Securities and Exchange Board of India (Sebi) chairman U.K. Sinha has said the regulator plans a thorough review of the market risk management system. He also said that exchanges and market intermediaries should review their own risk management systems, adding that if they are found wanting in this area, they will invite Sebi’s displeasure. This is a move in the right direction and one that is overdue.
India’s equity market has been known for its robust risk management system. Even on days of extreme volatility and large defaults, such as that of Lehman Brothers, trades have been settled, owing to a rigorous margin collection mechanism. However, there are some chinks in the armour. BSE has experienced two flash crashes in the past 18 months or so. In June last year, a freak trade caused an 18% drop in Reliance Industries Ltd within minutes. And just last month, the exchange was hit by large computer-driven freak trades in its Sensex futures contract, causing it to annul trades amounting to around Rs 27,000 crore.
Thankfully, in both cases, the contagion didn’t spread to the larger National Stock Exchange. Needless to say, there’s no assurance it will be the same case next time around. In this backdrop, Sebi’s review must be completed and acted upon urgently.
It is evident by now that the proportion of trades and orders that get generated electronically will increase with time. Sebi needs to get in tune with this fast-evolving world of electronic trading. Its traditional approach of monitoring trading activity on a post-trade basis will not suffice. It is time it invested in online market surveillance systems to monitor the markets better. Also, while it has done well to mandate an independent audit of exchange systems, there should be a similar move to audit the trading and risk management systems of market intermediaries. After all, in both of the above-mentioned flash crashes, the problem originated at a trading member.
But as much as the review is essential, Sebi must also be more transparent about its investigations into the flash crashes. It can take a leaf or two out of the book of the US Securities Exchange Commission, which has been transparent in discussing the 6 May flash crash and has received numerous suggestions from market experts. In the Sensex futures case, most people still don’t know what exactly happened, leave alone giving advice.
So, while Sebi is moving in the right direction, it needs to pull up its socks with respect to transparency as well as adapting to the pace at which the market is evolving.
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