In May 2011, long before the National Spot Exchange Ltd (NSEL) scam came to light, India’s financial regulators already knew trouble was brewing.
At a meeting of the Financial Stability and Development Council (FSDC) sub-committee, a Reserve Bank of India (RBI) deputy governor said that the exchange did not fall under the regulatory purview of the Securities and Exchange Board of India (Sebi) or Forward Markets Commission (FMC).
According to the minutes of the meeting, the Sebi chairman concurred, stating that spot exchanges functioned in a large regulatory vacuum.
Among other things, FSDC was created for better co-ordination among regulators and to address such risks. Having been set up by the government in end-2010, the NSEL case would have been a wonderful success story for the council and that too, fairly early in its history.
For starters, it was on to the NSEL danger fairly early. In fact, at the time, outstanding positions on the exchange were around Rs1,100 crore, according to market participants. By the time the exchange shut in July 2013, outstanding positions had risen by more than five times to Rs5,600 crore. If the FSDC sub-committee had decided on meaningful action at the time, the NSEL problem and investors’ losses would have been contained at much lower levels.
A forum of aggrieved NSEL investors has now dragged the central bank to court for not acting against the exchange. But why the central bank specifically, when other regulators had been present in the meeting as well?
The RBI deputy governor had added in the May 2011 meeting that the clearing and settlement services offered by spot exchanges may need to be authorized under the provisions of the Payment and Settlement Systems (PSS) Act, 2007. While the Act mentions that stock exchanges regulated by Sebi are exempted from its provisions, there has been a lack of clarity on whether other exchanges are exempt.
Because commodity futures exchanges were then regulated by FMC, RBI derived comfort from this and had written to the finance ministry in June 2010 to exempt them from the authorization process.
Although, seemingly, the finance ministry didn’t reply to this request, RBI took the view that these exchanges, too, didn’t require authorization for their clearing and settlement services.
But NSEL was a new animal, with no financial markets regulator overseeing it.
Based on RBI’s comments in the FSDC sub-committee meeting, it can be seen as effectively saying, “Since spot exchanges are outside the regulatory purview of both Sebi and FMC, or for that matter any of the other regulators sitting here, the central bank can correct the anomaly by forcing it to comply with our PSS Act.” It was sheer brilliance from the central bank, although, in hindsight, it looks more like an empty threat.
In fact, the FSDC sub-committee went on to say that if RBI’s conditions for better regulatory oversight of spot exchanges weren’t met, the central bank may have to prohibit banks from offering clearing services to spot exchanges. In other words, NSEL would have had to cease operations. All of this sounds too good to be true, because it is.
One of the conditions discussed by the sub-committee was that the concern about regulatory gaps should be resolved.
Soon after the meeting in May, the finance ministry wrote to the ministry of consumer affairs (MCA) regarding FSDC’s concern about regulatory gaps and the need for authorization under the PSS Act.
MCA, it must be noted here, was the government body that gave birth to the poorly regulated spot exchanges in the first place. Among other things, it allowed them a bizarre exemption from the regulatory purview of FMC, allowing the scam to go undetected for years.
In its reply to the finance ministry, in August 2011, an MCA official suggested that RBI can write to the government requesting exemption for spot exchanges from the PSS Act. It said concerns about gaps were addressed as FMC was being appointed the designated agency for spot exchanges, as a result of which they would be “substantially regulated”. The language used should have made it amply evident that regulatory gaps remained.
What the FSDC sub-committee thought of this gobbledygook is not known. RBI’s reply to the court suggests that the second FSDC sub-committee where the NSEL matter was discussed was as late as November 2012, or about 18 months after the first one. That this speaks poorly of the FSDC is an understatement.
In the November meeting, in which RBI interestingly could not be present, the FSDC sub-committee seemed to have taken comfort from the fact that spot exchanges were filing regular reports with FMC and that drafts of two regulations were being processed, which would purportedly take care of the regulatory gaps. The central bank took note of the minutes of this meeting in January 2013 and took a decision that NSEL needn’t be authorized under the PSS Act.
Whether FMC skipped the November meeting or not is not clear, but by then it was evident that it had serious reservations about NSEL’s operations. In fact, its study of NSEL’s data had resulted in a show cause notice to NSEL from MCA earlier in the year. Still, if there are any doubts of what FMC thought about the poor regulatory oversight over NSEL, do see this interview with the then FMC chairman. He clearly states that in December 2012, he had warned market participants that NSEL was operating outside regulatory purview.
It’s strange that RBI, at the same time, decided to allow spot exchanges to run clearing and settlement services without authorization, putting them on par with regulated stock exchanges and commodity exchanges.
In a recent note prepared by the central bank for the FSDC sub-committee, RBI said its decision was driven by the rationale that dual regulation of these exchanges is avoided. Interestingly, the note also adds that there remains a lack of clarity about regulation of spot exchanges and that the government should look into appointing a regulator for these entities.
While all of this reflects poorly on the central bank, it can be argued that the entire FSDC sub-committee is to blame. But since it’s the central bank that voluntarily said it can potentially act against NSEL under the PSS Act, it isn’t surprising it is the only one facing some heat.
Jayshree P. Upadhyay contributed to this column.
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