The Hindu Business Line : Reforms in global securities markets

The scope of regulation, based on increasingly stringent norms, is being increasingly delegated to the markets and institutions in the form of self-regulation, which brings a number of benefits.

Bandi Ram Prasad

From November 1, 2007, a major reform in the global securities markets in the form of Markets in Financial Instruments Directive (MiFID) has come into effect in the Eurozone. The directive is the key part of a package of European Union law aimed at creating a single, more competitive market in financial services across all EU member-states.

It replaces the existing Investment Services Directives (ISD), in place since 1995. MiFID, it is hoped, will lead to the better harmonisation of global regulatory practices in financial markets across European jurisdictions, a higher level of investor protection, a coherent and risk-sensitive market that enhances transparency on liquidity and an efficient and integrated financial market.

The new investment guidelines will enable participants to interact freely with counterparts in other EU countries on the same terms and conditions as they transact business in their home countries. It sets out some basic and high-level provisions governing harmonisation and market requirements vis-À-vis conduct of business.

Transparency

The Directive sets out more detailed requirements on operation of multilateral trading facilities (MTFs). It also includes new pre- and post-trade transparency requirements for equity markets; the creation of a new regime for systematic internalisers of retail order flow in liquid equities; and more extensive transaction reporting requirements.

The package improves the operation of the ‘passport’ for investment firms by more clearly delineating the allocation of responsibility between home state and host state for uncertainties that arose under the ISD.

MiFID follows an equally major reform in regulation that came into effect some time ago and takes from it important elements of best execution and price discovery. Regulation National Market System (Reg-NMS), that came into effect in the US in March 2007, underlines the promotion of competition across the markets under three major principles — best price, open access and transparency.

Under the new trade-through role, in whichever market a customer places his order, he should be able to access the best price that is immediately and automatically available anywhere in the NMS. The trade-through rule will not allow markets to ignore better priced automated quotes displayed by the competitors.

Similarly, open access to displayed prices will be a major feature governing the competition of the markets, and the regulation also stipulates that all significant markets must display their quotations and trade reports available to all interested parties on fair terms and in non-discriminatory manner.

Reg-NMS, while welcomed by regional exchanges and electronic communication networks, might dent the prowess of the main markets such as New York Stock Exchange (NYSE) and Nasdaq, a few signals of which are evident from the growing incidence of dark pools of capital (that bypass the organised markets) in recent times.

Harmonisation

Systematic and streamlined regulation leads to the strength and sustainability of the securities market. Some recent developments in the financial markets that are reshaping the scope and focus of regulation include:

Growing harmonisation of regulation across markets. Organisations such as International Organisation for Securities Commissions (IOSCO) are playing an important role in adoption of uniform principles and guidelines across markets;

The size and scope of securities markets is rapidly changing from being one- or two-product markets to multi-product systems with diverse features and a varied investor base;

Markets have become more democratised with more people and institutions participating in market-related activities;

Rapid increase in the size of the institutional participation in financial markets. For instance, equity markets, which were largely retail-investor driven, are now increasingly become institution-dominated;

Securities markets are transforming from being membership-driven to public corporations following demutualisation and corporatisation of stock exchanges in mature and emerging markets.

Growing self-regulation

The scope of regulation, based on increasingly stringent norms, is considerably delegated to the markets and institutions in the form of self-regulation, which brings a number of benefits to the business.

Institutions such as National Association of Securities Dealers (NASD) have played an important role in promoting self-regulation and in India, too, there is thinking on evolving best forms of self-regulation that will be beneficial to the business and at the same time protects the interests of various stakeholders. However, self-regulation has certain limitations that need to be overcome, before it becomes widely accepted across the markets. A few of these include:

Conflict of interest between self-regulatory organisation’s (SRO) regulatory operations and the other interests of its members, its market operations, issuers and shareholders;

Higher cost of multiple SROs and some of the inefficiencies associated with it;

The growing cross-market trading activity that makes it even difficult for the multiple SROs to conduct market surveillance;

Whether an SRO deploys sufficient resources to its regulatory operations.

To make SRO effective, it is considered important to keep market operations and market regulation separate, an endeavour which the combined regulation of the NYSE and National Association of Securities Dealers (NASD) are working on. Some of the features of this arrangement, which is also known as the hybrid model of regulation, as currently operational at the NYSE/NASD model, include:

Separating business

At NYSE, regulation is organised as a separate not-for-profit corporation, wholly owned by the NYSE Group, but with independent board of directors;

Independence of the regulation is strengthened and insulated from the for-profit interests of the NYSE Group;

Every director of NYSE Regulation is independent of the management of the NYSE Group, the exchange’s member organisations, and of its listed companies;

The NYSE Regulation board of directors oversees all compensation decisions for Regulation employees, as well as having the sole responsibility for the nomination of new directors;

The decisions of the NYSE Regulation and its board of directors are final and not subject to review or approval by the NYSE Group board.

Cooperation

There is a greater degree of cooperation between the regulatory organisations. For instance, NYSE Group and NASD entered into an informal cooperation in certain examination areas when both are conducting an exam in the same year. The cooperation of both these institutions is committed to identify unjustifiable difference between NYSE and NASD rules and interpretations and to propose a program of revisions to harmonise.

The Inter-market Surveillance Group, known as ISG, provides a framework for sharing information and coordinating regulatory efforts among its multinational membership. In India, the NSE and BSE quite often meet to share important developments in the areas of regulation, surveillance and issues sensitive to the market stability.

The underlining theme for the relevance of self-regulation is that though it has many strengths, it should never become an excuse for subjecting the financial industry to inconsistent rules that impose unacceptable financial costs.

(The author is a senior consultant at Dun and Bradstreet India Information Services (Pvt) Ltd, Mumbai. His views are personal.)