We must ensure that our commercial regulators that are focused on public interest are never seen to become regulatory duopolies focused on private returns: Ananth Narayan G
FinTech BizNews Service
Mumbai, 9 November, 2024: Shri Ananth Narayan G, Whole-Time Member, SEBI Board, Addressed the ‘Business Standard BFSI Insight Summit’ on the topic of ‘Reflections on our Market Infrastructure Institutions Ecosystem’ on November 7, 2024. Here is the complete text of his speech delivered on the occasion:
Thank you, Business Standard, for once again giving me the opportunity to address your annual BFSI insight Summit. We live in times when attention spans are sometimes limited to YouTube shorts and Insta reels, and yet where opinions are vehement. Amidst all this, policy formulation calls for informed, calm, and constructive engagement. Media houses such as Business Standard and Forum such as this Summit have a crucial role to play in this regard. Today, I will offer some reflections on our Market Infrastructure Institutions (MIIs)–namely, our exchanges, clearing corporations, and depositories–as a prelude to seeking your considered feedback. MIIs are statutory institutions that have played an admirable role in the development of our capital markets. They are required to put public interest first, serving as a first line regulator and as a public utility, even as they operate as commercial organizations. I will first make the case that we must continue to strengthen their governance framework, ensurethat they are staffed by high quality risk, compliance, and technology personnel, and further strengtheninstitutional mechanismsto ensure that theycan appropriately deliver on the corepublic interestmandate of the MII.I will also speak about the construct of our Clearing Corporations (or CCs). They are currently owned entirely by their parent exchange, and depend on them for equity infusion, contributions to their Settlement Guarantee Funds (SGFs), and for resources. There is an argument to be madeamongst CCs that operate in interoperable segments such as equities,for themtobe truly independentstandalone MIIs both in form and in substance. I will beginwith a background toour MIIs.1.Background:Our MIIs provide the critical superstructurefor our capital markets. Particularly overthe last 3 decades, guided bypolicymakersand regulators, they have played a crucial and pioneering role in growing our capital markets ecosystem. MIIs are the first line of defense charged with ensuringinvestor protection and market integrity. Amongst other things, they are required to ensureadequate disclosures by issuersof securities, conduct appropriate surveillance to deliver a free and fair marketbereft of unfair trading practices, manage risks and operationsto deliver smooth clearing
and settlements, monitor the conduct of brokers and other intermediaries, and ensurethat market technology platforms and ledgers arefair,secure, reliable, and resilient.MIIs have a unique operating model in thatthey are empowered by law to regulate their own paying clientssuch as listed corporates,Trading Members, Clearing Members, and Depository Participants. Theyare required to primarily focus onpublic interest and ensuringthe integrity of capital markets. At the same time, they are also commercial entities, and the larger MIIs in equity marketscurrentlyenjoy high operating marginswith Profit Before TaxtoIncome marginsof 60%or more, high equity price to earnings multiples, and significant dividend payout ratios. What is the framework that we have adopted to balance the public utility and commercial objectives of MIIs?2.Indian MIIs –competitive, publicly held, commercial regulatorsGiven the primary need for an MII toserve public interest and actas a first line regulator while staying commercially viable, different jurisdictions and regulators have adopted different operating models for differentMIIs. In India, following much consultation and deliberationover manyyears, we have chosen a model that allows for competition amongst MIIs, allows them to make profits and pay dividends to their shareholders, and allows for public shareholding in and listing of MIIs (except for Clearing Corporations).There are advantages of this construct. Competition, public shareholding, and profits fosterefficiency of MII operations, helps attracts market talentto MIIs, and spursand financesinnovation. Competition also creates a natural back-up and redundancy in the ecosystem, avoiding the risk of having all our infrastructure eggs in one basket. (Of course, in India, there is a concentration in terms of one exchange and clearing corporation dominating the equities landscape.) Public shareholding and listing can help improve transparency and enforcebetter market accountability.There are possible downsides to the construct as well. MIIs are not regular commercial entities. Competition, public shareholding, and listing can create incentives that give primacy to commercial outcomes, overthe intended core and primary statutory role of the MII as a first-line regulator and public utility provider. There is the risk of a potential race to the bottom with compromise on risk, or compliance, or in their role as a first line regulator of their members, particularly as MIIs compete forclients whom they must alsoregulate. There is the potential that investments into appropriate security, technology, risk, and operations are de-prioritized, overcommercial outcomes. There is the potential that products or securities are launched and persisted with, without adequate safeguards around investor protection, suitability, and appropriateness, and with a view to maximizing MII throughput and revenues. To foster long term confidence in the capital markets
ecosystemand to ensure financial stabilityof our capital markets, not only must all this be avoided, but theymust also be seen to be avoided.There are mitigants in place to ensure that these downsides do not materialize, but given the serious implications of any failure, there is always room for review and improvement.3.Risk mitigation –Governing Board, Management, SEBIThe firstand crucialmitigantis the governance framework of MIIs. MIIs are required to have a Governing Board in which Public Interest Directors (PIDs) must comprise the majority. SEBI chooses and appoints PIDs from amongst the candidatessuggested by the Governing Boardof the MII. This is a crucial appointment, calling on people of experience, competence, integrity, management and people skills, and stature.MII shareholders do not have a direct say in the appointment of such PIDs. Of course, shareholder and executive directors on the Governing Board of the MII arepart of the process of suggesting suitable candidates to SEBI. In selecting PIDs from amongst the candidates suggested by the MII, SEBI tries to ensure that the Governing Board has appropriate and diverse skillsand expertise, including in technology, markets, risk, compliance, management&administration, finance,and law. As a collective majorityon the Governing Board, PIDs are charged with ensuring that the MIIoperates primarily with public interest in mind, focusing on its role as a first line regulator and public utility, rather than on commercial outcomes. In recent times, SEBI has tried to deepen and formalize the two-way engagement with the PIDs, both collectively and as individual MIIs, so that these objectives are better appreciated and effected.As an aside, we had sought public feedback on whether we should change the process of appointing PIDs to allow for direct shareholders involvement in their appointment. The overwhelming feedback from an expert working group, the Secondary Market Advisory Committee, PIDs and MIIs themselves, and the public at large,was to continue with status quo. We will still explore ways to improve ease of doing business for our PIDs, while making the process of their appointment more institutionalized and objective.However, PIDs do not run MIIs on a day-to-day basis. While the Governing Board sets the tone at the top, the culture of giving primacy to public interest must run deep amongstthe management and employees of the MII as well. Besides having a capable MD&CEO who is accountable for the entireMIIincluding its commercial outcomes, there is a need forable andaccomplished heads of the primary MII verticals of Technology & Operations, andofRisk and Compliance. These crucial verticals must be willingand empoweredto operate independentof short-term commercial considerations,to ensure that theMIIdelivers its primary mandate as aquality public utilityand first line regulator.
SEBI has advised Governing Boards of MIIs to upgrade the KMPs in charge of these key verticals over time asnecessary. SEBI will also require the Chief Technology Officer, Chief Information Security Officer, Chief Risk Officer, and Chief Compliance Officers of MIIs to independently interact with the appropriateGoverningBoard Committees, whichwould also directly contribute totheir annual appraisals. Given the critical need to strengthen these verticals, we asealso considering SEBI’sown involvement in approving the appointment of thesespecificKMPs, just as we today approve the appointment of the MD&CEO of the MII. We believe that suchmechanisms can further facilitateand institutionalize appropriate focus on the core public utility mandate of the MII.Finally, SEBI is tasked with regulating and supervising thefirst-lineregulators, the MIIs.We have upgraded our supervision of MIIs significantly over the past few years and intend tofurther invest in enhancing and sharpening our tools and skills, particularly by building a specialized cadre of IT supervisors. SEBI’s standard enforcement processes can sometimes follow a long and legalistic journey. Automatic financial disincentives are designed to avoid such delays when it comes to supervision of MIIs –but that does come with the possibility of creating perverse incentives. For our part, we are happy to consider specific changes that could foster honesty and help sharpen the focus on material rather than peripheral supervisory issues. From the next year, we will also institute independent external evaluation of MIIs once every three years, to supplement and our own supervision.
I will now turn specifically to our Clearing Corporations (CCs).
Indian Clearing Corporations Clearing Corporations act as central counterparties for clearing and settlement. They play a crucial role as a first line regulator managing several forms of market, counterparty, operational, and technology risk that accompanies trading and settlement in securities markets. They provide the comfort of novation and ‘settlement finality’, backed by processes and ultimately, by a strong default waterfall. Given the crucial role that they play, in many jurisdictions and markets that have multiple exchanges and dealing platforms, CCs operate as true public utilities that are owned by stakeholders for their collective good. In India as well, while exchanges and depositories are allowed to be listed, our regulations clearly state that CCs will not be allowed to list.However, there is an anomaly here, in that currently, our CCs are 100% owned by their parent exchange. When the parent exchange lists, therefore, their CCs are also de facto listed, in that the shareholders of the parent exchange consider the consolidated financials of both the exchange and its CC. In the past, this was implicitly accepted, since the CC would only clear the trades of its own exchange. However, since 2018, we have introduced interoperability in the equities market settlement so that a CC can clear the trades of multiple equity exchanges, rather than that of the parent alone. This interoperability has improved the ease of trading and settlement for investors, while allowing for better back-up and redundancy in our securities ecosystem. It has also materially altered the implications of 100% ownership of a CC by a single exchange. As on date, the dominant equity clearing corporation, owned by the dominant exchange, clears over 85% of all cash and derivative equity market trades dealt on each of the large exchanges. In this context, 100% ownership of CCs by a single exchange does raise questions of the potential for actual or perceived conflict of interest. The second anomalous feature of CCs in India is that unlike many global and domestic peers, our CCs are dependent on their shareholder, i.e., their parent exchange, for equity infusion, default fund management, and for other resources such as technology and people. In most jurisdictions, participating Clearing Members contribute to the Settlement Guarantee Fund of the CC, and hence have a skin in the game depending on the risk that they bring into the platform. In India, as on date, CMs do not contribute to the CC Settlement Guarantee Fund. Instead, the CC itself, the exchanges from where the trades originate, and the owner of the CC must constantly enhance the SGF on their own. There is a need to fundamentally review this construct of our CCs. There is a case to consider making the CCs truly independent and self-sufficient, with broad-based ownership, and with clearing members having a risk-based skin in the game. All this may be crucial to ensure that there is an actual and perceived level playing field across all MIIs. This may also be crucial to ensure that sufficient resources are readily and independently available to the CCs to invest in appropriate technology, risk management, and people, for them to continue delivering on their mandate asa key public utility and first line regulator. If we agree on the principles here, the question of how to bring about this change in a manner that is fair, equitable, and non-disruptive for all stakeholders will then arise. We have debated this at our Secondary Market Advisory Committee, where some ideas have been proposed. In essence, some form of demerger of the equity stock exchange and the equity clearing corporation may perhaps be a way out, though there may be some legal and regulatory challenges to navigate. We will come out with a public consultation on all this shortly and seek your considered views on this subject.
Conclusion
I will now end where I began –on emphasizing the need for informed, considered, calm, and constructive engagement on policy formulation. My attempt today has been to lay out the contours of our thinking on a possible way forward for our MII ecosystem–on how to ensure they stay focused on the public interest, and how the CC construct can be reimagined. We must ensure that our commercial regulators that are focused on public interest are never seen to become regulatory duopolies focused on private returns. Bertrand Russell once said –‘I would never die for my beliefs, because I might be wrong’. I agree with him –we would be happy to be modulate our own policy views through our consultation process, based on the logic and data presented. Once again, I thank Business Standard for offering this platform for constructive engagement and deliberations.
