Sucheta Dalal :The muddled mind of the markets watchdog
Sucheta Dalal

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The muddled mind of the markets watchdog  

Nov 6, 2006

Amending the Sebi Act to create a surveillance SRO is not a reversible action and shouldn’t be done without wide public debate. Sebi is also known for shoddy investigation and weak orders that can’t be fixed with this proposal

In its 15-year existence, the Securities & Exchange Board of India (Sebi) has won kudos for creating a modern capital market that generated the global confidence required to attract billions of dollars in portfolio investment. But, despite automated stock exchanges, rolling settlements and robust risk containment systems, the regulator has never managed to check rampant price manipulation in a way that fosters a high degree of investor confidence.

Sebi got its statutory teeth because of the Harshad Mehta scam of 1992, but six years later, it was found wanting when Harshad Mehta attempted a comeback through similar manipulation. In 1999-2000, it failed again when the Ketan Parekh-led scam led to the near collapse of the Unit Trust of India. Even the mega bull run of the past three years has seen extreme manipulation in penny stocks and mid-cap stocks without serious regulatory action. Instead, the manipulators switched scrips or moved to commodities speculation when their price manipulation attracted media attention.

Every Sebi chairman knows that the inability to check price manipulation can undo all the good work on the development front. Yet, Sebi’s surveillance continues to be weak. But the euphoria of a bull run is so powerful that it is not even under pressure to track Ketan Parekh’s activities, although his repayment of a few hundred crore rupees to the Madhavpura Mercantile Cooperative Bank indicates that he is very active in the market after being barred for 14 years.

Sebi’s real-time, on-line surveillance system imported from Australia is supposed to allow it to check manipulation by tracking trading patterns, but its installation has been repeatedly delayed. Meanwhile, we have no clear explanation as to why the first line of surveillance, the national stock exchanges, have not been able to tackle price manipulation through their own surveillance systems.

Sebi chairman M Damodaran has now thrown up another idea to deal with the manipulation issue. He wants to set up a Self Regulatory Organisation (SRO), which will be a sort of watchdog within the regulatory body, but allowed to hire professionals and experts at market-linked compensation packages. What is known about this body is only what Mr Damodaran has let drop in his public speeches; there is no discussion paper and no invitation for public comments, although the Sebi chief has said, "Amendment to the Sebi Act is in the process." Finance ministry sources told us that the Sebi chief’s speeches are discussion enough. On pointing out that Sebi usually followed a laid down procedure of public discussion, we were told this may happen some time before the Act is actually amended.

Note that the world’s leading securities commissions—like the Financial Securities Authority in the UK or the US Securities Exchange Commission (SEC)—don’t have a separate SRO for surveillance, but take direct responsibility for this crucial activity. The SEC structure allows oversight by the commission as well as SROs, but the surveillance SROs are set up by stock exchanges (NYSE and Nasdaq are examples), while the SEC monitors the surveillance process. As Chester S Spatt, chief economist at the SEC said last week, "The hierarchical structure of review and inspection allows those closest to the business to develop the basic review and inspection procedures, while the statutory securities regulator has ultimate oversight authority and critiques the work of the front-line regulator." These SROs have become necessary after the demutualisation and listing of bourses in order to avoid "perceived conflict of interest."

Here, Mr Damodaran has been quoted as saying, "We hope to set up a body of market experts, which would include retired members of Sebi and representatives of mutual funds and asset management companies which can carry out surveillance." Elsewhere, it is reported that Sebi plans to hire CAs, lawyers and security experts on an ‘assignment’ basis. Sebi has indeed used experts effectively for the IPO-scam or the demat scam investigation, but they worked directly under Sebi’s senior officials and without market-based compensation.

While it is important to build expertise within Sebi to handle sophisticated economic crime, it is not clear if a separate cadre under an SRO is the answer. The national investigation, vigilance and intelligence agencies have similar problems about lack of expertise in handling economic crime, understanding sophisticated derivatives trading and dealing with cyber crime. None of them has set up SROs in order to be able to hire experts at better salaries. In fact, extraordinarily enough, the IAS and IPS services continue to attract persons with engineering and management degrees from India’s most elite institutions despite low salaries.

Has the government examined whether Sebi’s surveillance SRO, with its better-paid ‘experts’, will create dissonance within the organisation and in other branches of the government? Sebi already has a high attrition rate with many junior- and middle-level officials in sensitive positions moving to highly paid jobs with foreign institutions and banks. Will the SRO officials be allowed such migration? If yes, what are its implications?

Amending the Sebi Act to create a surveillance SRO is not an action that can be easily reversed; it shouldn’t be done without wide public debate. Poor surveillance skills are not Sebi’s only problem; it is also known for shoddy investigation and weak or muddled orders (the IPO scam is a prime example). These can’t be fixed by creating a separate SRO.

-- Sucheta Dalal