A Historical Perspective of the Securities Market Reforms in India
His Excellency Mr. Mohammad Fazal, Governor of Maharastra, Sir Howard Davies, Director of the London School of Economics and Political Science, distinguished colleagues, friends from press, and ladies and gentlemen, good evening to all of you.
First, the Appetiser
Let me start with a very innocuous question: Which is the most televised structure in India? I am told that a study has revealed that it is not the Rastrapati Bhawan or Parliament House; it is not the Taj Mahal; it is not even the abode of Lord Tirupati; it is the Pheroze Jeejeebhoy Towers which houses the oldest securities market participant in India, i.e. The Stock Exchange, Mumbai. This indicates our intimate relationship with the securities market. In today’s rational world, it really means the immense contribution of the securities market to the our life and economy.
I took charge as Chairman, SEBI about two years ago. During my initial days of explorations for understanding the organization and the market, I was faced with a set of questions: Which is the most reformed sector / segment / market in the Indian economy? Which sector / segment / market of the economy has witnessed as much as nine special legislative interventions during the last decade? Which market / segment / sector acquired the first ever autonomous regulator (which in course time became the model regulator) in India? Which sector / segment / market of the economy consumes 3/4th space of the pink newspapers everyday? Which sector / segment / market of the economy most promptly reflects the feel good factor? The answer to all these questions is the securities market. It expresses the significance of the securities market in our life.
Now a few figures to illustrate the importance of the securities market in our life. While the corporates and governments raise resources from the securities market to meet their obligations and / or make investments, the households representing investors invest their savings in securities. The corporate sector and governments together raised a sum of Rs. 2,52,018 crore from the securities market during 2002-03. The household sector invested Rs. 21,000 crore in the securities (shares, debentures, public sector bonds and units of UTI and other mutual funds and government securities) during 2001-02. Though firm data are not yet available, these figures have gone up substantially in the years 2002-03 and 2003-04. About 20 million investors have invested in securities.
Two years down the line, I have a few questions to ask, even though I may appear like a quiz master. Which is the securities market first to set up demutualised stock exchanges in the World? Which is the securities market first to use satellite communication technology for securities transactions? Which is the securities market first to introduce the straight through processing in securities transactions? Which major securities market has implemented T+2 rolling settlement? Which is the largest market for stock futures? Which securities market started real time on line position monitoring of brokers? Which is the securities market where trading terminals go off automatically when the margins are exhausted? Probably answer to all of these is the Indian securities market. This has earned a place of respect amongst the comity of securities markets in the World.
Now, the Side Dish – A Brief History
The importance of the securities market in our life and our economy, as stated so far, did not happen overnight. Countless people have slogged for over two centuries to bring the market to the centre stage stage. In honour of such people, I would like to briefly reminiscence the evolution of the Indian securities market. And I could not have got a better occasion to do so.
Though the historical records relating to securities market in India is meagre and obscure, there is evidence to indicate that the loan securities of the East Indian Company used to be traded towards close of the 18th century. By 1830’s, the trading in shares of banks started. The trader by the name of broker emerged in 1830 when 6 persons called themselves as share brokers. This number grew gradually. Till 1850, they traded in shares of banks and securities of the East India Company in Mumbai under a sprawling Banyan Tree in front of the Town Hall, which is now in the Horniman Circle Park. It is no surprise that the majestic Phiroze Jeejeebhoy Towers is located at the Horniman Circle. In 1850, the Companies Act introducing limited liability was enacted heralding the era of modern joint stock company which propelled trading volumes.
The American Civil War broke out in 1861 which cut off supply of cotton from the USA to Europe. This heightened the demand for cotton from India. Cotton prices increased. Exports of cotton grew, payments were received in bullion. The great and sudden spurt in wealth produced by cotton price propelled setting up companies for every conceivable purpose. Between 1863 and 1865, the new ventures raised nearly Rs.30 crore in the form of paid up capital and nearly Rs. 38 crore of the premia. Rarely was a share which did not command a premium between 1861 and 1865. The Back Bay Reclamation share with Rs.5,000 paid up was at Rs.50,000 premium, the Port Canning share with Rs. 1,000 paid up was at Rs.11,000 premium, etc. There was a share mania and every body was after a piece of paper, variously called ‘allotments’, ‘scrips’ and ‘shares’. The people woke up only when the American Civil war ended. Then all rushed to sell their securities but there were no buyers. They were left with huge mass of unsaleable paper. This occurred then. This also occurs today at regular intervals. I think, little seems to have changed since then; the bubbles and burst continue to be a perennial feature of the securities market world over.
The depression was so severe that it paved way for setting up of a formal market. The number of brokers, which had increased during the civil war to about 250, declined. During the civil war, they had become so influential and powerful that even the police had only salams for them. But after the end of the civil war, they were driven from pillar to post by the police. They moved from place to place till 1874 when they found a convenient place, which is now appropriately called Dalal Street after their name. They organized an informal association on or about 9th July 1875 for protecting their interests. On 3rd December 1887, they established a stock exchange called ‘Native Share and Stock Brokers’ Association’. This laid the foundation of the oldest stock exchange in India. The word ‘native’ indicated that only natives of India could be brokers of the Exchange.
In 1880s a number textile mills came up in Ahmedabad. This created a need for trading of shares of these mills. In 1894, the brokers of Ahmedabad formed "The Ahmedabad Share and Stock Brokers' Association".
The 1870s saw a boom in jute prices, 1880s and 1890s saw boom in tea prices, then followed coal boom. When the booms ended, there were endless differences and disputes among brokers in eastern India which was home to production of jute, tea and coal. This provoked the establishment of "The Calcutta Stock Exchange Association" on June 15, 1908.
Then followed the proliferation of exchanges, many of them even do not exist today. The rest is history.
Let us look at the legal developments. Control of capital issues was introduced through the Defence of India Rules in 1943 under the Defence of India Act, 1939 to channel resources to support the war effort. The control was retained after the war with some modifications as a means of controlling the raising of capital by companies and to ensure that national resources were channeled to serve the goals and priorities of the government, and to protect the interests of investors. The relevant provisions in the Defence of India Rules were replaced by the Capital Issues (Continuance of Control) Act in April 1947.
Though the stock exchanges were in operation, there was no legislation for their regulation till the Bombay Securities Contracts Control Act was enacted in 1925. This was, however, deficient in many respects. Under the constitution which came into force on January 26, 1950, stock exchanges and forward markets came under the exclusive authority of the central government. Following the recommendations of the A. D. Gorwala Committee in 1951, the Securities Contracts (Regulation) Act, 1956 was enacted to provide for direct and indirect control of virtually all aspects of securities trading and the running of stock exchanges and to prevent undesirable transactions in securities.
Main Course – Fast Forward to 1990s
In 1980s and 19990s, it was increasingly realized that an efficient and well developed securities market is essential for sustained economic growth. Without venturing into a detailed discussion, it would suffice if I just say that the securities market fosters economic growth to the extent it augments the quantities of real savings and capital formation from a given level of national income and it raises productivity of investment by improving allocation of investible funds. The extent depends on the quality of the securities market. In order to improve the quality of the market, that is, to improve market efficiency, enhance transparency, prevent
unfair trade practices and bring the Indian market up to international standards, a package of reforms consisting of measures to liberalise, regulate and develop the securities market is being implemented since early 1990s. Let me sound a little academic, in presence of Sir Davies, to explain why the package included liberalization, regulation and development?
Why liberalization? I strongly believe that the more liberalised a securities market is, the better is its impact on economic growth. Interventions in the securities market were originally designed to help governments expropriate much of the seigniorage and control and direct the flow of funds for favoured uses. These helped governments to tap savings on a low or even no-cost basis. Besides, government used to allocate funds from the securities market to competing enterprises and decide the terms of allocation. The result was channelisation of resources to favoured uses rather than sound projects. In such circumstances accumulation of capital per se meant little, where rate of return on some investments were negative while extremely remunerative investment opportunities were foregone. This kept the average rate of return from investment lower than it would otherwise have been and, given the cost of savings, the resulting investment was less than optimum. Hence, it was necessary to do away interventions hindering optimum allocation of resources.
Why Regulation? Do you know what a ‘security’ is? Our laws provide an inclusive definition of ‘securities’. It says that ‘securities’ include shares, bonds, debentures, units of CIS, etc. It does not define in terms of ingredients an instrument must have to be considered as ‘securities’. I have not seen an ingredient type definition of ‘securities’ in any other jurisdiction. It is precisely because ‘securities’ are most insecure instruments. The only ingredient common to all types of securities is its associated ‘insecurity’. It is like a blind man named padmalochan. If it is a market for such insecure instruments, market would collapse if some body does not regulate away the insecurities.
We need regulations to correct for identified market imperfections which produce sub-optimal outcomes and to prevent market failures. In the absence of regulation by a specialized agency, each participant would do its own due diligence before undertaking any transaction in the market. This imposes huge social costs. Besides, regulations signal minimum standards of quality and hence enhance confidence in markets. With a known asymmetric information problem, risk averse investors may exit the market altogether if such minimum standards are not signaled. In its extreme form the market breaks down completely.
There is an apparent contradiction that the reforms aim at liberalization while regulations appear to restrict liberalization. Liberalisation does not mean scrapping of all codes and statutes, as some market participants may wish. It rather means replacement of one set by another set of more liberal code / statute, which allow full freedom to economic agents, but influence or prescribe the way they should carry out their activities, so that the liberalized markets operate in an efficient and fair manner and the risks of systemic failure are minimized. It is, however, desirable to keep in mind the contradiction to ensure that we do not resort to excessive regulation and regulations are designed and implemented properly. Otherwise the costs of regulation would exceed the benefits from regulation.
Why development? Unless you develop market, what do you regulate? Unless there is regulation, how does the market develop? It is a chicken and egg issue. Regulation is necessary to develop market and once the market develops, it needs to be regulated. That is why many of the reform initiatives combine the elements of regulation and development. Besides, some developmental measures are introduced as a part of general programme for economic and political development. The macro economic policies relating to interest rate, prices, etc can have salubrious effect on the growth and development of the securities market. Other developmental measures include provision of realiable payment system and clearing mechanism, standardized accounting procedure, good corporate governance, skilled manpower etc. which improve the efficiency and transparency of the market.
Though it is incidental that reforms in true sense happened since early 1990s, that is, since the establishment of SEBI, I, by no means, propose to suggest that SEBI is the agency exclusively responsible for all the reforms. These reforms have been designed and implemented jointly by all stakeholders, including the government, the regulator, and the regulated.
It would do justice with your time and attention if I make a dhobi list of reforms undertaken since early 1990s. In stead let me discuss only a few major reforms.
a. Control over Issue of Capital: A major initiative of liberalisation was the repeal of the Capital Issues (Control) Act, 1947 in May 1992. With this, Government’s control over issue of capital, pricing of the issues, fixing of premia and rates of interest on debentures etc. ceased and the market was allowed to allocate resources to competing uses. In the interest of investors, SEBI issued Disclosure and Investor Protection (DIP) guidelines. The guidelines allow issuers, complying with the eligibility criteria, to issue securities the securities at market determined rates. The market moved from merit based to disclosure based regulation.
b. Establishment of Regulator: A major initiative of regulation was establishment of a statutory autonomous agency, called SEBI, to provide reassurance that it is safe to undertake transactions in securities. It was empowered adequately and assigned the responsibility to (a) protect the interests of investors in securities, (b) promote the development of the securities market, and (c) regulate the securities market. Its regulatory jurisdiction extends over corporates in the issuance of capital and transfer of securities, in addition to all intermediaries and persons associated with securities market. All market intermediaries are registered and regulated by SEBI. They are also required to appoint a compliance officer who is responsible for monitoring compliance with securities laws and for redressal of investor grievances.
c. Screen Based Trading: A major developmental initiative was a nation-wide on-line fully-automated screen based trading system (SBTS) where a member can punch into the computer quantities of securities and the prices at which he likes to transact and the transaction is executed as soon as it finds a matching sale or buy order from a counter party. SBTS electronically matches orders on a strict price/time priority and hence cut down on time, cost and risk of error, as well as on fraud resulting in improved operational efficiency. It allowed faster incorporation of price sensitive information into prevailing prices, thus increasing the informational efficiency of markets. It enabled market participants to see the full market on real-time, making the market transparent. It allowed a large number of participants, irrespective of their geographical locations, to trade with one another simultaneously, improving the depth and liquidity of the market – over 10,000 terminals creating waves by clicks from over 400 towns / cities in India. It provided full anonymity by accepting orders, big or small, from members without revealing their identity, thus providing equal access to everybody. It also provided a perfect audit trail, which helps to resolve disputes by logging in the trade execution process in entirety.
The SBTS shifted the trading platform from the trading hall of an exchange to brokers’ premises. It was then shifted to the PCs in the residences of investors through the Internet and to hand-held devices through WAP for convenience of mobile investors. This made a huge difference in terms of equal access to investors in a geographically vast country like India.
d. Risk management: A number of measures were taken to manage the risks in the market so that the participants are safe and market integrity is protected. These include:
i. Trading Cycle: The trading cycle varied from 14 days for specified securities to 30 days for others and settlement took another fortnight. Often this cycle was not adhered to. This was euphemistically often described as T+ any thing. Many things could happen between entering into a trade and its performance providing incentives for either of the parties to go back on its promise. This had on several occasions led to defaults and risks in settlement. In order to reduce large open positions, the trading cycle was reduced over a period of time to a week initially. Rolling settlement on T+5 basis was introduced in phases. All scrips moved to rolling settlement from December 2001. T+5 gave way to T+3 from April 2002 and T+2 from April 2003.
ii. Dematerilaistion: Settlement system on Indian stock exchanges gave rise to settlement risk due to the time that elapsed before trades are settled. Trades were settled by physical movement of paper. This had two aspects. First, the settlement of trade in stock exchanges by delivery of shares by the seller and payment by the purchaser. The process of physically moving the securities from the seller to the ultimate buyer through the seller’s broker and buyer’s broker took time with the risk of delay somewhere along the chain. The second aspect related to transfer of shares in favour of the purchaser by the company. The system of transfer of ownership was grossly inefficient as every transfer involved physical movement of paper securities to the issuer for registration, with the change of ownership being evidenced by an endorsement on the security certificate. In many cases the process of transfer took much longer, and a significant proportion of transactions ended up as bad delivery due to faulty compliance of paper work. Theft, forgery, mutilation of certificates and other irregularities were rampant, and in addition the issuer had the right to refuse the transfer of a security. All this added to costs, and delays in settlement, restricted liquidity and made investor grievance redressal time consuming and at times intractable.
To obviate these problems, the Depositories Act, 1996 was passed to provide for the establishment of depositories in securities with the objective of ensuring free transferability of securities with speed, accuracy and security by (a) making securities of public limited companies freely transferable subject to certain exceptions; (b) dematerialising the securities in the depository mode; and (c) providing for maintenance of ownership records in a book entry form. In order to streamline both the stages of settlement process, the Act envisages transfer of ownership of securities electronically by book entry without making the securities move from person to person. Currently 99% of market capitalization is dematerialized and 99.9% of trades are settled by delivery.
iii. Derivatives: To assist market participants to manage risks better through hedging, speculation and arbitrage, SC(R)A was amended in 1995 to lift the ban on options in securities. The SC(R)A was amended further in December 1999 to expand the definition of securities to include derivatives so that the whole regulatory framework governing trading of securities could apply to trading of derivatives also. A three-decade old ban on forward trading, better known as BADLA, which had lost its relevance and was hindering introduction of derivatives trading, was withdrawn. Derivative trading took off in June 2000 on two exchanges.
iv. Settlement Guarantee: A variety of measures were taken to address the risk in the market. Clearing corporations emerged to assume counter party risk. Trade and settlement guarantee funds were set up to guarantee settlement of trades irrespective of default by brokers. These funds provide full novation and work as central counter party. The Exchanges /clearing corporations monitor the positions of the brokers on real time basis.
Various measures taken over last decade or so have yielded considerable benefits to the market, as evidenced by the growth in number of market participants, growth in volumes in securities transactions, increasing globalization of the Indian market, reduction in transaction costs, and compliance with international standards. In terms of number of trades, NSE is the third largest exchange in the world. I am not going in to these details, as my objective is not to boost our performance here except to quote from the Economic Intelligence Unit 2003 study: "Top of the Country class, as might be expected is Singapore followed by Hongkong and, somewhat surprisingly, India where overall disclosure standards have improved dramatically, accounting differences between local and US standards have been minimized and the number of companies with a majority of independent directors has risen significantly."
Recent Initiatives : Let me now present a list of our recent initiatives. We have, only on 19th March 2004, rationalized the margin trading and securities lending mechanism. This should promote liquidity in the market. We have also done away with the auctions. The clearing corporations / houses have been authorized to borrow securities to complete settlement without resorting to auctions. Hence there would be no short delivery in settlement. We have assigned NSDL the responsibility to construct and maintain a central registry of securities market participants and professionals. This would come very handy in market surveillance. We have recently set up the Central Listing Authority to dynamise listing requirements and to issue a gate pass for entry into trading platform. We are in the process of appointing ombudsman to redress the grievances of investors expeditiously. We have introduced limited STP in the securities leg for institutional investors. We have implemented market wide T+2 rolling settlement. We have expanded the availability of products for trading by making a variety of derivatives; including interest rate derivatives, corporate debt securities, retail government securities, available on exchanges. We have significantly improved disclosure and corporate governance standards.
Deserts - Road Ahead
SEBI is working continuously and in close co-ordination with the regulated and the government, to improve market design to bring in further efficiency and transparency to market and make available newer and newer products to meet the varying needs of market participants, while protecting investors in securities. The aim is to make Indian securities market a model for other jurisdictions to follow and make SEBI the most dynamic and respected regulator globally. Some of the initiatives on which SEBI is working are:
a. Set up a national institute to build a cadre of professionals to man the specialised functions in the securities market. We are also working on a nationwide certification to ensure that any person or agent working with a market intermediary has the necessary knowledge and skill to render quality intermediation.
b. Corporatise and demutualise exchanges where the ownership, management and trading rights would be with three different sets of people in order to avoid conflict of interest.
c. Introduce market wide straight through processing from trade initiation to settlement.
d. Migrate to T+1 rolling settlement.
e. Continuously review and upgrade accounting standards, disclosures, corporate governance practices in the interest of investors.
f. Continuously review and amend the various regulations to bring them in tune with dynamics of market requirements.
g. Introduce new products in the market to meet all kinds of needs of market participants.
We will continue to work to improve the functioning of the securities market to meet the challenges of the changing environment. We will do so because we are fully convinced that securities market allows people to do more with their savings and to do more with their ideas and talents than would otherwise be possible. In the process, we would ensure that every citizen of the country participates in the securities market in some form or other and shares the prosperity.