Opinion
GN Bajpai: Sebi should review market infrastructure institutions
Summary
- India’s MII framework needs the attention of the securities market regulator, Sebi. Risks have changed, new technology has been deployed and innovations have been used. The capital market’s institutional set-up mustn’t get left behind the curve.
The Indian capital market’s regulatory regime has seen fast-paced reforms in areas of operational-risk management such as contract settlement cycles, public offer processes, and so on. In several areas, the market has moved appreciably ahead of the expected curve of evolution, even if compared to capital markets in developed economies.
Capital-market risks have three frames: structural, systemic and operational. While the focus of reforms has been on minimizing operational risks and to some extent also systemic risks, the framework for market infrastructure institutions (MIIs) has not been transformed in tandem with either these changes or the market’s growth, leaving the market exposed to structural risk.
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In December 2024, NSC Clearing Ltd (NSCL) reported a shortfall of ₹176.65 crore in meeting required liquidity norms, which was explained as its non-receipt of ₹312.37 crore in dues from BSE, the stock exchange. This speaks volumes about risks that arise from weak financial links.
To obviate settlement risk, the Indian stock market had shifted from delivery versus payment (DVP) to a central counterparty (CCP) system, transferring this risk burden from brokers to the clearing corporation. Centralized clearance guarantees the settlement of trades.
Recall that in 2001, the Ketan Parekh scam unfolded with a Kolkata Stock Exchange default in the settlement of trades worth about ₹120 crore. Brokers of the exchange failed to meet their obligations. Now, NSCL’s inadequate liquidity endangers the CCP settlement guarantee.
There are other problems too. In February 2021, NSE, the world’s largest derivative exchange in terms of number of contracts, suffered a technical glitch that halted trading for hours. Similarly, in October 2023 and July 2024, BSE had glitches and investors could not place orders. Such disruptions could be caused by hardware, software, brokers’ connectivity and/or capacity issues. But they affect millions of investors. More recently, on 11 October 2024, Sebi after an inspection issued a ‘show cause’ notice to NSDL, a stock repository, for non-compliance.
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In February 2023, Sebi had launched a Qualified Stock Brokers’ (QSB) framework to minimize risks emerging from brokers, which it revised in March 2024. To qualify, brokers must meet size and scale criteria, apart from standards of risk governance, rule compliance, service quality, grievance redressal, etc. The number of designated QSBs is just 24 out of thousands of brokers that operate in the market, several of which have come under enforcement action.
For over two decades, the Indian capital market has had a smooth run without any major failure or scandal involving large-scale misconduct. For this, we must credit regulatory regimes under successive leaderships. Smooth functioning enhances public confidence and market participation.
Recent numbers bear this out. By September last year, India had over 175 million demat accounts, with over 4 million being added every month. India recorded the world’s most initial public offers (IPOs) in 2024, helping raise ₹1.71 trillion. Yet, instances of glitches and misconduct mean it’s time to review the MII framework.
The MII framework encompasses the market’s structure, rules and participants, while MIIs include stock exchanges, depositories and depository participants, brokers, clearing houses and financial institutions.
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The market is undergoing a metamorphic transformation. The number of transactions is growing, variety of products is increasing and methods of intermediation are getting reshaped. The volume, variety, velocity and value of market transactions are being engineered by algorithmic, ‘quant’ and high-frequency trading. Meanwhile, market innovation is on a flight of fancy. A few months ago, Black Rock, the world’s largest asset manager, unveiled a new product incorporating a variety of assets, from real estate, gold and equity to debt, crypto, etc, that took advantage of fractionalization and composability.
The name of the game is newness and higher returns. It follows that ‘dark patterns’ of trading may have become even harder to spot.
The Ketan Parekh scam, which involved the connivance of issuers and brokers, apart from front-running and circular trading, was facilitated by the underutilized market infrastructure of exchanges and brokers. The regulator back then addressed these lapses through the consolidation and demutualization of exchanges and brokers, obligatory stock dematerialization and a broad relook at the regulatory regime.
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Enabling the smooth flow of capital demands MII strength, be it physical infrastructure, technologies, competencies or governance. Rising volumes call for a capacity boost, plus a technological upgradation to keep up with innovations, combined with the application of human minds to understand what ideas market participants might be coming up with. Real-time information on market moves is a must and MIIs must not be left behind the curve.
Stock exchanges, which act as subordinate regulators, need to be more proactive too. Deficiencies in the MII framework invite human ingenuity to find kinks in the market to exploit for profits, some of which could end up distorting the marketplace.
An MII review therefore needs Sebi’s urgent attention. Of course, without causing any ‘regulatory inflation.’
The author is former chairman, Life Insurance Corporation of India and Securities and Exchange Board of India.
