Last fortnight, RBI sought fresh powers to regulate trading in certain kinds of securities such as money market instruments, government securities, credit-linked and foreign exchange-linked derivatives. It issued the Electronic Trading Platforms (Reserve Bank) Directions, 2018 that prescribe a separate licensing and regulatory framework for platforms offering trading facilities for such securities. It also issued a draft Reserve Bank of India (Prohibition of Market Abuse) Directions, 2018 seeking powers to penalise persons indulging in market abuse when trading in such securities.
Until now, except for the RBI-run platform for government securities, all other platforms offering trading facilities for securities were considered stock exchanges and were regulated by SEBI. Similarly, investigating and penalising market abuse in the securities markets is within the regulatory domain of SEBI. The new approach of bifurcating regulatory powers for securities markets platforms is problematic and tantamount to regulatory over-reach on the part of RBI. The central bank's draft directions seeking to penalise persons engaging in market abuse is conceptually weak, and violates fundamental elements of the rule of law.
Unlike other jurisdictions with comparable financial systems, the regulatory architecture governing the Indian securities markets has been bifurcated between SEBI and RBI. While SEBI regulates all kinds of securities, including intermediaries and trading platforms, RBI has been empowered to issue directions to persons dealing in the short-term debt market, credit-related derivatives and foreign exchange derivatives. Thus, for instance, RBI may give directions to persons dealing in commercial paper, interest-rate futures and currency futures.
At the outset, there is a fundamental problem with the approach of segmenting the securities market into multiple regulatory structures. An efficient financial regulatory architecture is one that enables seamless trading in all kinds of securities. It should allow people to take advantage of arbitrage opportunities, minimise the cost of trading across multiple platforms and the regulatory norms governing them, and obtain the benefits of common risk management systems.
Contrary to this notion, the RBI's ETP directions envisage a parallel and separate market infrastructure for trading in securities that are intrinsically linked to securities regulated by SEBI. For example, a person taking exposure in the bond market would need access to the credit-derivatives market to hedge credit-linked risks and the forex derivatives market to hedge currency-risks. This is most efficiently done under a unified structure that does not require a market participant to follow different rules and pay separate costs for trading across different markets.
The economic rationale for unifying the commodities and securities markets in 2015 was to enable such seamless trading across commodity derivatives and other securities. RBI's vision of a differently governed market infrastructure for RBI-specified securities is, therefore, a retrograde step in India's journey toward a unified market for organised financial trading, an idea that has been repeatedly emphasised by several expert committees including the report of committee on financial sector reforms led by Raghuram Rajan.
Second, the ETP directions could constitute legal over-reach on the part of RBI as trading platforms for securities are governed by the Securities Contracts (Regulation) Act, 1956 (SCRA). RBI derives its power to issue such a direction from Section 45W of the RBI Act. Section 45W empowers RBI to "determine the policy relating to ... interest rate products and give directions...to all agencies..., dealing in securities, money market instruments, foreign exchange, derivatives, or other instruments of like nature as the Bank may specify from time to time." (Here, the term 'securities' is limited to G-secs or securities issued by a local authority.)
A plain reading of Section 45W would indicate that it does not empower RBI to regulate a platform that provides trading facilities for such instruments, as such platforms do not actually 'deal' in securities. They comprise market infrastructure to facilitate such dealing.
Third, the ETP directions ignores critical lessons for regulatory governance of financial market infrastructure, that India has only too well learnt from experience. For instance, the intent underlying the de-mutualisation of stock exchanges was to pre-empt the capture of such institutions by broker-members. For this reason, SEBI is empowered to cap the shareholding and voting rights of broker-shareholders of exchanges. Another important lesson is the separation of the clearing function from the trading platform. The ETP directions are devoid of such checks and balances.
The rationale underlying the RBI market abuse directions is weak. The RBI purports to have issued these directions to curb market practices that adversely impact the outcome of the measures taken by the central bank towards attaining its monetary policy objectives. Toward this end, they seek to penalise market manipulation and insider trading in the market of RBI-specified securities. First, it is unclear how market abuse in these securities affect the RBI's ability to deliver on its inflation-targeting mandate. The discussion paper should have supplemented this intervention with evidence of linkages between market abuse and the transmission of its monetary policy measures.
Second, the approach is inconsistent with the way inflation-targeting central banks work. An inflation-targeting framework allows the central bank to use certain specified tools - in most cases, the repo rate - to achieve its target inflation. The transmission of the measures taken by the central bank are then left to market forces and the rest of the institutional framework in the country. Assuming jurisdiction to penalise securities market abuse to achieve monetary policy aims is an over-reach and steps on the jurisdiction of the securities market regulator.
Most importantly, the RBI market abuse directions create a new category of violations, such as market manipulation, not present in the primary law governing it. It is a basic principle of good governance that violations, offences and their penalties must be defined in the primary law. For example, the Indian Penal Code defines theft and its punishment. The police is empowered to investigate allegations of theft, and the courts are empowered to sentence people for theft. The same principle should apply to financial regulation as well. Allowing a regulator to define a violation and its penalties is akin to allowing the police to define theft and its punishment.
The RBI market abuse directons also suffer from serious ambiguities that could make them vulnerable to constitutional challenges. For instance, they loosely provide that participants found guilty of market abuse may be subject to regulatory action without defining what action may be taken.
A regulatory framework that seeks to penalise persons found guilty of market abuse must be supported by a robust law that builds in due process for an investigation, a show-cause notice, a hearing, the defenses that she may take and a process for appeal or review. The absence of these elements in the RBI market abuse directions undermines the rule of law by vesting excessive discretion in a regulator to investigate and penalise persons in the absence of a legal framework supporting the rights of an accused.(Bhargavi Zaveri is a researcher at the Finance Research Group, IGIDR. Views expressed are personal.)