[Shiv and Siddharth are students at National Law University Odisha.]
Market Infrastructure Institutions (MIIs) form the backbone of financial markets, providing essential services such as trading, clearing, and settlement. Their importance cannot be overstated, and therefore, ensuring their proper governance is critical.
However, as with any system, there is always room for improvement. The existing governance framework for MIIs in India has been reviewed by a committee headed by G. Mahalingam, which has made 15 key recommendations to strengthen MII governance norms. These recommendations cover many issues, including transparency, accountability, and independence.
A relook at the governance of MIIs is the need of the hour, and this article aims to explore the various aspects of this topic. This article will delve into the intricacies of governance in the context of MIIs.
Key Recommendations by the Committee
One of the critical issues addressed by the committee was a ‘balanced approach’ to the regulation of MIIs, instead of a purely ‘rule-based’ or ‘principle-based’ approach. The committee’s recommendations aim to strike a balance between these approaches, promoting innovation and protecting public interest simultaneously. As a result, the committee’s recommendations hold significance in strengthening the governance norms for MIIs and ensuring that they maintain their regulatory roles without hindering innovation.
The committee has proposed such recommendations after consulting various stakeholders and reviewing past committee reports. These recommendations are geared towards strengthening MII governance norms while remaining focused on their regulatory roles. The recommendations cover various aspects which include categorising MII functions into verticals, giving higher priority to key managerial personnel, requiring a board with two-thirds public interest directors, setting guiding principles for the senior management team, enhancing transparency, emphasising accountability and objective appraisals, amending regulations for compensation, and rationalising codes of conduct and ethics.
However, shifting towards a principle-based approach or saying that a balanced approach needs to be followed, without defining or attempting to explain what such balanced approach means in the report, is in itself subjective in nature. Such subjectivity leads to ambiguity and inconsistencies in enforcement.
Analysis of the Impact of the Recommendations
Proponents of the principle-based approach argue that it is more flexible and adaptable to changing circumstances. Instead of being bound by rigid rules, market participants can use their judgement to interpret and apply principles in a way that is appropriate for situations at hand. This leads to more innovative and efficient solutions to regulatory problems.
On the other hand, proponents of the rule-based approach argue that it provides greater clarity and certainty for market participants. By laying out clear rules and guidelines, participants know exactly what is expected of them and can act accordingly. This can lead to greater compliance and a more level playing field for all market participants.
In order to clearly identify which approach should be followed, it is essential to look at a few factors pertaining to regulation, characteristics of market participants as well as the general nature of markets.
Factors pertaining to regulation
In situations where there is a requirement for swift action to be taken in order to regulate the volatility of markets, it is always better to follow a principle-based approach. On the other hand, if there is prevalent conduct deviating from established market practices, a rule-based approach to governance will be more effective. Further, in conditions where there is asymmetry of information between the regulatory and regulated bodies, a set of core principles which can act as a regulatory measure without imposing rules, which may restrict activities of such bodies.
Factors pertaining to characteristics of market participants
Whether market participants are retail or institutional is also an important factor in determining the correct approach to be followed while framing regulations. Historically, rule-based approaches have been followed to safeguard retail investors because institutional investors are more sophisticated and are in a position to protect their own self-interests, where principle-based approaches come into play.
Factors pertaining to the general nature of markets
In a world where technology is rapidly evolving, a principle-based approach is more suitable as a rule-based approach is seen to act as a barrier to innovation and progress. Market maturity levels are also to be considered to apply a mixture of principles and rules, and pertaining to different situations, principles may be further developed into consistent practices and rules.
Considering and applying the aforementioned factors in taking decisions related to which approach to be followed serves as a measure to reduce the ambiguity that currently exists with regard to the enforcement of the balanced approach. It is important to have clarity over the situations in which particular approaches are to be followed.
While SEBI recognises that such balance needs to be maintained, it does not delve into how exactly is such balanced approach proposed to be followed, effectively rendering the approach to be a principle-based one, and thereby arising ambiguity.
Striking the Right Balance: A Hybrid Approach
Regulatory practices often involve a blend of principle-based and rule-based approaches, with each approach having its strengths and limitations. While some regulatory regimes may emphasize one approach over the other, hybrid regulatory systems that combine both principles and rules are becoming more common. These hybrid systems can provide greater flexibility to address the complex and dynamic nature of regulatory challenges while also maintaining clear guidance for those being regulated.
Take National Stock Exchange as an example; it is a self-regulatory organization that operates as a regulatory and profit-making entity, similar to public sector undertakings. As such, it is responsible for ensuring compliance with market rules and maintaining fair and transparent trading practices while generating revenue through fees for services such as stock listings, trading, and data dissemination.
In case of MIIs, by combining both rule-based and principle-based approaches, they can reap the benefits of both while minimizing the potential limitations of these individual approaches. One example of a hybrid approach is to combine a binding rule-based approach with non-binding guidelines or safe harbours, which can provide regulatees (people being regulated) flexibility while reducing uncertainty. Similarly, a binding principle-based approach can be paired with non-binding rules to help regulatees understand the broader regulatory goals being pursued.
The United States has traditionally favoured a rule-based approach, while the United Kingdom has tended to favour a principle-based approach. India, as an emerging market, could potentially benefit from adopting elements of both approaches. For example, India could introduce more detailed rules to provide greater legal certainty and investor protection while also relying on high-level principles and broad standards to promote innovation and flexibility.
The primary concern with a hybrid approach is the risk of gaming, where regulatees may seek out loopholes in the rules to avoid compliance. However, this risk can be mitigated through careful design and implementation of the hybrid model. For example, regulatees could be required to justify how their actions are consistent with the relevant regulatory objectives if they choose not to follow a specific rule. Additionally, a system of checks and balances could be put in place to ensure that regulatees are not abusing the flexibility provided by the principle-based approach.
By consistently monitoring and refining the hybrid model, MIIs in India can adapt to the rapidly evolving market and promote sustainable growth. This emphasizes the importance of policymakers and regulators in India to remain vigilant and continuously evaluate the hybrid governance model to ensure its effectiveness. In doing so, they can draw on best practices from other jurisdictions and incorporate them into the hybrid model to create a regulatory framework that is tailored to India's unique challenges and opportunities.
Conclusion
The governance of MIIs is of utmost importance in ensuring trust and accountability in financial markets. By promoting innovation while maintaining regulatory stability and reducing compliance costs, a clearer hybrid approach can help MIIs adapt to the rapidly evolving market and promote sustainable growth.
Therefore, there is a need for SEBI to clearly lay down in what manner the proposed balanced approach is to be followed. This requires careful design and monitoring of the hybrid model to mitigate potential risks and ensure that it remains effective in achieving its goals over time. Policymakers and regulators in India should consider the adoption of a more structured hybrid governance model for MIIs and draw on best practices from other jurisdictions to ensure its success.
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