Securities and Exchange Board of India (Sebi) plans to set up an independent self-regulatory organization (SRO) to oversee trading members of stock exchanges, according to a report by Press Trust of India. The report said that the SRO (which will be set up in the long run) will only take over the regulation of trading members. Other areas such as oversight of listing regulations and market surveillance will remain with exchanges.
When a stock exchange is responsible for the oversight of its trading members, who are also the main source of its income, there is evidently a conflict of interest. Carving out this regulatory function must be done sooner than later. But the role of trading regulation or market surveillance is equally important, and it is foolhardy to think that this function can be left with the exchanges.
To be sure, Sebi acknowledges that there are conflicts of interest even in listing and trading regulation. Its solution is to put in place a dual reporting structure for the heads of the listing and trading regulation departments. They should report both to the chief executive officer of the exchange as well as an independent oversight committee, set up by the board of the exchange. These independent committees should be chaired by a public interest director, Sebi stated in its recent Securities Contracts (Regulation) (Stock Exchanges and Clearing Corporations) Regulations, 2012.
But will this solution, akin to creating a Chinese Wall between the business and regulatory departments, work? Former Sebi executive director Pratip Kar wrote in a Business Standard column last year, “Looking for a solution through a mechanism to ensure regulatory autonomy through the separation of personnel who are carrying out regulatory functions…and the introduction of the concept of ‘Chinese Wall’ are non-solutions. In financial markets, when human behaviour is involved, and one has to constantly deal with greed and the need to cut corners to grab market share, a ‘Chinese Wall’ becomes a euphemism for the most porous walls through which information flows freely...”
The best solution is to carve out the above-mentioned regulatory functions and place it either in an independent regulatory organization, which reports to Sebi, or is managed by Sebi entirely.
Additionally, a coordinated approach to market surveillance is critical because market manipulation strategies can involve trading positions across two or three different trading venues. When each exchange’s market surveillance division looks at their trading data separately, they will only get a partial picture. While it’s true that Sebi has an integrated surveillance software, it doesn’t use real-time data. This column has argued in the past that Sebi needs to spruce up its technology capabilities to be able to better monitor algorithmic trading. Whichever way one looks at it, it makes sense to invest much more in technology and equip itself to provide effective market surveillance.
Of course, it is possible for an independent regulatory organization on the lines of Financial Industry Regulatory Authority to perform these regulatory roles. But even with such a model, a keen oversight by Sebi is critical. According to a Reuters news report, a study by the Government Accountability Office found that the US Securities and Exchange Commission can do a better job of overseeing the Financial Industry Regulatory Authority.
Sebi’s proposals to address the conflicts of interest issues of stock exchanges give the impression that it wants to stay as far away from the solution as possible. Even with the dual-reporting proposal, the second level of reporting is to a committee set up by the exchange, rather than to Sebi itself.
It must give more thought to the implementation of the independent SRO and look to play a more active role in the regulatory roles that exchanges are currently playing.
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