VR Logo

Irregular Regulations

Some of SEBI’s regulations achieve the opposite of its objective, making one regulation work against another

Companies make Vision Statements that tell you (if they are honest) the broad direction that you can expect it to take. So an Apple Inc can be expected to focus on design, while a Samsung can be expected to focus on take-to-market. These Vision Statements usually come from deliberate planning efforts, which are often called ‘Strategic Planning’. The outcome of these planning exercises is that there is an explicit statement of ‘strategy’, which is like a positioning statement for the company, a statement of aspiration for a ‘state of being’.

Even countries have something like that. India has a Constitution and ‘Directive Principles of State Policy’, which give a deliberate structure to the direction of actions taken by the State. Have you ever wondered why the people who regulate these ‘companies’, don’t consider it necessary to let their subjects (and the general public) know where they are headed?

Let’s take an example. When TRAI or IRDA are given their mandate over their respective industries, do they lay out a ‘Constitution’ that binds their own behaviour and a Statement of Strategic Intent that lays out just what Utopia they are looking for? These statements can be changed from time to time, but they should be clear and transparent. It should be binding on the regulator to demonstrate, by every action of his, that he has kept in mind his objective while formulating a regulatory stance or taking some regulatory action.

At a much wider level, you will discipline various arms of government from ‘playing to the gallery’ by pandering to media frenzy, which sets up these lynch mobs that destroy reputations. And you will bring some predictability and consistency to regulatory action.

Let’s take a very small example. The move to shift currency trading to an exchange-traded format was part of the movement towards full currency convertibility. It accelerated after the forex derivatives ‘scam’, in which a large number of small companies were (mis)sold complex OTC derivatives, with structures that increased risk rather than reducing them. During the 2008 crisis, most of these structures unravelled, causing huge losses and even bankruptcies among SMEs. Justifiably, the RBI took it upon itself to tighten the screws on this ‘business’ and put a stop to these bilateral transactions in exotic derivative structures. Through a slew of circulars and guidelines, it made life difficult for the foreign and private banks that were preying on the SMEs. Meanwhile, the door was thrown open for exchange- traded vanilla products, which became increasingly liquid, thanks to retail participation.

As the currency exchanges gained volumes and market share, a minor argument ensued over who should regulate these currency exchanges. Were these formats more to do with ‘currency’ or did they have more to do with ‘exchanges’. Traditionally, exchanges had been regulated by SEBI, while currencies, naturally, had more to do with the central bank. The matter was resolved in favour of SEBI, probably with reason.

Meanwhile, things improved rapidly for those SMEs who understood both trading formats and international economics. The first good thing was that ‘underlying’ was no longer needed, everybody could trade and you could hedge, speculate, invest or trade, regardless of whether you were exporter, importer or neither. This promoted genuine price discovery with depth and liquidity appropriate to a money market.

‘Underlying’ is a FERA-era regulation, under which exporters/ importers have to prove that they have a ‘genuine’ trade transaction ‘underlying’ the hedging transaction they are undertaking with the banks. Otherwise, you were ‘speculating’, a bad word in Indira Gandhi’s time. Those days, foreign exchange was ‘precious’ and the buying of any foreign exchange was seen as a one-way bet against the rupee. The regulation continues today, nobody knows why. Sometimes I think that the RBI very smartly uses this (regulation) as a tool to push corporates to trade on the currency exchanges, rather than deal bilaterally with the banks. Eventually, when enough corporates are forced onto the exchanges, the banks will follow, deepening the market. Meanwhile, regulations about ‘underlying’ are tightened, forcing mid-corporates out of the bank (trading) market. Needless to say, there is no question of any exotic derivatives being traded any more.

Meanwhile, SEBI and the exchanges did a good job, pushing liquidity and promoting currency trading with good risk management practices and low impact costs. However, SEBI carried into this new product its equity trading mindset and continues to regulate the currency markets as if it is still regulating an equity-like instrument. For example, it continues with ‘market concentration’ limits in currency markets, as if it was possible to ‘corner’ all the currency in the country. Believe it or not, the market concentration limit on a major currency like the Euro and the Yen is about € 5 million, and ¥ 2 million, respectively.

As background, it is understandable for SEBI to be obsessed by ‘market concentration’. Its very existence was triggered by the Harshad Mehta scam, which was all about cornering shares of companies (sometimes in collusion with the promoters of those companies) with money siphoned out from banks through the securities trading market. Both segments of these (exchange-traded) markets ended up under SEBI regulation and led to the development of electronic exchanges. Then came the Ketan Parekh scam, which was almost exclusively about the ‘KP10’ companies. This was nothing but cartelization, in collusion with company promoters. Thereafter, SEBI has been dealing with cartelization and market rigging, either through P-notes masquerading as ‘FII’ investment or through ‘persons acting in concert’ in high- promoter- stake companies. So it is understandable if it carries a paranoid mindset about ‘market concentration’ into its regulation of currency markets.

However, the key underlying premise in ‘market concentration’ is a limitation on the ability to create supply. In some cases, companies were accused of putting out duplicate shares into a very ‘hot’ market, in effect short-selling their own stock with fake currency. But in currency markets, this pernicious activity is done by the regulator itself (and goes by the respectable name of deficit financing). So how can a poor trader ever be able to ‘corner’ a currency?

In India, as in most countries of the world, the central bank routinely intervenes in forex markets, creating money supply at one extreme end of the market. That takes the effect of ‘reducing volatility’ and is seen as honourable activity; but isn’t that what jobbers do? By the simple expedient of telling a PSU bank to monitor the exchange-traded markets, the government can ensure that price differences between the bank market and the exchanges do not exceed a certain maximum. In any case, some banks are already doing that through their propriety trading desks.

In any case, can they (RBI and SEBI) see how they are working at cross purposes, simply because they have different objectives and hence, different mindsets. RBI, very justifiably, is clear that SMEs (and later maybe big corporates) must operate on the currency exchanges. Hence, it is gently but firmly pushing smaller corporates out of the bank markets. It will probably now ask the banks to shift their propriety trading volumes onto the currency markets; I have not understood why it has not done so (maybe because enhancing liquidity in currency markets is not its objective). Finally, when there is enough depth and liquidity (currency markets’ turnover has already reached $7 billion, out of a total of about $50-60 billion, i.e. about 10%), it will close down the bilateral bank/ OTC market.

This has had the ‘unintended consequence’ of bringing in day traders from the equity/commodity markets, who like the huge liquidity and low volatility of the currency markets, as compared to the equity markets. They particularly like the periodic RBI intervention, which cools down one-way movements and gives them an exit if they get something seriously wrong. When a currency trader hits her stop loss, she can at least find an exit. So HNIs and jobbers have started to populate the market.

But what does SEBI do? It puts on its equity regulators’ hat and sets ‘market concentration’ limits that ensure that big jobbers (and later, bigger corporates and the banks) DON’T enter the market. What is the objective of this? It achieves precisely the opposite of the regulators’ original objective. Can you see how one (regulator) works against the other?