DAMODARAM SANJIVAYYA NATIONAL LAW UNIVERSITY

VISAKHAPATNAM, SABBAVARAM.

SUBJECT:

INVESTMENT LAW

PROJECT TITLE

CONCEPT OF SECURITIES LEGISLATION MARKETS

NAME OF THE FACULTY

Dr. SUNITHA V

NAME OF THE CANDIDATE

G. VENKATA SAI KIRAN

ROLL NUMBER

2018031

SEMESTER – VIII

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ACKNOWLEDGEMENT:
I am highly indebted to my Hon’ble Competition Law Professor Dr. SUNITHA V, for giving
me a wonderful opportunity to work on the topic: CONCEPT OF SECURITIES
LEGISLATION MARKETS and it is because of his excellent knowledge, experience and
guidance, this project is made with great interest and effort. I would also take this as an
opportunity to thank my parents for their support at all times. I have no words to express my
gratitude to each and every person who has guided and suggested me while conducting my
research work.

”Secondly, I would like to thank the team DSNLU, who provided me assistance through various
online resources to accomplish this research work.

G. V SAI KIRAN
2018031
SEMESTER VIII

CHAPTERIZATION

2
INTRODUCTION:..........................................................................................................................4

SECURITIES REGULATIONS:.....................................................................................................5

QUALITY OF REGULATORY STRUCTURE:............................................................................7

EFFECTIVENESS OF ENFORCEMENT:.....................................................................................9

REGULATION OF PUBLIC ISSUERS:......................................................................................10

REGULATION OF COLLECTIVE INVESTMENTS SCHEMES:............................................11

REGULATION OF MARKET INTEMDIARIES:.......................................................................12

REGUALTION OF SECONDARY MARKETS:.........................................................................13

SECURITIES MARKET REGULATION IN INDIA:.................................................................14

CONCLUSION:............................................................................................................................20

INTRODUCTION:
Securities markets play a crucial role in economic growth and financial stability. The primary
purpose of securities markets is to serve as a mechanism for the transformation of savings into

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financing for the real sector, thus constituting an alternative to bank financing. Markets provide
the best (albeit sometimes imperfect) mechanism for asset pricing. Markets are also a mechanism
through which risk is transferred and risk exposure diversified—which allows firms to unlock
capital for new investments.1 Risk transfer and pricing mechanisms in the market allow financial
institutions, such as banks and insurance companies, to manage risk more efficiently; and
markets may therefore work as a buffer for disruption of banking system and therefore contribute
to financial stability. The more efficient markets are, the better these outcomes are achieved and
the greater the contribution to the economy.

While the role of securities markets is more meaningful in developed economies, there is
evidence of the growing importance of securities markets in emerging market and developing
countries. In many emerging market and developing countries, securities markets are beginning
to gain a place as a source of financing for the corporate sector, although in most markets this is
initially restricted to the larger corporate players. Along with private and public pension funds,
collective investment schemes have become important players in many developing and emerging
market countries and their demand for suitable investments is driving development.

Despite the growing understanding of the role that securities markets play, we find that the
systemic importance of securities regulation has been neglected as a topic of academic study. It
has been argued, most famously, in remarks by the former Chairman ofthe Federal Reserve
Board, Alan Greenspan, that a financial sector that is well-rounded and does not rely entirely on
the banking sector is less vulnerable to external shocks. Yet there have been few attempts to
examine the effects of securities regulation, or regulatory weaknesses, on stability and growth.2

This paper examines the strengths and weaknesses of securities regulatory systems worldwide
with a view to a better understanding of common problems and areas of global concern. In doing
so, we contribute to the depth of understanding of the state of regulation of securities markets
around the world and enable others to further explore the connections between securities
regulation and systemic risk and securities regulation and market development.

1
Richard Herring and Anthony Santomero, 2000, “What is Optimal Regulation?” (Pennsylvania: Financial
Institution Center, University of Pennsylvania).
2
One exception is Rafael LaPorta, Florencio Lopez-de-Silanes and Andrei Shleifer, 2003, “What Works in
Securities Law” Journal of Finance, American Finance Association, vol.61

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Our research suggests that securities regulatory systems suffer from persistent weaknesses in a
number of countries and there is an urgent need for improvement. We have used the unique set
of data produced under the IMF and World Bank Financial Sector Assessment Program (FSAP)
—which entails a systematic assessments of regulatory systems—to examine problem areas and
explore the connection to income level of the country and possible regional trends. We found
that a consistent theme emerges regarding the lack of ability of regulators in many countries to
effectively enforce compliance with existing rules and regulation. A combination of factors,
including the lack of power and authority, a lack of resources and skill, and the lack of political
will has undermined the regulator’s ability to effectively execute regulation. This is a particular
problem in areas of increased complexity—such as valuation of assets and risk management
practices and internal controls requirements for market participants and trading systems.

SECURITIES REGULATIONS:
Securities regulation comprises the regulation of public issuers of securities, secondary markets,
asset management products and market intermediaries. Regulation is designed to address
asymmetries of information between issuers and investors, clients and financial intermediaries
and between counterparties to transactions; and to ensure smooth functioning of trading and
clearing and settlement mechanisms that will prevent market disruption and foster investor
confidence.3

Regulation of public issuers is based on the principle of full, timely and accurate disclosure of
relevant information to investors. Generally, securities regulators have moved away from merit-
based regimes to disclosure-based regimes; that is, the regulator does not take on the role of
determining whether or not an offer is too risky for investors—that is a decision to be made by
the investor. Rather, the regulator’s role is to ensure that investors are given full, timely and
accurate information to enable them to make informed decisions. For that purpose disclosure
obligations are imposed on issuers both at the moment of authorization for public offering and on
a continuous basis. Mechanisms are also put in place to ensure the reliability of the information
provided by issuers. More recently, the regulation of issuers has highlighted the need for

3
A good overview of the approach to securities regulation can be found in Bernard Black, 2001 “The Legal and
Institutional Preconditions for Strong Securities Markets,” UCLA Law Review, vol. 48, (Los Angeles, California:
University of California at Los Angeles), pp. 781–855.

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adequate corporate governance to ensure effective accountability of management and board
members to shareholders.

Regulation of market intermediaries seeks to ensure that intermediaries (such as brokers, dealers
and advisers) enter and exit the market without disruption, conduct their business with their
clients with due care and trade fairly in the markets. The main tools for the regulation of
intermediaries are licensing requirements (including prudential requirements) and market and
business conduct obligations.

The regulation of asset management aims to ensure professional management and adequate
disclosure of investments to the investors. Most regulatory systems focus on collective
investment schemes, usually in the form of mutual funds or unit trust funds. Because units of
collective investment schemes are investment instruments, they are bound by the same principle
of full, timely, and accurate disclosure applicable to issuers generally. In addition, the operator
and investment manager of the collectives investment scheme are financial intermediaries and
are regulated in a manner similar to other intermediaries.

The regulation of secondary markets seeks to ensure the smooth functioning of the markets.
Regulation of market conduct and trading seeks to ensure fair access and adequate price
formation, thus preserving the market’s efficiency and reputation. Regulation also aims to limit
the disruptive effects that the failure of an intermediary could have on the market and, thus, is
focused on ensuring that market participants settle their trading obligations in an orderly and
timely manner through regulation of the clearing and settlement, and the setting of standards for
risk management.

Responsibility for the development of the regulatory framework as well as the supervision of
regulated entities is typically assigned to a public agency. The structure of the securities markets
regulator may vary from a single-agency specialized in securities regulation to a unified
regulator that regulates more than one sector. The regulatory framework should ensure that the
regulator has sufficient independence, powers and resources to effectively regulate and supervise
market participants. In most jurisdictions, selfregulatory organizations (SROs), such as
exchanges, and industry associations, carry out part of the regulatory function in the jurisdiction

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(in many cases, SROs take on a significant role). In these cases, the regulatory framework should
ensure proper oversight of SROs by the public regulator.

QUALITY OF REGULATORY STRUCTURE:

STATUTORY REFULATOR:

While in many countries securities markets started to develop without the existence of a public
regulator, it is now widely accepted that the existence of a public entity charged with the
regulation and supervision of the market and market participants, is key to the healthy
development of markets. Regardless of the institutional structure chosen, it is important that the
responsibilities of the regulator be clearly defined and that it be given an adequate level of
independence, legal authority and resources to enable it to carry out its functions.

The assessments show that many regulators are not sufficiently independent of government
and/or industry, with less than half of countries achieving a fully or broadly implemented
grading. This may be because governance structures allow for interference in the regulator’s
daily activities, with the potential to cause regulatory forbearance, or because funding or staffing
mechanisms create avenues for outside control of the regulator actions. For example, some
regulators cannot grant or withdraw licenses—a key supervision tool— instead that power
remains with the Ministry of Finance. In other cases, the governing body of the regulator is
controlled by a government ministry. While the trend has been toward fully independent
regulators, there are still a significant number of agencies whose work is impeded by this
political overshadowing which raises the potential for interference. Shortcomings in
independence are regarded as connected to many other weaknesses in the regulatory system such
as weak enforcement. On the other hand, many assessments also noted the need to establish
additional accountability measures, such as annual reporting, financial reporting and greater
transparency of decision making processes at the regulator.

A shortage of funding and legal authority is a common problem among regulators, with less than
half of countries meeting or almost meeting the standard set by IOSCO. Many regulators still
lack a stable and adequate level of funding, in particular in countries where funding stems from
the state budget. In many countries, the impact of inadequate and uncertain funding on the skill
level at the regulator is compounded by a requirement that the regulator pay staff at the public
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employee pay scale, thereby limiting the regulator’s ability to recruit qualified personnel and
thus its capacity to discharge its functions properly. In some jurisdictions, there is also a shortage
of personnel with the necessary expertise in the country as a whole (for example, qualified
accountants and auditors are in short supply in many places). In addition, in some jurisdictions
the regulator still lacks sufficient licensing power, which limits its ability to verify the fitness and
propriety of market participants, and also investigative and enforcement power, which hinders its
ability to supervise compliance and enforce the securities laws and regulations.

SELF REGULATORY ORGANIZATIONS:

A unique feature of securities regulatory systems is the widespread use of SROs to carry out
regulatory functions. The term SRO is used to describe a variety of institutions (exchanges, trade
associations, private agencies, etc.), and in the context of the IOSCO Principles is given a broad
definition: any organization other than the statutory regulator that is responsible for regulation.
The use of self-regulation varies widely, although most countries rely upon it to some extent,
particularly for market oversight and regulation of intermediaries. In many countries, a stock
exchange is the SRO and regulates listed companies and trading. In a few countries, for example,
the U.S., Canada, and Japan, a separate private agency is responsible for regulation of
intermediaries, including designing and monitoring of prudential standards and business conduct.

The assessments evaluate the adequacy of oversight of SROs by the statutory regulator. The
reports found that weaknesses in oversight of self-regulation are widespread; only a quarter of
jurisdictions were considered fully compliant with the standard. The most pervasive issue is a
lack of inspection programs for SROs, which, in turn, was due to a lack of resources and capacity
at the regulator. In a number of countries, there was very little active oversight at all. Many
assessors commented on weaknesses in governance structures at self-regulatory organizations,
but views of assessors on what constitutes an appropriate structure varied widely. In some
jurisdictions, there was an overlap of responsibilities between the regulator and the SRO(s) that
resulted in inefficiencies or a lack of activity in the particular area. Many assessors raised
concerns regarding the handling of SRO conflicts of interest (for example, the treatment of self-
listing at an exchange or the fair treatment of members).

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EFFECTIVENESS OF ENFORCEMENT:
‘Enforcement’ in this context refers to the agency’s ability to both affect compliance with
regulation (through active supervision) and its ability to bring an action against a person or entity
that has violated regulations. The lower grades in this area reflect weaknesses in enforcement
powers and more importantly the inability of many regulators to carry out an effective
enforcement program. An effective regulator must have the ability to obtain all necessary
information from regulated entities in a timely fashion, both in the course of supervision (such as
in inspections) and in extraordinary circumstances (such as in investigations). Regulators must
also have the ability to penalize regulated entities that do not comply with rules—either in the
course of supervision or as the result of a proven violation of the rules.

The assessments noted than in some jurisdictions regulators lack comprehensive investigative
and enforcement powers (such as the ability to enter premises to collect information or to compel
testimony from individuals). They also showed that many regulators lack the authority to impose
administrative sanctions, and therefore had to rely on the criminal authorities for enforcement
purposes which hinder their credibility and effectiveness.

However, the main problem in enforcement relates to the actual capacity of the regulator to
implement adequate supervisory programs, as well as to appropriately use its disciplinary
powers. Roughly 50 percent of the countries ranked either partly and not implemented in an
assessment of the use of their enforcement powers. Assessors highlighted that in many countries
on-site inspections are not a regular part of the supervisory program of the regulator, and the
problem is particularly acute concerning exchanges. Finally, in some countries the supervisory
programs were deemed adequate, but disciplinary powers were used very scarcely, which hinder
the credibility of the regulator. A lack of skilled personnel to conduct both supervisory and
enforcement actions was perceived by most assessors to be a consistent problem in many
jurisdictions.

The poor quality and ineffectiveness of the judiciary system also negatively impacts enforcement
efforts in a number of jurisdictions, primarily in emerging market and developing countries.
While a supportive judicial environment is a pre-condition to effective regulation, rather than
part of the IOSCO standard, a number of assessors noted that the lack of a fair and impartial

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judiciary that could arbitrate disputes and impose or enforce sanctions within a reasonable
timeframe, undermined both the credibility and effectiveness of securities regulation.

COOPERATION:

In an increasingly globalized market it is necessary that regulators be able to share public and
non public information with one another. While progress has been made, the assessments show
that roughly 40 percent of the jurisdictions still encounter problems in their ability to share
public and non public information with domestic and foreign counterparties.

REGULATION OF PUBLIC ISSUERS:

The quality of disclosure by issuers of securities to investors, and the fair treatment of minority
shareholders are key to the credibility of a market place. The market (investors, intermediaries,
analyst, etc.) must be able to rely on the information given by management of issuers in order to
appropriately value securities—this includes financial information, business plans and disclosure
of ownership interests and conflicts of interest. This information must be timely and must be
equally accessible to all shareholders simultaneously. Minority shareholders must be given
adequate voting rights and notice of meetings and corporate changes, access to information
regarding insider transactions and dealings with the company, and fair treatment in take over
bids and related party transactions. These protections are particularly important in jurisdictions
with concentrated ownership of public issuers, which describes the majority of emerging market
and developing countries.

Few countries received a failing grade on their disclosure regimes. Most jurisdictions have
adequate disclosure in place for initial offerings, requiring that a prospectus complete with
audited financial statements be given to investors prior to the purchase of the offering. However,
in many countries there is a lack of proper review of prospectus disclosure by the staff of the
regulator or exchange, and a lack of skill at the regulator in ensuring that disclosure is
meaningful to investors. In these jurisdictions, disclosure may strictly meet criteria set out in
legislation but fail to convey to investors and others an adequate understanding of the business
plan, business risks and financial condition of the issuer.

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In a number of countries there was also a lack of continuous disclosure requirements—that is
requiring material events to be immediately disclosed to the market, and annual and quarterly
reporting. In many developing countries, continuous disclosure requirements either did not exist
or were not practically enforced in the case of companies that did not trade on an exchange. A
number of assessments concluded that disclosure, particularly of price sensitive information, was
not timely and therefore did not provide investors with sufficient transparency.

Most jurisdictions had basic shareholder meetings, notice and voting provisions set out in
company law as well as securities regulation. Many, however, had insufficient rules with respect
to changes of control (takeover bid and mergers) and related party transactions. Insider
transactions in many countries are not reported with sufficient speed to ensure transparency to
shareholders. In a number of developing and emerging market countries, the reporting of insider
transactions is made to the regulator, but not the public or investors. Following on the theme of a
weakness in enforcement of requirements—regulators in many countries were regarded as
putting insufficient skill and resource into ensuring that the standards were actually applied.

REGULATION OF COLLECTIVE INVESTMENTS SCHEMES:

The regulation of collective investment schemes (CIS), including mutual funds, aims to ensure
adequate disclosure to investors, appropriate valuation of fund units and the safeguarding of
investor’s assets from the operator of the fund. CIS are popular retail investments and therefore
attract a high degree of customer protection regulation. They are also an important force in the
market, and therefore the accurate valuation of their assets may have systemic importance. Many
of the countries assessed had nascent CIS industries— future assessments will reflect a fast-
growing industry, particularly in emerging market countries.

While the data show a high level of implementation of the IOSCO standards for CIS, the
comments of the assessors suggest that important weaknesses remain in the legal and regulatory
framework, as well as in the supervisory arrangements. This outcome may be a consequence
assessors’ focus on the legal and regulatory framework rather than on its actual implementation,
because in many jurisdictions the laws regulating collective investment schemes were relatively
new, and because in developing and emerging market countries the CIS industry was very small
and underdeveloped. Finally, while compliance monitoring and enforcement is said to be weak

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in these jurisdictions, lack of enforcement activity may not be sufficiently taken into account in
assessing this area.

. Comprehensive licensing requirements applicable to CIS managers are in place only in about
half of the jurisdictions assessed and some emerging and developing markets still lack a
licensing regime for CIS managers altogether. Licensing requirements are not comprehensive in
many countries: while they usually include a minimum level of capital, other requirements aimed
to verify that the entity has the technical and operational capacity to manage CIS are not in place
nor are fit and proper requirements for certain controlled functions. Given the importance of
licensing as a supervision tool through which standards are set and applied, these shortcomings
in licensing regimes are significant.

The assessments noted deficiencies in CIS oversight by the regulator. Assessors found that in
many jurisdictions licenses are approved without a thorough examination of the CIS manager’s
technical and operational capabilities to manage funds, and the licensing process does not
include an on-site visit. In many jurisdictions, the regulator has not included on-site inspections
as a regular part of their on-going supervisory programs. In some of these cases, the regulator is
relying on the depository to conduct oversight of the CIS manager; however assessors concluded
that, in practice, the depositories were not adequately fulfilling their role and should not be relied
on so extensively.

Many jurisdictions still lack a comprehensive set of business and market conduct rules for CIS
managers, including the regulation of conflict of interest. Assessors also noted that in some
jurisdictions where bank platforms were used to market and place CIS, bank personnel was not
subject to the same market conduct rules, nor were they supervised with the same intensity as the
personnel of the CIS manager. Without appropriate market conduct and business conduct rules,
investors are at risk of mis-selling and other abuses. Development of CIS markets will depend
on, among other things, the ability of CIS to maintain investor confidence and properly manage
conflicts of interest addressed by such rules.

REGULATION OF MARKET INTEMDIARIES:

The regulation of market intermediaries has three main objectives: to protect client assets from
insolvency of the firm or appropriation by the firm or its employees; guard against defaults and
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sudden disruption to the market, either through sudden insolvency or settlement failure; and, to
ensure that intermediaries are fair and diligent in dealing with their clients. Regulation, therefore,
sets licensing standards (limiting the market place to those with sufficient resources and
qualification), prudential standards (protecting against sudden financial failure), internal controls
and risk management standards (reducing the possibility of default or appropriate of client
assets), and business conduct rules (ensuring proper handling of client accounts).

The assessments found regulation of intermediaries to be an area of weakness. While licensing

standards and a supervisory framework may be in place, many regulators lack the skilled staff to
oversee market intermediary activity effectively or to set detailed standards for internal controls,
risk management or adequate prudential requirements. This lack of indepth understanding
prevents regulators from executing effective inspections and examinations and from detecting
potential insolvencies. The regulation of market intermediaries in jurisdictions with these
weaknesses, takes on a ‘form over substance’ character, with formal reporting and inspection
programs that do not yield results.

REGUALTION OF SECONDARY MARKETS:

Secondary markets are regulated to ensure the efficiency and credibility of the markets as
mechanisms for pricing and transfer of securities.13 Exchange and other public trading systems
are subject to licensing requirements, including standards applicable to information technology
systems and risk management, and are subject to on-going supervision, including inspections and
reporting requirements. Potential sources of market disruption are addressed through the
regulation of clearing, settlement and depository services, including risk management
mechanisms designed to ensure that intermediaries settle their market obligations in a timely and
orderly manner. Market activity is subject to market abuse rules, including prohibitions on
trading on insider information, market manipulation and misrepresentation.

The IOSCO Principles cover these issues in Principle related to secondary markets (Principles
26–30), which have mixed levels of implementation. Overall, oversight of secondary markets
operations and regulatory functions remains a challenge in many jurisdictions. Regulators
struggle with a lack of capacity to build the necessary knowledge and skill required to
understand and monitor markets. There is a lack of attention to technology, an issue of ever-

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growing importance, and an over-reliance on formal rules and reporting as a means of
conducting oversight.

As with the risk management of market intermediary activity, there are sometimes limitations on
the assessor’s knowledge and understanding of market operations and the risks they entail. The
effectiveness of oversight, rules, and practices is undermined by this gap in understanding.

SECURITIES MARKET REGULATION IN INDIA:

A stable and efficient financial system provides the foundation for implementation of effective
stabilization policies, more accurate pricing of risk and more efficient use of capital. Efficiency
of the financial system is governed by the role of markets in mobilizing and allocating financial
resources, in providing liquidity and payment services and in gathering information on which to
base investment decisions. Stability, on the other hand, is concerned with safeguarding the value
of liabilities of financial intermediaries that serve as stores of wealth. This also involves
questions relating to prudential supervision, financial regulation and good governance. It needs
to be added here that as financial systems get increasingly globalized, capital moves not only in
response to competing monetary policies, but also to competing financial systems. Inefficient
and unstable financial systems are therefore likely to be increasingly penalized.

In India, as in other parts of the world, securities regulations have evolved in the face of two
apparently diverging trends. One relates to a move toward liberalization of financial markets,
which entails elimination of measures of financial repression such as direct controls on interest
rates, mandatory investment in government securities, administrative pricing of securities and so
on. The other force is toward stronger regulation. The need for stronger regulation comes to the
fore since financial markets are characterized by significant asymmetries of information, which
contribute to moral hazard and in extreme cases leads to market failure. In sum, an unregulated
market can entail high systemic risk. This section briefly discusses the problems faced by the
market prior to reforms and outlines the major reform initiatives of the 1990s with what results.

EQUITY MARKET:

NATURE OF MARKET PRIOR TO REFORMS:

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As compared to other developing countries, the Indian stock markets have a fairly long history. 4
However, the volume of transactions in these markets remained limited until the late 1970s, but
grew rapidly during the 1980s as the corporate sector turned increasingly to the equity market.
Although the volume of transactions increased, the market remained primitive, insulated from
foreign investment and continued to suffer from several problems. Most importantly, to access
capital markets, companies needed to have prior permission from the government, which had to
approve the price at which new equity could be raised. The aim was ostensibly to control flow of
funds to the private corporate sector in view of the requirements of public finance and also to
provide a “fair value” to investors. However, the practice effectively penalized firms raising
capital from the market: the Initial Public Offerings (IPOs) of equity were typically under-priced
in relation to the price upon listing, and the new issues by listed companies were at a substantial
discount to the prevailing price. While the new issue market was overly regulated, there were
inadequate regulations of secondary market activities. The domestic capital market had no global
link. Information and transparency were limited, reflecting the individual, dealer-based trading
system. All these contributed to high transaction costs.

In addition, public sector financial institutions such as the Unit Trust of India (UTI), the
insurance companies and the Development Finance Institutions (DFIs) were dominant players in
the stock market. This had two significant effects. First, the government had major influence on
the domestic financial markets. 5
Second, it allowed promoters of public companies to run their
companies with relatively small holdings of their own, because public sector financial
institutions generally supported the status quo ownership and management position, unless
something drastic happened.

EQUITY MARKET REFORMS:

As part of a broad set of reforms, the Securities and Exchange Board of India (SEBI) was given
the legal powers in 1992 to regulate and reform the capital market, including new issues. The

4
The Bombay Stock Exchange is over a hundred years old.
5
During the 1990s, this meant that public sector mutual funds and other financial entities supported the
government's divestment program.

15
equity market reforms since then can be divided into two broad categories: one that increases the
level of competition in the market and the other that deals with problems of information and
transaction cost. The most important initiative to enhance competition was the free pricing of
IPO and formulation of guidelines concerning new issues. The new regulatory framework
sought to strengthen investor protection by ensuring disclosure and transparency rather than
through direct control.

Secondly, the National Stock Exchange (NSE) was set up, which competed with the Bombay
Stock Exchange (BSE). The NSE introduced an automated screen-based trading system, known
as the National Exchange for Automated Trading (NEAT) system, which allowed members from
across the country to trade simultaneously with enormous ease and efficiency. Faced with stiff
competition, the BSE adopted similar technology. Competition was also enhanced through an
increased number of participants—foreign institutional investors (FIIs) were permitted to trade
and private sector mutual funds came on the scene. To deal with market imperfection such as
information asymmetry and high transaction costs, a number of measures were taken. At the
trading level, transparency was facilitated by the new technology (NEAT system), which
operated on a strict price/time priority. 6
At the investor level, transparency was augmented by
the regulation that required listed companies to increase the frequency of their account
announcements.

To ensure transferability of securities with speed, accuracy and security, the Depositories Act
was passed in 1996, which provided for the establishment of securities depositories and allowed
securities to be dematerialized. Following the legislation, National Securities Depository
Limited—India’s first depository--was launched. Other measures to reduce transaction costs
included: a) a movement toward electronic trading and settlement, and b) streamlining of
procedures with respect to clearance of new issues.

RESULTS:

6
A member places an order on the computer stating the quantities of securities and the price at which he wants to
transact and the order is executed when it finds a matching sale or buy order from a counter-party. It is possible for
market participants to see the full market, which has made the market more transparent.

16
Following these measures, the Indian equity market has modernized rapidly and its ability to
serve investors has increased considerably. Competition among stock exchanges has intensified.
With all stock exchanges introducing screen-based trading, trading has become more
transparent.7 With the option of settling through depository now available to investors in case of
most of the liquid stocks, it is possible to eliminate risks of bad delivery and counterfeit shares.
The two depositories that are in operation now ensure faster, cleaner and cheaper settlement.
Dematerialized settlement now accounts for about 90 percent of settlement settled by delivery.
Disclosure standards by companies and financial intermediaries are higher. Following the
introduction of prudential regulations, stock exchanges have become safer and more dependable.
One area where there has been only limited progress is in reducing the dominance of public
sector financial institutions.

DEBT MARKET:

The Indian debt market can be classified into three segments:

 The government securities market;

 The public sector units (psu) bond market; and

 The corporate bond market.

Each segment has its own distinctive practices, procedures, institutional framework and
regulatory structure. The focus of debt market reforms has been on government securities
market, because not only does it dominate the debt market, 8 but also plays an important role in
establishing benchmarks for the rest of the market.

NATURE OF MARKET PRIOR TO REFORMS:

Until the early 1990s, the debt market received very little attention. The government securities
market, which constituted the bulk of the debt market, remained dormant. The reason for this
was simple. Since the government could borrow at pre-announced coupon rates at below
market rates from a set of captive institutions, there was no need for the government to
7
Earlier, brokers routinely inflated (deflated) the prices at which they bought (sold) shares for their clients, thus
earning a hidden margin.
8
Government debt constitutes about three-fourth of the total outstanding debt.

17
 directly place its securities on the market. The captive institutions largely held on to
government paper until maturity; whatever little trading existed, was aimed at adjusting the
maturity structure of the portfolio, rather than at profit making. As a result, the market did not
develop.

REFORMS SINCE EARLY 1900s:

Debt market reforms began with the establishment of a primary market for government
securities. It was followed by the strengthening of the legal, regulatory and payments
infrastructure which contributed to the development of a secondary market. Some of the
important reform initiatives undertaken since the early 1990s are given below

 There have been progressive restrictions on on-demand government borrowing from the RBI.
The earlier system of issuing ad hoc treasury bills has been replaced by a system of ways and
means advances, which are being made increasingly restrictive.
 Auction for treasury bills of varying maturity—14-day, 91-day, 182-day and 364-day—have
been introduced. To encourage aggressive bidding, uniform price auctions have been
introduced for 91-day treasury bills. Also, to foster competition, non-competitive bids are
now kept outside the notified amount.
 To widen the investor base, foreign institutional investors have been allowed to invest in
government securities including treasury bills in both primary and secondary markets.
 The RBI has introduced a Delivery versus Payments (DVP) system, which ensures settlement
by synchronizing transfer of securities with cash payments, thereby accelerating settlement,
enhancing transparency and eliminating settlement risk. (Earlier, settlements in securities
transactions between any two parties were recorded without any direct link with cash
settlement between buyers and sellers, which entailed delays in settlement and counterparty
risk.)
 A primary dealer system has been developed to channel securities from primary auctions to
ultimate investors. Primary dealers facilitate debt trading through committed participation in

18
 primary market auctions and by creating an active secondary market in securities by giving
two-way quotes.
 The RBI is actively promoting retailing of government securities by providing liquidity
support to satellite dealers and dedicated gilt funds to help them sustain their retail activities.
Gilt funds also benefit from special tax incentives.
 An active interbank repo market has been developed, which has helped to boost liquidity in
government securities. To provide depth to the interbank repo market, a number of measures
have been taken, including permission for all government securities to be eligible for
interbank repos.

RESULTS:

These initiatives have resulted in a significant transformation of the debt market. The size of
the market has grown rapidly in the past four years. Activity in the secondary debt market has
also accelerated during recent years as reflected by the turnover of traded securities rising
from 3.3 percent of GDP in 1996/97 to 6.7 percent in 1998/99. The market has not only
grown in size, but has become more efficient too. Prices for government securities are
increasingly market-determined. The government, like any other issuer, has to come to the
market to raise its resources. The ability of the market to signal changes in interest rate
structure has been augmented through regular auction of treasury bills of different maturity.
The market has been broadened through primary dealers and the FIIs. Introduction of DVP
has enhanced transparency. The move toward price discovery through a price-based auction
system has contributed to the development of bidding skills among market participants.
Although reforms have clearly achieved some success in the development of a modern, well-
functioning market, the overall progress toward modernization has been smoother and more
substantial in the case of the primary market in government securities than in the secondary
market.

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CONCLUSION:
Enforcement of compliance with rules and regulations emerged as the overriding weakness in
regulatory systems. Regulators rely on a continuum of operations to effect regulation: beginning
with routine inspections and reporting and culminating in special investigations and enforcement
actions. We observed a chronic lack of skill and knowledge in the practice of inspections and the
use of reporting tools. Further, there was a lack of resources, skill and legal authority required to
effectively undertake investigations and bring enforcement actions. While the regulator may be
able to react to market needs with new laws and new regulatory guidance, it appears it is much
more difficult to ensure these laws are complied with and the lack of ability to do so undermines
the whole regulatory process. This is of particular concern since the success of securities markets
depends, to a great degree, on market confidence, which in turn can be adversely affected by a
lack of credible regulation.

Weaknesses in enforcement may also be related to another key finding—that of insufficient

independence of regulators. The fully-independent and independently-funded securities
regulator, even where it exists, is a relatively recent phenomenon. Many countries still resist
allowing full independence and thus regulators can be mired in political or bureaucratic
considerations that prevent them from fully engaging in regulation and supervision.

Valuation rules for investment funds is a difficult and technical area of regulation that requires
serious attention. In many countries, we found that inadequate attention is paid to reviewing
valuation practices, particularly in markets where funds would have significant holdings in
relatively illiquid securities and should not rely entirely on the price given by an organized
market or exchange. Risk management and internal controls at market participants is another
difficult and technical area that emerged as a source of weakness in many countries. Many
regulators do not have staff skilled enough to properly understand the activity of market
participants and the risks that these activities produce and therefore cannot effectively set
standards for risk management and internal control nor effectively evaluate the practices
employed by firms.

These findings enhance our understanding of financial sector regulation and challenges facing
policy makers in improving conditions in local markets. The findings will be immediately useful
as guidance to financial sector surveillance work being undertaken by the IMF, the World Bank

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and others, pointing in the direction of areas that require particular scrutiny. In addition, the
paper’s findings can be used as a tool to prioritize technical assistance that the IMF provides to
countries and as useful input to other technical assistance providers and IOSCO in formulating
work programs. In further developing its technical assistance program, the IMF should focus on
the practice areas of enforcement and inspections and on the technical areas of risk management
and valuation of portfolios in investment funds.

The findings are potentially valuable to understanding the source of vulnerabilities in the
financial sector and providing countries with policy advice in addressing these vulnerabilities,
although much work remains to be done in connecting the weaknesses in securities markets
regulation to crisis or potential crisis events. Future work may establish these connections and in
addition, increase our understanding of the value of institutional (including regulatory)
strengthening in view of increased cross-border trading and capital flows.

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