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Opportunities and Challenges of Regulatory Convergence in India’s Financial Sector The Case of the SEBI–FMC Merger

Nilanjan Ghosh, Kushankur Dey

The authors acknowledge the very helpful comments from the reviewer. Views expressed are personal. Nilanjan Ghosh (nilanjanghosh@orfonline.org) is with the Observer Research Foundation, Kolkata, and the World Wide Fund for Nature, India; Kushankur Dey (kushankurd@iimahd.ernet) is with the Indian Institute of Management Ahmedabad.

Various opportunities accompany the merger of the

Securities Exchange Board of India with the Forward

Markets Commission, as announced in the 2015–16

union budget. At the same time, important regulatory

and developmental challenges have to be overcome for

instilling efficiency in the market, along with promoting

investor protection. Whether the merger is the

beginning of financial market regulatory convergence or

merely a “one-off” incident can only be known with

developments over time. Similar types of opportunities

and challenges may arise in generally adopting

regulatory convergence in India.

The union budget for 2015–16 saw the announcement of the convergence of the Forward Markets Commission (FMC), the regulator of the commodity derivatives mar-

kets, with the Securities and Exchange Board of India (SEBI), the regulator of the capital markets. The merger will require several legislative changes, including amendments to the SEBI Act, 1992 and the Securities Contracts (Regulation) Act (SCRA), 1956. These legal changes required for the merger have been incorporated in the Finance Bill, 2015 so that there is no fur-ther requirement for separate parliamentary approval. With the President giving his assent to the Finance Bill, the changes are automatically notifi ed. This will usher in a new era not only in the domain of fi nancial markets and its regulation, but also in the regulatory architecture of the generic fi nancial market in India.

Regulatory convergence is being seen as the new emerging face of the regulatory architecture of fi nancial markets in many parts of the world. This has been achieved either through the mechanism of creating a super-regulator oversee-ing regulators or through merger of regulators (Turner 2013). There is now a global trend towards even greater regulatory convergence, which accelerated after the 2008 credit crisis and is being pursued with an enthusiasm that is sidelining the earlier trend towards multilateral rule convergence (Broby 2013; Turner 2013). As such, the current system of fi nancial supervisory convergence has evolved by default. A process of substituted compliance has become the de facto modus oper-andi between the UK, Europe and the US since the 2008 credit crisis. It has been widely accepted that competition in regula-tion is not as effi cient as cooperation, provided the same risks are addressed by similar rules. Whether such a practice should be accepted beyond the Western economies of the US and the UK, which have more developed fi nancial markets than others, requires a major gap analysis, where a global regulatory body such as the International Organization of Securities Commis-sions (IOSCO) compares regulatory oversight and outcomes to expected standards as determined in Europe and the US under the current status quo (Broby 2013).

The advantages and disadvantages of such a mechanism are many. In the process, regulatory convergence has its champi-ons and detractors in India as well (Pavaskar 2004). Regula-tory convergence in the present case seems to be an outcome of the recommendations of several committees, for instance,

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the Inter-Ministerial Task Force on Convergence of Securities and Commodity Derivative Markets (2003); the Parliamentary Standing Committee on the Forward Contracts (Regulation) Amendment Bill, 2006; the Percy Mistry Committee (2007); the Raghuram Rajan Committee (2007); the Parliamentary Standing Committee on the Forward Contracts (Regulation) Amendment Bill, 2010; and the Financial Sector Legislative Reforms Commission (2013). Around eight years ago, a high-powered executive committee of the Ministry of Finance chaired by Percy Mistry submitted a report on “Making Mumbai an International Financial Centre.” The report talked of the missing bond–currency–derivatives (BCD) nexus, and emphasised, “A series of measures are needed to achieve market integration and con-vergence and thus enable economies of scale, economies of scope, greater competition, and enhanced IFS export capability.”

The Financial Sector Legislative Reforms Commission (FSLRC) that submitted its report in 2013 felt that regulatory convergence is one of the ways for markets to move in sync, and exploit economies of scale and scope. It looked at two im-portant aspects of the Indian fi nancial sector—its legal struc-ture and regulatory set-up. One of the most important changes recommended by the FSLRC was merger of the SEBI, FMC, Insurance Regulatory and Development Authority of India (IRDA), and Pension Fund Regulatory and Development Authority (PFRDA) into a single regulator called the Unifi ed Financial Agency (UFA), on the ground that all fi nancial acti-vity other than banking and the payments system, which would continue to be regulated by the Reserve Bank of India (RBI), should be brought under a single authority. So, it is note-worthy that the initiative of merging the SEBI and FMC was well thought out, and a competent authority weighed the merits and drawbacks of it in the light of recommendations by several committees.

The Process of Regulatory Convergence

Apparently, it seems that the SEBI–FMC merger is driven by the recommendations of the FSLRC. But, there are drivers embed-ded in market development too. It is worth noting that the FMC before the merger was not an autonomous regulator, unlike the other market regulators. The commission operated under the aegis of Ministry of Consumer Affairs, Food and Public Distribution until 2013 and was mandated to regulate com-modity futures markets. The union budget of 2013–14 declared that there is no difference between commodity derivatives and security derivatives, while imposing the commodity transac-tion tax (CTT) in the same way as with security derivatives. The FMC was brought under the Ministry of Finance in 2013.

The need for an autonomous and strong regulator for the commodity markets has been long expressed in the academic literature (Sahadevan 2012: 108), as also in policy circles (FCRA Amendment Bill 2010). Public perception of the steady growth of capital markets under the regulatory control if the SEBI has strengthened the need to put in place an equally powerful stat-utory regulator for commodity markets, especially because the scale of its effect is signifi cantly larger than that of the capital markets (Sahadevan 2012: 108).

Eventually, the Finance Bill 2015 aims at materialising the merger of the FMC with the SEBI. The merger process is to be actualised between September 2015 and early 2016. To effect the operation of the SEBI as an independent or autonomous regulator of both capital markets and commodity derivative markets under the Ministry of Finance, Parts II and III of the bill have introduced amendments in the statutes governing se-curities/capital markets and commodity forward/futures mar-kets. Section 28A is introduced as a clause in the Amendment of the Forward Contracts (Regulation) Act (FCRA), 1952. The clause states that all recognised associations under the FCRA shall be considered as “stock exchanges” under the SCRA, 1956. Under the SCRA, the bill is required to amend the defi nition of securities under Section 2(ac) to include commodity deriva-tives and forward trading in its ambit. In addition, an amend-ment to Section 18A is said to empower the central government to proclaim certain contracts—commodity price index, option in commodities, weather derivatives and index investment, among others—as derivatives (Ghosh 2015a).

While the SEBI provides commodity exchanges adequate time to comply with the SCRA until the FCRA, 1952 is repealed, a stockbroking entity needs to be set up under the aegis of the SEBI. The entity is to be independent and can work closely with clearing houses of commodity/stock exchanges (Mondal 2015). Though not clear till now, the apparent impression is that this merger with phasing out of the FCRA and amendment of the SCRA will actually blur the difference between commodity and stock exchanges by creating a greater fungibility between securities currencies and commodities.

The question that automatically arises is—does the SEBI have the regulatory bandwidth and expertise to handle this gamut of new regulatory responsibilities? Apparently, the SEBI’s expertise in monitoring and surveillance of capital markets is illustrious, while the FMC has demonstrated its ability in regu-lating commodity derivatives markets. It has been said in many quarters that commodity derivatives are different instruments from equities and bonds—the former is meant for hedging, the latter for investment. Hence, different types of expertise are needed for regulating commodity exchanges and stock exchanges. However, this contention was challenged in the union budget for 2013–14. Given the nature of participation and characteristics of participants, the budget speech stated, “there is no distinction between derivative trading in the secu-rities market and derivative trading in the commodities market, only the underlying asset is different” (MoF 2013: para 149).

In any case, after the merger of the SEBI with the FMC, the latter will be converted to a department to assist the SEBI for regulating the derivative segment in commodities. Since its inception, the SEBI has been a professional-run autonomous organisation while the FMC has been bureaucratic in nature, a relatively fl at organisation managed by a few government executives. Thus, with a blend of professionals having the required skill sets and bureaucrats, the regulatory bandwidth of the SEBI will only increase. Further, the SEBI already has ex-perience of regulating brokers and members of an exchange. Since the FMC’s hands were tied under the FCRA 1952, it was

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never directly exposed to brokers and members of an ex-change. It used to do that through the exchanges. Therefore, in the changed regime after the merger, the optimum combi-nation of two different types of skill sets and experience will infuse more rationality to the trade by offering a broad-based yet effective platform.

Rationale for Convergence and Opportunities

The rationale for the convergence stands on several grounds. First, it will improve the comparability of fi nancial informa-tion, in terms of consistent valuation practices of both stock and commodities businesses with respect to reliable price dis-covery and effective risk management.

Second, the auditability of fi nancial statements of exchanges and member fi rms may be on a par with global exchanges since “fungibility” bridges the gap in the nomenclature of stock and commodity exchanges. Improvisation in the fi nancial statement comparison and auditability would be the natural outcomes of the process.

Third, worldwide there are many instances where a single regulator has successfully regulated equities and commodities segments as they are traded in a single regulated entity. Such examples of regulated exchanges trading in both commodities and securities exist in Australia (Australian Stock Exchange, and Sydney Futures Exchange), France (Matif), the UK (Lon-don International Financial Futures and Options Exchange), Taiwan, South Korea and so on (MoF 2003).

Fourth, from the hedging perspective, the merger reduces the transaction cost. There are many physical market players who have to take positions in both commodities and curren-cies for risk management—more so, while dealing in interna-tional commodities such as bullion, base metals and the like. Since these two had so far been dealt with by two different regulators, the hedgers had to comply with two different regu-latory norms. Now, with regulatory convergence, that situa-tion will change and this has the potential to reduce the cost of hedging.

Fifth, this merger opens up avenues for various types of products that could not be traded under the outmoded FCRA. These include, in particular, options and index-based prod-ucts. These enormous opportunities can bring about various product innovations—investment derivatives such as exchange-traded funds for silver and other metals, weather and freight derivatives, and index futures and options trading in commo-dities can be introduced. In the process, it will offer arbitrage opportunities across various segments in an exchange, and make margin money fungible for trading across various asset classes such as commodities, currencies and equities (Bhayani 2015). Thus, if stock exchanges begin trading in commodity derivatives, the same margin money can be made applicable to all segments because the clearing corporation will be the same. In other words, market depth and liquidity enhancement would be an outcome of the regulatory convergence.

Sixth, from the participation standpoint, since the regulatory system will move to an autonomous regulator,

avenues for banks and fi nancial institutions are opened in the process. This will not only help the hedging effi ciency process, but also infuse liquidity and bring in more depth to the market.

Seventh, it will reduce or eliminate the scope of “regulatory arbitrage,” a process by which agents in the principal–agent framework could have capitalised on loopholes in regulatory systems to circumvent what they perceive as unfavourable regulation.

Eighth, and most importantly, the merger could reduce the potential threat of systemic risks and the cascading effect of inter-sectoral defaults, and might bring down search or infor-mation costs. The convergence might offer fl exibility to stock brokers to operate in fi nancial as well as in commodities mar-kets simultaneously as it allows integration at the level of bro-kerage fi rms. These entities are required to comply with the regulatory prescriptions—capital adequacy, various types of margins, nature of membership, and net worth, among others—of their concerned regulator and exchanges. It may be noted that exchanges and brokers may leverage their operations (without having two independent entities/establishments deal-ing with commodities and stocks) in a uniform overarching regulatory architecture. There need not be separate set-ups for commodities, securities and currencies. As a natural corollary, interoperability between “stock” and “commodity” exchanges would take place in terms of limit order book maintenance, order entry, margin calculation and value-at-risk analysis of holding portfolios.

Opening the Avenue for Innovation

There are many risk management products, or, to be specifi c, insurance products that lie at the interface of being commo-dity and securities. As argued by Ghosh (2010), India needs to have trading in water futures and options. It has been argued that a water futures index can reduce the scarcity value of water, thereby helping in water confl ict resolution. Such deri-vatives cannot be delivery-based; they should be index-based. Delivery is a costly affair, and completely defeats the purpose for which such a product is conceived. Many of these sustaina-bility-related products such as weather derivatives, which can also be linked to crop insurance products fl oated by banks in the markets, are index-based and non-deliverable. In the pre-vious regulatory regime governed by the FCRA, such products were not allowed to be traded as the statute governing com-modity markets mandates derivative products to be generally delivery-based. Carbon credit derivatives that were fl oated in India failed and there were two reasons for that—the improper timing of launch as carbon markets were moving down from 2009 onwards and its unattractiveness to speculators due to the delivery clause (Ghosh 2015b).

In the face of climate change and with increasing frequency and intensity of extreme events, there are various risk man-agement products that are needed for Indian agriculture. Worldwide, there are various risk management instruments such as crop-yield insurance (linked to the productivity), crop-hail insurance (covers against hailstorm in the US),

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multi-peril crop insurance (covers against multiple extreme events such as fl oods, droughts, hail, and so on), crop-revenue insurance, and the like. Further, even weather derivatives products such as High Degree Day (HDD) and Cold Degree Day (CDD) are in vogue. While insurance companies or banking in-stitutions worldwide have conceived such products, globally these institutions access the futures or derivatives markets for their own risk management. However, in India, the statute does not allow access to the commodity derivatives markets. Even the Banking Regulation Act, 1949 prohibited institu-tional access to commo dity markets, though banks can access stock markets. One of the reasons cited was that the com-modity markets regulator was not autonomous and did not have enough teeth to regulate such products and institutions.

Further, as argued by S Ghosh (2015), a disguised offset pro-cess known as “compensatory afforestation” has taken off in India under state and judicial patronage. Besides, India has the credential of having hosted a more common form of offset trading in the Clean Development Mechanism (CDM). If CDM or related offset markets are to be developed, their associated derivative markets should also be encouraged for risk manage-ment. Under the outmoded FCRA 1952, one cannot conceive of such products.

With the new statutes in place, all such restrictions will be gone. There will be more ideas to be implemented as the rele-vance of the FCRA will cease to exist. Despite contending claims, the fi nancial market in India has so far failed to play any role in the context of sustainability (Ghosh 2015b). There have only been proposals to trade on sustainability indices of listed companies in the stock exchanges, which might have some implications for the implementation of sustainable devel-opment goals, but it hardly has anything to do with ground-level risk management, and the creation of social security. The SEBI–FMC merger opens up the avenue for innovative products to bridge that gap. It will also open up avenues for foreign in-stitutional investors (FII) and other foreign players to access the markets, thereby enhancing liquidity. Hence, this might create the opportunity for many derivative products based on “global commons” (such as carbon dioxide emissions) to succeed, which have otherwise failed in India due to lack of foreign participation.

From the participation standpoint, since the regulatory sys-tem will move to an autonomous regulator, avenues for banks and fi nancial institutions are opened. This will not only help the hedging effi ciency process, but also infuse liquidity, and bring in more depth to the market.

Necessary Ramifications and Challenges

The effect of the SEBI–FMC merger as a case of regulatory con-vergence may be amplifi ed in the regulatory architecture in commodities markets, among others, in product–market inno-vation, surveillance and risk management and confl ict man-agement of the regulator and exchanges/members and protec-tion for customers (Dey 2015b). However, the implications of the SEBI–FMC merger need to be examined from an economic and regulatory standpoint. Regulatory harmonisation in terms

of consistency and complementarity is of crucial relevance to the convergence (Jordan and Majnoni 2002).

Regulation, Governance and Welfare Issues

The SEBI needs to work on how to pursue fi nancial regulatory harmonisation and how it should instil rationality in commod-ity trade with the adoption of a utilitarian approach to ex-changes and brokers/members. Domain expertise of the FMC may help the SEBI understand the depth and breadth of com-modity futures and its underlying markets. The most impor-tant issue is that the commodity derivatives markets will be under a strong, autonomous regulator that can come down heavily on illegal trading, also known as dabba trading. As such, the FMC, through various by-laws, has acquired a few powers but that often prove inadequate to curb practices that are “off-markets” (Pavaskar 2007). With an autonomous regu-lator in place, more trades will come under legal purview, and in the process help the government exchequer.

The convergence may have some positive effect on govern-ance. Exchanges, regardless of commodity/stock, need to adopt good governance practices to strengthen their operations by formalising performance goals in alignment with their mis-sion and vision. Adoption of good governance practices could help rationalise their existence and the constitution of a diver-sifi ed board through succession planning, and it may be a desi-red outcome of the SEBI–FMC merger. A principle-based regu-latory structure will help rope in the commodity and fi nancial ecosystem and infuse more rationality in the commodity value chain. The new regulator could be able to resolve the inherent confl icts between the principal and agents (Dey 2015b).

Governance may resolve inherent confl icts between the ex-change and its promoters and members and help constitute a diversifi ed board (Poitras 2013). While talking about the regu-lation of the Chicago Board of Trade, Lurie (1972: 221) pre-sented a view on the management of board in the corporation.

A basic purpose of the board was to facilitate profi table economic acti-vities by members. Thus its directors had to sense with some accuracy how far they could go in the areas of rule enforcement. If rules were enforced too harshly, board members could either ignore them or de-cline to remain in the organisation. Another purpose of the exchange was to rationalise the commodities market through effi cient and effec-tive regulation. The efforts of the directors to reconcile this inherent tension between private economic activities and an ordered national market represent a recurring theme throughout Board history.

An autonomous regulator may bring about certain guide-lines and terms and conditions on the functioning of the board. Incidentally, the FMC brought about quite a few guide-lines on the functioning of exchange boards.

On the other hand, since agency problem seems to have sur-faced in earlier regulatory structures, the new regulator being a principal will impose a set of checks and balances on activi-ties of exchanges (agents) on market monitoring, surveillance, and risk management. This might help regain market integ-rity, trust and completeness (Sahadevan 2012).

The inclusion of independent directors (not in relation to promoters or members of family-run business entities) by the SEBI might be viewed as a positive stroke to regulatory

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harmonisation. In addition, changes in surveillance of exchanges on audit and technology adoption may be accom-plished, bringing vibrancy to commodity markets.

Another challenge arises here. Despite the 2013 budget decl-aring the similarity of characteristics of traders trading in the commodities and stock markets, it needs to be understood that commodities and capital markets are fundamentally different (Pavaskar 2004). While a rise in stock prices is viewed as a signal towards general well-being, if the commodity deri-vatives market is an avenue for price discovery, a rise in prices in the derivatives markets might lead to infl ationary pressures in the economy. Hence, commodity derivatives markets need to be regulated with adequate price circuits, position limits, consortium limits, and so on so that its price risk management platform does not become a source of infl ation risks. The FMC’s initiative in managing this deserves special mention. There-fore, despite the last guar gum price rise issue for which no such empirical evidence for vilifying commodity exchanges was found, there have been no recent allegations of futures markets leading to infl ation.

As the capital market regulator enjoys fl exibility in the given regulatory capacity, it might work on design-related issues and contract specifi cations for commodity markets. So far, this has been the domain of the exchanges, and this worked well, given that contract design by the exchanges engendered competition among them and led to market development on certain counts. But, there is another framework that exists with the SEBI and that is with regulation of the currency derivatives markets that are traded in the stock exchanges. The currency contracts are homogeneous and this has helped in market penetration and risk management. So, it is now up to the SEBI to decide which specifi c model or a combination of both (some working con-tracts left to the exchanges, some to be designed by the SEBI) is more applicable for general well-being. Apparently, it seems that there is a need to engender competition and so exchan ges should be encouraged to innovate further, even as the regula-tor may also mandate certain necessary products designed by it to be traded for enhancing social well-being.

From the stakeholder point of view, robust risk management mechanisms need to be in place to avoid systemic risks. So far, in none of the regulated domains have systemic risks arisen. Regulators in that sense have done a commendable job so far (MoF 2003). A robust yet fl exible regulatory structure can ensure that individuals or groups in the corporation/exchange or self-regulatory organisations cannot infl uence or exercise their power adversely. Moreover, assets or profi ts of the corpo-ration cannot be used for the well-being of groups that might otherwise cause moral hazard to a majority of stakeholders. While abusive related-party transactions might hurt minority shareholders, audit at periodic intervals needs to be conducted at the behest of the new regulator.

On the social welfare front, active intervention of the new regulator and the Ministry of Finance is expected, especially in a developing market such as India, where fi nancial (and commodity) markets are not so perfect or legal and other infrastructures are relatively insuffi cient, in addition to varied

risk structures and governance mechanisms (Levine 2012; Shleifer and Vishny 1997).

The challenge arises not merely from the perspective of reg-ulatory convergence between different markets. The issue of regulatory convergence across different jurisdictions to pre-vent regulatory arbitrage and migration of risk is extremely important. For instance, the Financial Stability Board (FSB) and International Monetary Fund (IMF) are overseeing regula-tory convergence across major jurisdictions, including through peer reviews such as the Financial Sector Assessment Pro-gramme (FSAP), which provides in-depth examinations of countries’ fi nancial sectors. In this context, it is noteworthy that the FSB has brought about signifi cant regulatory struc-tures for fi nancialisation of commodities for Group of Twenty (G-20) nations (Gibbon 2013). In April 2010, the FSB created the OTC Derivatives Working Group (ODWG) that plays a piv-otal role in transposing the G-20’s objectives into domestic regulations, relating to central counterparties and trade re-positories. Therefore, in the context of the SEBI–FMC merger, while the challenge of regulatory arbitrage and risk migration arises, there are international examples showing pathways to combat such challenges.

Market Microstructure and Trade Issues

The new regulator needs to analyse whether imposition of the CTT in futures contracts, especially in non-agricultural com-modities, has increased the impact costs in trading since met-als and energy account for a large share of the value in the commodity basket (Ghosh 2015a). There is already a substan-tial decline in volumes after the CTT imposition and there has not been any revival because of a rise in the total cost of trans-action. Further, the revenue implication of the tax needs to be re-examined yet again, as with a volume drop in commodity exchanges, the actual tax collection may be less than what was expected. This, of course, needs further deliberation and research from the public fi nance perspective.

Further, the regulator and the ministry concerned need to ensure that all the self-regulatory exchanges comply with environmental, social and governance protocols, and that ad-junct clearing houses maintain an arm’s-length relationship with exchanges to curb illicit trading that may otherwise con-centrate the mercantile power of traders in derivative trading. In addition, the SEBI should issue disclosures on the participa-tion of commercial traders or hedgers and non-commercial traders/non-users, along with their open interest positions, at regular intervals and devise some computational measures for liquidity, price discovery and hedging effectiveness that may be issued in the public interest (Kolamkar et al 2014).

The market environment plays a key role in the transaction between parties. However, a consequence of trading activity can affect unrelated third parties, or what is known as an externality, for example, the notion the general public had on the price rise of pulses and cereals in 2007–08. The merger could oversee this problem in a logical manner. The SEBI can issue a directive indicating the incentive structure for affected individuals or groups that may be a pro-governance measure.

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This has twin benefi ts—one is the minimal direct intervention of the SEBI and the other one is that the bargaining mechanism may bring about an optimal outcome given low negotiation/transaction costs (Dey 2015b).

Adoption of good governance practices is critical to organi-sation growth on a learning continuum that might have sev-eral implications at the operational or/and tactical level of the exchange. Before permitting any innovative contract or/and programme trading, the new regulator should weigh the pros and cons of products and technologies from the cost–benefi t point of view. For instance, high frequency trading (HFT) was formally launched in 2008, especially in metals and energy contracts. HFT, a predefi ned trading protocol aims at enhan-cing liquidity and hedging effectiveness by reducing trade impact cost (Aggarwal and Thomas 2013), might affect market stability adversely. For a year, HFT in mini- and micro-contracts were disallowed on commixes, but was reintroduced from January 2014, and the exchanges were asked to exercise their discretion to choose the commodities in which the effects would not be adverse. It has been reported that there can be adverse effects on volatility destabilising the market at low levels of liquidity, while there are no such effects at high levels of liquidity (Ghosh 2014).

Market making to infuse liquidity might not be a viable proposition for all commodities. It might work for some, as the operating system is yet to be compatible with other operating systems in capital markets. Hence, protectionist measures need to be taken only after assessing the effects of liquidity-enhancing measures. While metals (precious and base) and energy products respond to innovations or shocks emanating from global markets, insulating agricultural commodities from external shocks or excessive price spikes may be the regulator’s priority. The SEBI thus needs to protect the stakeholders, namely, producers and processors, promoting a hedge- effective environment and creating a level playing fi eld for the market participants.

Commodity, pension, and insurance markets globally are now also avenues for investment as asset classes. In the wake of the global fi nancial crisis, the G-20 was very concerned, among others, about this fi nancialisation of commodity markets and its disassociation from underlying economic activity, and even set up the Nakaso Committee under the chairmanship of the deputy governor of the Bank of Japan. Oil prices rose to $150 a barrel when great economic uncertainty prevailed at the onset of the global fi nancial crisis. The fi nancialisation of various asset classes is one of the chief reasons why the regula-tion of all fi nancial markets is being considered. While India’s fi nancial markets may not be as developed as those in Western economies, they may well get there in the near future. Inter-estingly, the SEBI–FMC merger could draw a parallel from the US market where the merits and risks of the merger of the Se-curities and Exchange Commission (SEC) and Commodity Fu-tures Trading Commission (CFTC) were incisively analysed and presented before the Congress.

Congress must ultimately weight the potential benefi ts of a merger against its potential risks. The major risks include (1) a potential for

over-regulation that may result in decreased market innovation and (2) a potential dominance of one market and regulatory perspective to the detriment of the other. There is also an operational risk arising from the fact that merging two agencies is at best a diffi cult task...these potential risks, like the potential benefi ts, are also not easy to quantify (US General Accounting Offi ce 1995: 5).

More importantly, investment in index-linked products such as Exchange Traded Funds (ETF) might attract fi nancial mar-ket participants in a big way. However, market makers or fund managers should promote “active portfolio management” of such products to enhance the liquidity and magnitude of par-ticipation. The SEBI should make a concerted effort to unearth unobserved heterogeneity in participation to the extent possi-ble. Further, the new regulator could draw some insights from existing commodity indices that are not allowed to be traded, namely Dhaanya and Comdex (Dey 2015a). The lessons of these indices might help the regulatory authority redesign ex-isting products or facilitate some new product offerings, say commodity mutual funds. To make such products appealing to investors, rebalancing the portfolio with actively traded com-modities on a periodic basis and respective futures/forward prices and spot prices in a block should be taken into consider-ation. A unifi ed market platform can be a welcome move to bringing in transparency in commodity spot price polling and legitimacy in forward/futures trade settlement, especially agricultural commodities trade. Moreover, the regulator needs to obtain approval from the Ministry of Finance to permit foreign portfolio investment—a combined category of foreign institutional investors and qualifi ed foreign institutional buy-ers in index or derivative trading in commodities.

Concluding Remarks

It is yet to be seen whether this move towards regulatory con-vergence needs to be typifi ed as a “one-off” incident or as the initiation of a process of regulatory convergence, as is the worldwide trend and the recommendation of the FSLRC. Only time can say. Be that as it may, there are merits from various perspectives in the move to regulatory convergence, as illus-trated above. Yet, the challenges are also many. As such, “one-size-fi ts-all” might not work for the commodity segment and the new regulator needs to be cautiously optimistic in market regulation and management of exchanges and market partici-pants. Blanket application of stock exchange practices might not enhance the effi cacy of commodity exchanges. It has to embrace the good features already prevalent in commodity market regulatory frameworks and the proclivity of exch-anges’ product innovations. Rather, if a greater regulatory convergence is envisaged bringing in other market regulators as per the FSLRC recommendations, one needs to apply regula-tory norms according to the needs of the market concerned so as to bring about product innovation, process innovation and safeguarding the interests of investors.

The FMC, within the ambit of the FCRA, has done its bit to the extent possible. The SEBI has shown exemplary perform-ance as the regulator of securities markets up to now. With the two coming together, the possibility of good results exists. At

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the same time, the new regulator has to adopt a protectionist approach to safeguard the interests of producers and commer-cial users—key stakeholders in commodities markets.

Do we have really similar types of opportunities and chall-enges with mergers of the PFRDA and the IRDA with the SEBI–FMC to form a Unifi ed Financial Agency? It is diffi cult to address at this stage. Commodity derivatives and stock futures and options in terms of apparent structure may be identical, though different in terms of their effects on the macroeconomy, and characteristics. Stock markets are meant for investment, while commodity markets were opened for

hedging against adverse price movements. On the other hand, it has been proposed that commodity futures can be stated as insurance products because they can be construed as providing insurance against price risks. In contrast, the provident fund is a different animal altogether, with major implications for social security benefi ts. This necessitates a deeper analysis in a broader regulatory context to examine whether the same economies of scale can be achieved through following the FSLRC’s recommendations to form a single unifi ed regulator to regulate the fi nancial market beyond the money market.

References

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Bhayani, R (2015): “Two Sides of the SEBI–FMC Merger,” Business Standard, 24 March.

Broby, D (2013): “The Case for a Roadmap Towards Financial Regulatory Convergence,” Journal of Financial Regulation and Compliance, 21(4), pp 397–402.

Dey, K (2015a): “Why Portfolio Risks Should Be Diversifi ed,” Business Line, 9 February.

— (2015b): “SEBI-FMC Merger: What the Market Regulator Needs to Do,” Business Line, 18 March.

FCRA Amendment Bill (2010): Forward Contracts (Regulation) Amendment Bill 2010, Bill No 146 of 2010, As introduced in Lok Sabha.

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Conflict, Transition and DevelopmentFebruary 28, 2015

War, Conflict and Development: Towards Reimagining Dominant Approaches – Vijay K Nagaraj

Protests and Counter Protests: Competing Civil Society Spaces in Post-war Sri Lanka – Harini Amarasuriya

Contradictions of the Sri Lankan State – Devaka Gunawardena

The Reintegration of Maoist Ex-Combatants in Nepal – Chiranjibi Bhandari

Myanmar: Conflicts over Land in a Time of Transition – Soe Nandar Linn

Making Pickles during a Ceasefire: Livelihood, Sustainability, and Development in Nagaland – Dolly Kikon

Peeling the Onion: Social Regulation of the Onion Market, Nangarhar, Afghanistan – GIulia Minoia, Wamiqullah Mumtaz, Adam Pain

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