meeting decisions - on commodity market integration, requirement of networth for credit rating agencies, cross holding restrictions in mutual fund AMCs and CRAs, routes of complying with minimum public shareholding and FPI investment regulations. The full piece is copied below, and linked here:

SEBI board has come out with several interesting decisions this month end. There are many areas where it has chosen the prudent path of the Aristotelian mean. However, in many areas it needs to relook at the reforms carried out. This piece focuses on the latter.

The regulator has announced the integration of trading in commodity derivatives market with other segments of securities market at exchange level. While in Phase-I, integration has been achieved at the intermediary level, in Phase-II, necessary steps would be taken to enable a single exchange to operate various segments such as equity, equity derivatives, commodity derivatives, currency derivatives, interest rate futures & debt etc. This would happen by October 2018 from a regulatory perspective. However, it is possible that the exchanges are ready much in advance of that date. The integration is a logical conclusion and a good move.  An even closer integration would be possible if clearing corporations, those invisible but critical bodies which manage money, securities and risk, become inter-operable bringing efficiencies in risk management and more efficient deployment of capital.

SEBI’s dealing with credit rating agencies is well calibrated where it speaks of improved standards. But, it needs to review two decisions. First, increasing networth of CRAs to Rs. 25 crores in an area depleted of competition should be reviewed. If lawyers don’t need a networth to operate, why should credit rating agencies? We need smarter and better intermediaries, not richer ones. The policy leanings towards richer is more honest than poorer is misguided and in fact counter-productive. A liquor baron may be eligible to set up a CRA, but an IIMA graduate would not. Additionally, the cost of capital lost with this requirement would be passed on to the ultimate customer – the investor. The policy of networth in areas which do not require capital should be reviewed across the board not just for CRAs. Second, restriction on one CRA holding shares or directorship of another CRA would limit the free flow of capital and controls without reducing any conflict and is thus over-regulation. If at all any conflict mitigation is require from the perspective of rating shopping, that can be addressed by appropriate substantive restrictions.

On sponsors of AMCs of mutual funds, SEBI seeks to address potential conflict of interest by mandating that a sponsor cannot own shares of more than two mutual funds over 10%. It is unclear which conflict of interest SEBI is seeking to reduce. It would limit the market for capital and controls without reducing conflict. Does, say a private equity investor owning 15% of two mutual fund AMCs put the investors in any conflict situation. It is unclear how an investor is short changed if a credible person controls substantial stakes in multiple asset managers. If Warren Buffet can take multiple insurance companies or AMCs and merge them later, why outlaw that market in India. Taken to its logical conclusion, AMCs, almost ten in number, with public sector banks or other government sponsors would be in conflict of this provision, as the government is the ultimate sponsor of these AMCs.

On additional methods for listed entities to achieve minimum public shareholding (MPS) requirements of 25%, SEBI is directionally correct in liberalising two additional methods-Qualified Institutions Placement (QIP) and Sale of shares up to 2% to comply with the MPS requirement. But is it unclear, why the restrictions were in place in the first place and why sale in secondary markets is limited. Is the highly efficient secondary market deserving of this suspicious treatment? Why not allow promoters to sell in the market in a transparent and anonymous market when SEBI itself says that “open market will facilitate quicker and cheaper compliance”. As the US appeal court held in the famous Business Roundtable ruling striking down an SEC rule: “Indeed the Commission has a unique obligation to consider the effect of a new rule upon efficiency, competition, and capital formation”.

The Foreign Portfolio Investor norms too have met with reforms in terms of regulations. The regulator seems to have seen the difficulty of privatising the registration of FPIs and the private players being even more stringent in implementing the norms relying more on grammar than the intent of the law.  It has therefore rationalised fit and proper criteria for FPIs, simplified requirements of broad based nature of FPIs etc. These are good moves. The essence of foreign portfolio money should be on clean money and not on other factors which have fascinated the regulator for two decades. It is unclear why it should get into whether or not funds are ‘broad based’ or not. When SEBI has allowed even individuals to invest through the erstwhile FII regulations and continues to allow it under the current regulations, why being ‘broad based’ is a point of regulatory virtue is unclear, as narrower ownership of funds makes it easier to see ultimate ownership and thus make KYC easier.

SEBI has wisely decided to defer both the deep segregation of investment advisors from distributors, which would have hurt investors rather than help them and also the implementation of the Kotak Committee report which require substantial rethinking, and divvying up regulations from best practices.