Mumbai: India’s capital market regulator has issued a show-cause notice to Asia’s oldest bourse, the 134-year-old Bombay Stock Exchange (BSE), for allegedly violating regulations related to market making.

The Securities and Exchange Board of India (Sebi) issued the notice to the exchange for artificially creating volumes in the derivatives segment in 2008 through market makers without acquiring approvals from the regulator, according to a Sebi official who didn’t want to be named.

Asked why: Without getting Sebi approval, BSE artificially created volumes in the derivatives segment in 2008 through market makers. Ashesh Shah / Mint

Kalyan S. Bose, head of corporate affairs at BSE, declined to comment on the issue.

Zia Mody of AZB and Partners, a Mumbai-based law firm, is drafting BSE’s reply to the show-cause notice, according to people familiar with the situation who didn’t want to be named.

Market making is an activity to infuse liquidity by way of two-way quotes given by jobbers or market makers. A market maker quotes both a “buy" and a “sell" price in a financial instrument or commodity, hoping to make a profit on the bid/offer spread.

In 2007, a market-making scheme was approved by the BSE board, chaired by its then managing director and chief executive officer Rajnikant Patel, to ramp up the volumes in derivatives trading, in which its younger rival, the National Stock Exchange (NSE), is the leader.

BSE appointed two of its corporate broker members—Delhi-based SAM Global Securities Ltd and Hyderabad-based Apollo Sindhoori Capital Investments Ltd (later acquired by Aditya Birla Nuvo Ltd)—as market makers, which helped generate trading volume.

Patel resigned in August 2008 and M.L. Soneji, the exchange’s chief operating officer, was given the charge of acting chief executive officer until Madhu Kannan, its current managing director and chief executive officer, was appointed in May.

In July 2008, the exchange withdrew the market-making arrangement after the exchange’s audit committee found some loopholes in its implementation and PricewaterhouseCoopers (PwC) was appointed to look into it.

According to media reports, PwC noted that the way in which the trades were conducted through market making were inappropriate and recommended recovering the amount the exchange lost during the market-making process from SAM Global and Apollo Sindhoori.

The average daily turnover of derivatives trading on BSE in the first quarter of calendar year 2008 was around Rs1,000 crore. It started slipping in April and fell to Rs41 crore in July, according to the BSE website.

In August 2008, trading volumes fell to Rs10 crore while its rival NSE was clocking a turnover of at least Rs44,000 crore.

At present, BSE’s share in the derivatives segment is almost nil, but in the cash segment its market share is around 24%.

Indeed, market-making activities are not banned by Sebi, but it seems that the exchange did not seek the regulator’s clearance before introducing them and allegedly violated some norms.

In an effort to provide liquidity to relatively less traded but fundamentally good stocks, Sebi had in 1999 constituted a committee headed by G.P. Gupta, former chairman of the erstwhile Unit Trust of India, to study the concept of market making.

It issued guidelines to the exchanges to allow brokers to take up market-making activities, following the recommendations of the Gupta panel.

Incidentally, in March 2008, Yogesh Mehta, a former member broker of BSE, filed a petition against the exchange for carrying out the market-making activity to create artificial volumes in the derivatives segment without obtaining permission from Sebi.

Mehta claimed that the profit made out of artificially created volumes in the derivatives segment of BSE should be transferred to its investors’ protection fund (IPF).

He also claimed that BSE incurred a loss of Rs85 crore by appointing two market-maker firms to create volume on its derivatives segment, without Sebi’s permission. Mehta could not be contacted for his comments for this story.

BSE had in 1996 declared Mehta a defaulter. In 2004, after a high court order, Mehta’s BSE membership was withdrawn.

Mehta has filed many appeals with Sebi and the central information commissioner (CIC) against the exchange for not providing information about the stocks and funds remaining in IPF under the Right to Information (RTI) Act.

In November 2008, Sebi’s whole-time member M.S. Sahoo passed an order seeking information about IPF from BSE, under the securities laws.

BSE, however, did not oblige and argued that though various sections of the RTI Act do provide citizens the right to get information, which is under the control of a public authority, it does not provide the same right to the public authority to collect information from private bodies.

In July this year, CIC asked Sebi to collect information from BSE on IPF and give it to RTI applicants.

Sebi has not done so and instead moved the Bombay high court challenging the CIC order, saying it is a regulator and not an information provider.