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Capital market regulation on an even keel
December, 21st 2009

The Indian stock markets have rebounded sharply since March 2009. The SEBI, which has introduced many regulatory changes during the calendar year, ought to take credit for the fact that there have been no major scandals or market shenanigans.

As the year 2009 draws to a close it is worth recalling the role the capital market regulator, the Securities and Exchange Board of India (SEBI), has played in the past few months.

At the start of the year the environment was extremely tough. Equity markets everywhere had plunged.

The global economic crisis had shown few signs of abating. Equity investors in India as in nearly all other countries faced a serious erosion in stock valuations. Those who had bought during the markets peaks (December 2007-January 2008) and remained invested lost as much as two-thirds.

Betrayal of investors

In those circumstances, it was difficult for the average investor to retain his faith in the markets. Sadly, financial intermediaries such as mutual funds and portfolio managers who were supposed to manage funds better than lay individuals were found totally wanting.

That might be a common complaint of most investors but some among them have more specific reasons to complain about some portfolio management schemes (PMS) floated by leading asset management companies. These fared far worse and outdid the markets in declines. So high was the negative return that investors who had thought that professional managers were better equipped to ride out the markets in volatile times were utterly disappointed.

To add insult to injury, the fund houses concerned abruptly exited the failing schemes leaving investors with no hope of recouping even a portion of the losses incurred. It is time for the SEBI to look at these schemes more critically. Over the medium-term at least the regulators must insist on a higher degree of professionalism from those who manage funds under whatever garb.

On the brighter side, the Indian capital market has been spared of scandals and market shenanigans even as stock indices perked up dramatically since March 2009. In the U.S., the regulators are in the dock for not spotting the elaborate Ponzi schemes perpetuated by operators like Madoff over a long period. The Satyam debacle was not anticipated but after Ramalinga Raju made his infamous confession the spotlight was more on the company law administration, auditors and of course the top management of the company than on the SEBI. The government and the regulators acted quickly. The company has now a new owner who has infused additional capital.

Watch on fund sources

There are, of course, outstanding issues for the capital market regulator. Redefining the role of independent directors, for instance. A check on auditors by insisting on peer review of working papers on financial statements is another.

A prime regulatory concern in a rising market is to keep a tab on the source of funds. It is clear foreign institutional investors (FIIs) have returned to the Indian stock markets in search of higher returns. The volume of such flows this year is placed at over $16 billion.

Participatory notes (PNs), offshore derivative instruments that concealed the identity of investors abroad had invited regulatory action some two years ago. Contrary to expectations, there has so far been no concerted action by the SEBI and the RBI, probably because fund flows through the PN route are only a small proportion of total FII inflows.

A large proportion of the FII money has come in through the qualified institutional placement (QIP) route. Analysts attribute this to the SEBIs amendment concerning the pricing. Instead of basing pricing on a six months average the regulator has allowed the QIP issues to be priced at the average of two weeks closing prices. In a rising market this gave promoters an incentive to raise resources through the QIP route.

Interest rate futures

Interest rate futures were reintroduced after a gap of years, using the NSEs trading platform. An extremely useful tool to hedge interest rate risks, the product has not however been popular, judged by the initial response from public sector banks. The volumes are generated largely by private banks led by ICICI Bank. May be the government-owned banks and others will realise the potential of this hedging instrument in due course.

More controversial has been the SEBIs decision in July to abolish entry loads in mutual fund schemes. Investors stand to gain as they can acquire units at a lower cost. However, the regulator has not taken into account the intermediary role of distributors between funds and investors. Distributors will now have to earn their fee directly from the investors.

The move to do away with commissions to distributors is not confined to mutual funds. A high level committee has suggested that the LIC can do away with commissions paid to its large network of agents.

Distributors future role

Decisions to downplay or eliminate distributors altogether are fraught with risks and are best taken after due deliberations. For instance, mutual funds simply do not have the large number of branches needed to support their business.

Most mutual fund investors would continue to depend on distributors not only for sending applications but also for advice. But will they compensate the distributors for such services? It will take a paradigm shift in the mindsets of investors, funds as well as regulators before attempts to streamline financial distribution bear fruit.

The decision to let stockbrokers handle purchase and sale of units of mutual funds through the trading platforms of NSE and BSE is meant to expand their reach. Here again, one gets a feeling that the objective to reach out to mutual funds will not be achieved. An equity broker caters to a different type of clientele. The process of acquiring units has been simpler and easier than buying equity shares.

There have been other initiatives by the SEBI: simplifying disclosure requirements for rights issues and follow on issues. The concept of an anchor investor in public issues has been introduced.

The issuing company can allocate up to 30 per cent of the QIB portion to anchor investors who will provide stability to the issues.

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