Thursday, August 27, 2015

How to think about one rank one pensions

Monday, August 10, 2015

Witch hunt against PNs considered harmful

by Susan Thomas.


A slightly different version of this appeared in the Indian Express today.



The Supreme Court appointed SIT on black money has asked that the ultimate beneficiary owner of every Participatory Note (PN) be traced. This brings back an old mistrust from nearly a decade ago, which careful examination suggests is misplaced. PNs help India better integrate into the global financial system. When India fixes her financial systems to become more competitive, these very PN customers will bring their business onshore.

What are PNs? PNs are one way that international investors can invest in Indian assets today. When this investor wants to invest in an Indian firm, they buy a contract from financial firms in their country. In turn, these financial firms may either choose to invest in the Indian asset. Or they can ``replicate'' Indian returns by doing financial engineering using other securities.

The investor buys a PN from a SEBI-registered Foreign Porfolio Investor (FPI). Let us call this registered FPI a "PN seller". Many times, one firm comes to buy a contract from the PN seller, and at the same time another person comes to sell it. The PN seller makes money charging fees to both. No back-to-back transaction takes place in India. The PN seller is "running a book". Sometimes the PN seller sells 100 to one person and buys 80 from another. This leaves an imbalance of 20 on his book. This net imbalance shows up as a trade in India when the FPI sells the security. This imbalance is reported as PN trades to SEBI. The PN seller is continuously selling contracts to end-users and adjusting his position in India reflecting the net imbalance. There are a number of such PN sellers in the world. Their activities are good for India because they connect the world of global finance into India.

So, PNs are a reflection of the world investment community's interest in Indian assets. When India grows, this interest will grow. The puzzle with PNs is why they exist at all. Why does the international financial investor buy a PN and not come into India directly? As with everything in finance, it about getting the best (lowest) price. There are several mistakes in Indian policy where directly trading in India means a higher price.

Three policy mistakes


India has a policy mistake in the form of the securities transaction tax (STT). Trades on Indian exchanges are charged the STT. There is no such cost for the global investor when they buy from their domestic financial firm. PN sellers are domiciled in places like London, New York or Singapore, where tax policy is done correctly and transactions are not taxed. Since the PN seller only sends his net imbalance as trades to India, the burden of the STT is lower. So customers send their orders to PN sellers.

India has policy mistakes in the form of taxation of non-residents, other than the Mauritius/Singapore channel. Some foreign investors invest in India through Mauritius or Singapore to achieve residence-based taxation. Others send their business to PN sellers, who are domiciled in places like New York, London or Singapore, where financial activities of non-residents are tax exempt, and have worked out Mauritius/Singapore vehicles to do trades in India. Hence, the PN business is helping India obtain non-resident participation in the economy, by avoiding the consequences of our flawed approach to taxation of non-residents.

India has policy mistakes on capital controls. For example, India makes it difficult for anyone to take a position on currency futures in excess of $15 million. PN sellers are domiciled in places like New York, London or Singapore, where financial regulation makes no such mistakes. By buying from a PN seller, the customer avoids this problem.

Hankering after the ultimate beneficial owner


Indian authorities want to know the ultimate beneficiary of a PN transaction. This is incorrect for three reasons.

  1. The PN related trades in India are a reflection of a net position between all buyers and sellers, it is impossible to ask who exactly is the ultimate beneficiary owner.
  2. It is when an investigation starts, that the regulator has the ability to trace the links of the chain. This suffices for regulators in 33 of the FATF signatory countries, alongside India. India is the only country asking for information about the ultimate beneficiary owner at all times.
  3. Insisting on the knowledge of the ultimate beneficiary owner will likely cause a push-back against India's attempt at extra-territorial jurisdiction. If a person in India buys a derivative in India and sells it to an investor in London, India does not have the right to ask about the London investor unless in the context of an investigation, and in cooperation with the authorities in London. Strong arm tactics for unreasonable information requests will drive up the cost of doing business in India. This is not in our interest.


Conclusion


To conclude, Indian regulators and Indian tax authorities, amongst others, have long expressed concerns about PN. A better understanding about how the PN market serves India's interest shows that this concern is misplaced. This market provides a valuable service by giving global investors a lower cost channel into Indian investments. Without this market, the cost to the global investment community in Indian investments would go up, their engagement with India would go down. This is not in India's interest. If we do want better knowledge about the beneficiary owner, we would do better to reform our tax policy, our capital controls and our financial regulation to bring the business directly into India. This would be far more effective in strengthing our regulatory control, without hampering much needed global investments into India.

Friday, August 07, 2015

SEBI's new "trade annulment" policy

by Nidhi Aggarwal, Chirag Anand.

One of the main functions of organised financial markets is efficient price discovery. Under certain circumstances, prices fail to reflect the correct information. These include erroneous trades or market manipulation. Trades at non informative prices impose significant costs on other market participants and the public at large. There can be a market failure in the form of a negative externality imposed on other market participants by way of distorted prices.

As has been found around the world, incidents of erroneous trades and market manipulation have been experienced in India, which have adversely affected the functioning of markets. Erroneous trades can occur either due to the so-called fat-finger trades, trades caused by bad algorithms, or buggy software. With the growth of algorithmic trading and an overall increase in the number and pace of orders entering the exchanges, the probability of such occurrences may increase.

In an attempt to address these concerns, in a circular dated July 16, 2015, the Securities and Exchange Board of India issued guidelines for annulment of trades by stock exchanges. These new provisions are required to be implemented by the exchanges within one month of the issue of the circular. The policy comes after a discussion paper released by SEBI in October 2013 on the same topic. The paper had sought public comments on a policy that proposed trade annulment on occurrence of erroneous trades under "exceptional circumstances". The Finance Research Group at IGIDR had responded to the discussion paper with an analysis of the proposed intervention by SEBI. We argued that the costs of cancelling trades under any circumstances are much higher than the benefits envisioned. The published regulation suffers from the same flaws that were present in the discussion paper.

The new framework


Traditionally, stock exchanges have been empowered to annul trades either suo moto, or on receipt of requests from stock brokers. Under the new regulation, the regulator has directed the stock exchanges to consider a trade annulment request if it is sent within 30 minutes of execution of the trade(s). This time limit can be extended to 60 minutes in case of "exceptional circumstances". The stock exchanges are required to communicate the receipt of such requests in a time bound manner to all market participants and convey a decision on the request not later than the start of next trading day. With respect to examining such requests, the circular mentions:

"2.5. .. While examining such requests, stock exchanges shall consider the potential effect of such annulment on trades of other stock brokers/investors across all segments, including trades that resulted as an outcome of trade(s) under consideration."

"2.7. Stock exchanges shall undertake annulment or price reset only in exceptional cases, after recording reasons in writing, in the interest of the investors, market integrity, and maintaining sanctity of price discovery mechanism."

In addition, stock exchanges are required to define "suitable" criteria so as to discourage frivolous trade annulment requests from stock brokers. The regulator has asked exchanges to charge stock brokers an annulment application fee which could range between Rs 1 lakh to Rs 10 lakh. The circular also says that the exchange shall penalise brokers who put in erroneous orders.

Evaluating the new framework


A clear policy on erroneous trades is a welcome step from the regulator, since a) it addresses the market failure induced by hurting the normal course of price discovery process, and b) it removes the uncertainty for other market participants on how such trades will be handled in the event of their occurrence. However, as has been argued on this blog before (see here, here and here), trade annulment is a bad solution for numerous reasons:

  1. Moral hazard: Bailing out trading firms by cancelling trades introduces moral hazard. These firms are supposed to have adequate risk control systems. With such an option in place, trading firms will be less careful in building high quality algorithms or trading systems.
  2. Deters market stabilising trading strategies: In the case of extreme events, two types of trading strategies help markets to recover: First, strategies that place orders far away from the touch, and second, the presence of active traders who come into the market to take opposite position. These strategies are often high risk strategies. Trade annulment will deter these traders to enter the market during stress events. This will reduce market resilience. The idea should instead be to make markets more resilient to such shocks.
  3. Hurts other market participants: Several market participants (especially the liquidity providers) generally take positions across several asset classes (example: equity spot and futures). Cancellation of trades on one asset class leaves them exposed to risk on the other leg.
  4. Leaves space for regulatory capture: The current policy essentially leaves the decision for trade annulment to the subjective satisfaction of the exchanges. Such vague powers give the exchanges undue power and leaves space for regulatory capture -- a dominant group of traders or large firms with large share in trading will stand to benefit under such a system, while day traders and other small traders will lose out. A previous instance of trade annulment by BSE after a trading error shows how giving powers to the exchanges to decide on trade annulment can result in undesired outcomes.
  5. Moral hazard in trading strategies: It is difficult to ascertain whether trade cancellation requests are made in good faith. Once the law allows that fat finger trades can be annulled, rogue traders can take advantage of that rule to enter into trades and get them cancelled subsequently. As an example, imagine the following steps: Long nifty vol followed by a big fat finger trade on Nifty spot followed by closeout of the options position.
  6. Ambiguity in language: Section 2.7 of the regulation uses the phrase "in the interest of the investors, market integrity". These are very broad terms, and, as discussed above, open to subjective interpretation by the exchanges. Such words should not be used when drafting law.

The issue of erroneous trades is analogous to the issues of industrial safety, where a failure occurs when a firm fails to deploy adequate safety measures to prevent catastrophic events. The Bhopal gas tragedy in 1984 is an example of such a failure. The gas leak accident at Union Carbide India Ltd. caused several deaths and affected many thousands of people. The firm failed to deploy enough resources to have developed a safety mechanism to avoid such a catastrophe.

By this reasoning, trade annulment should be prescribed only if the exchange's order matching software fouls up, or if there was a systematic breakdown of connectivity to the exchange. In all other circumstances, trade annulment is a poor strategy. It messes up the sanctity of order matching processes and questions the finality of trades. It provides wrong incentives to the doers of such acts and sets all the wrong precedents. A trading firm should be mandated to place proper checks and balances in their operations, and in the event of such a failure, should be penalised to compensate for the damage caused to other participants in the system.

Taking the example of other jurisdictions, internationally, such trades are cancelled only if the price movements are beyond certain thresholds. Even though such a practice is not recommended and often debated, there are clearly laid rules on when a trade will be termed as clearly erroneous. This leaves no ambiguity with respect to an exchange's decision on when a trade will be annulled versus not. The question of such thresholds does not arise in India since Indian exchanges already have hygiene checks in the form of margin money, price bands, circuit filters, pre-trade order limits, that should not allow large price movements beyond thresholds. Exchanges are responsible for maintaining and running perfectly functional systems with all these hygiene checks well in place. These systems should guarantee functionality and is a service provided by the exchange to the investors. Any failure in a service should be considered a breach of contract between the exchange and the investor, and the exchange should be penalised subject to the terms of the contract.

Good governance practices


The Handbook on adoption of governance enhancing and non-legislative elements of the draft Indian Financial Code issued by the Ministry of Finance in December 2013 states the good governance practices for issuing regulations. Section 4.4 'Comments on draft Regulations' of the handbook says:

"The regulator has to publish all representations received, and at least a general account of the response to the representations while publishing the final regulations."

SEBI has failed to publish an account of the representations made and explain why the clear criticisms were rejected.

Conclusion


SEBI's new policy on trade annulment does not address the issue of erroneous trades appropriately. If anything, it only leaves a great deal of ambiguity. Public policy thinking and regulation-making should be done in a more rational way.

Reducing delays in litigation by reshaping the incentives of litigants

by Shubho Roy.

Judicial delays are a major problem in India. There have been a number of attempts to solve these through introducing new legislation or tweaking existing laws. The tweaks usually involve putting ad-hoc numerical limits on the number of proceedings or delays. This approach has failed. A different approach is to create incentives for parties to not delay legal proceedings. This approach has been used worldwide with success. One example we show here, from the US, is Rule 68 of the Federal Rules of Procedure which sets up an interesting game to speed up litigation.

The problem


In enforcing contracts, India ranks 186 out of 189 countries. Judicial delays in criminal cases probably cause even more harm. To solve this problem the government has tried quite a few things. Amongst them are:

  1. The Arbitration Act and Conciliation Act, 1996 was made with the objective of providing litigating parties (mostly in commercial disputes) a system outside the court system through arbitrators, but within a legal system of the Arbitration Act. This law succeeded an older law of 1940 and was supposed to make India's law aligned with international law of arbitration.
  2. The Code of Civil Procedure which governs court proceedings in civil disputes was amended in 1999 (effective from 2002) requiring courts provide a maximum of three adjournments to a party in a case (times a party can delay a court proceeding for the day). This rule appears to be followed more in its breach. Similarly the costs imposed on parties for adjournments are puny compared to the actual costs in an adjournment. E.g.  Bombay caps costs for each days proceeding at Rs.100.

These attempts have not resulted in improved arbitration or reduced court delays. As a recent arbitration order against India in an arbitration under a bilateral investment treaty notes: An international investor could not enforce the arbitration award (i.e. legally collect the award) after winning the arbitration for a period of 8 years.

The government proposed an ordinance to amend the Arbitration Act, 1996 to speed up the process of arbitration. Amongst other changes, two key proposals are:

  1. A time of limit of 9 months for arbitrators to finish proceedings. If the time for proceedings exceeds the limit, the arbitrator will have to apply to the High Court to get an extension. The High Court may prevent arbitrators with long delays from taking up new proceedings.
  2. The government will cap total fees payable to an arbitrator.

These quantitative restrictions and price controls have three features:

  1. They are not new, and have been tried multiple number of times before.
  2. They have been a resounding failure in the past.
  3. They have many unintended consequences.

While speeding up arbitration is a step in the right direction, at the end if the losing party does not cooperate, the coercive power of the state has to be exercised. The Ease of Doing Business report notes that a contract enforcement in India involves 46 steps. Arbitration proceedings constitute only a fraction of those steps.

This award is symptomatic of what is wrong with squeezing the balloon in one place. We just create incentives for parties who want to litigate and delay to move their delaying tactics to other areas including:

  1. Appointment of arbitrators: When parties disagree whether an arbitration is required or who should be an arbitrator, the courts have to step in to start arbitration proceedings or appoint arbitrators. Parties unwilling to cooperate, will just use the same old delaying tactics in Indian courts to delay the appointment of arbitrators.
  2. Execution of arbitration awards: After winning an arbitration, the winning party still has to go to the court to force an unwilling losing party to pay up. Only a court order can block and transfer money out of a bank account or hold auction for a property of the loser. Again, this requires the winning party to go file an application before the court to get court official to assist in forcible takeover of properties, or get bank account records changed (usually called execution proceedings). The losing party can again use time tested delaying tactics in execution proceedings to lengthen out the suffering of the winning party.

Emphasising a single bad metric may have many bad unintended consequences. Arbitration proceedings should not be judged solely on the basis of time taken for the award. The quality of the award is also an important desirable feature of an arbitration. Arbitrary limits on time and fees work against the quality of the awards.

With the nine month deadline in the mind of arbitrators and a probable reduction of fees, the arbitrator will have the incentive to:

  1. Hurriedly finish arbitrations and push out a low quality award. Which will then be challenged in appeal before courts, thereby burdening the judiciary again.
  2. Take up more number of arbitrations to have the same level of income as before. This will have the same effect of pushing down the time and effort an arbitrator allocates to each case.

A single cost cap for arbitrator fees also ignores the complexity of modern arbitrations. Arbitrations today are not just limited to legal questions, complicated contracts in engineering, construction, high end services require specialist arbitrators with technical knowledge. Capping costs has a high risk of driving out competent and therefore expensive aribtrators outside India.

Reshaping incentives


In order to make progress, we should look deeper. We should understand the incentives of the parties to a litigation and then use policy interventions to modify these incentives. One useful example is from the US: Rule 68 of the Federal Rules of Civil Procedure. This is a more nuanced approach which discourages parties to litigate.

Rule 68: Winner beware


Rule 68 involves civil cases where the plaintiff (the suing party) is seeking monetary damages against the defendant (the party being sued). The rule has the following proposition:

At any time before the trial starts, the defendant can make an offer to the plaintiff to settle the case. Two copies of the offer terms are made. The plaintiff can accept or reject the offer. If the plaintiff accepts the offer, the cost of the trial is eliminated.

If the plaintiff rejects the offer, the judge is informed about the rejection but not the terms of the offer that was rejected (this is kept in a sealed copy with the court). If the plaintiff wins, there can be two scenarios at this point:

  1. The sum awarded in the judgment is higher than the sum offered by the defendant before the trial started.
  2. The sum awarded in the judgment is lower than the sum offered by the defendant before the trial started.

In the second case, the plaintiff has to bear the entire litigation costs incurred by the defendant from the date the offer was made by the defendant. The offer is not seen by the judge before the trial to prevent the judge's final determination from getting coloured by the offer of the defendant. The judge comes to the determination of judgment amount through the independent judicial process.

This rule is an elegant way to reduce litigation. At the beginning of a case, the judge has very little information about the merits of the case: In contrast, the parties know much more, having lived through the dispute. They are also in a better position to understand the true value of their economic loss. However, every plaintiff (who believes she will win) has an incentive to ask for more damages than actually suffered. Conversely, every defendant who knows that he has a weak case still has some incentive in drawing out a litigation, thereby delaying the eventual payout she has to make.

When an offer is made to settle, every plaintiff takes it as a signal about what the defendant thinks about the merits of her case. A high offer is interpreted by the plaintiff as that the defendant considers that the plaintiff is on strong legal grounds to win. This may push the plaintiff to continue with the trial, with the hope of getting a higher award in judgment rather than the settlement. However, by transferring the trial costs in case of a lower judgment value, a good counter incentive is created for the plaintiff. The plaintiff has to think hard about the offer and cannot reject it summarily.

Similarly, defendants have an incentive to offer lower settlement amounts because it may be used as a signal that the defendant has a good case. However, this rule gives an incentive to the defendant to make a fair and generous offer, knowing that if the court gives a lower amount the defendant will make significant savings in litigation costs.

The rule thus sets up an economic game where there is a strong incentive for both parties to avoid judicial systems without doing injustice and reducing the burden on the state.

Conclusion


Few problems are as important to India's emergence as a mature market economy and successful liberal democracy, as the problem of making courts work better. One element of this is a fresh approach to the administrative aspects of how courts work. The second element is to rethink rules in a way that is grounded in thinking about incentives. Compare and contrast the sophistication of Rule 68 with the 9 month and price capping rules that we are proposing in our arbitration law.

Thursday, August 06, 2015

Commentary on the MPC question


For older material: RBI independence and the IFC and How to design a Monetary Policy Committee.

And, see this on the work process that led up to the IFC.

Wednesday, July 29, 2015

Self trading is not synonymous with market abuse

by Nidhi Aggarwal, Chirag Anand, Shefali Malhotra, Bhargavi Zaveri.

1   Introduction


Orders that match with each other with no resultant change in the ownership are termed as self-trades. Lately, there have been increased concerns regarding self-trades in equity markets in India. With no genuine trading intent, these trades are seen as manipulative in nature, aimed at artificially pumping up the turnover to portray a false picture of liquidity. Self-trades are prohibited under the present law, and SEBI has punished several firms on this score.

In this article, we argue that there are some kinds of self-trades which do not constitute market abuse. With no manipulative or fraudulent intent, a trading firm can hit its own bid or offer. Penalising firms in such situations is wrong, and can act as a deterrent to trading in capital markets. Internationally, regulators have realised such possibilities, and taken necessary steps to ensure that legitimate cases of self-trades do not get punished. The Indian regulator needs to undertake similar steps.

2   Legitimate self-trades


Self-trades are generally considered to be non bona fide transactions. However, there can be instances where genuine trading intentions within the same firm result in self-trades. Such trades can occur in the course of normal trading when i) orders from two independent trading strategies coincidentally interact with each other, or orders originated from the same trading desk match with each other due to technical and operational limits of the existing infrastructure (such as matching engine technology). The following text illustrates such situations in detail.

2.1   Manual trading


Proprietary trading firms typically have several dealers operating in multiple securities. These dealers, independently, deploy trading strategies to make profit and to manage their own risk. Orders from these independent dealer desks originate from accounts with common ownership. Such orders, though initiated with legitimate purposes, can result in self-trades.

As an example, suppose a firm has two independent dealers. Both these dealers could be separated from each other by information barriers. Suppose they pursue following strategies:

  • Dealer 1: Arbitrage between BSE-NSE stock prices
  • Under this strategy, arbitrage opportunities arise when the price of a security trading on both BSE as well as NSE diverges significantly. By selling the security on the exchange with higher price, and buying on the one with lower price, a trader can make arbitrage gains. 

  • Dealer 2: Bullish strategy
  • In this strategy, the trader has a view about the direction of a security's price based on his analysis. If he anticipates that the price of the security is likely to go up in the future, he will buy that security. The trader makes a profit if the price actually moves upward at a later time-period.

Suppose that at a certain point of time, Dealer 1 sees a significant divergence between NSE and BSE prices of a security, with higher price on NSE and lower price on BSE. He, thus, sends a buy order on BSE, and a sell order on NSE to pursue his arbitrage strategy. Dealer 2, at the same time, places a buy order on NSE in pursuit of his bullish strategy on the same security.

Though completely legitimate, and without an intent to manipulate, the two buy-sell orders on NSE from two independent dealers can end up matching with each other. This trade, while being unintentional and completely co-incidental, when tracked at the legal entity level of the parent proprietary firm, will be characterised as a self-trade.

2.2   Algorithmic trading


The incidence of self-trades increases much more in the case of automated trading due to higher speed and the use of algorithms for making trade decisions. Similar to manual trading, two different algorithms within the same firm could be trading completely unrelated strategies. However, orders originating from these algorithms can also interact with each other without any malicious intention.

2.3   Latency issues


Another source of legitimate self-trades could be technological limitations. Exchanges and trader terminals are situated at different physical locations which affect order placement and trade confirmation timings. Orders sent to two different exchanges could reach with a delay because of difference in the speed of computer network lines. This time delay is known as "latency".

Algorithmic trading strategies doing arbitrage across two exchanges continuously send buy and sell orders. Due to latency differences across the two exchanges, traders may get "trade confirmations" exchanges at different time-points. A possible scenario where a self-trade can happen due to such technological issues and with absolutely no malicious intent is described below:

  • The arbitrage algorithm keeps sending buy orders to BSE and sell orders to NSE based on a price difference.
  • For a particular set of orders, trade confirmation on one leg of the order is received from one exchange, but not from the second exchange.
  • Meanwhile, the trader's algorithm sends a second pair of a buy and sell order to BSE and NSE respectively.
  • Later, it is realised that the second leg of the first order on BSE did not get execution. The trader will, thus, have to reverse the executed position on NSE for the first order.
  • To reverse the position, the trader sends a buy order to NSE.
  • This buy order on NSE ends up interacting with the sell order sent in Step 3 resulting in a self-trade.

All of the above are cases of self-trades that can occur within the same firm, but from separate or distinct underlying strategies with genuine trading interest. These examples show that it is wrong to think that all self-trading is market abuse.

3   Regulatory mechanism worldwide


Self-trading in securities is a concern for regulators worldwide. It has, however, been recognised that such trades can also happen with legitimate purposes. As a result, regulators globally have made various changes to accommodate for such transactions.

3.1   The US securities law


In an amendment to the securities law, the US SEC approved a rule change proposed by the Financial Industry Regulatory Authority, Inc. (FINRA) relating to self-trades in 2014. In its description of the proposed rule change, FINRA noted:

  • Transactions resulting from orders that originate from unrelated algorithms or from separate and distinct trading strategies within the same firm would generally be considered bona fide self-trades.

    Thus, the proposed rule allowed for legitimate cases of self-trades arising from unrelated trading strategies. Caution is however taken in allowing this form of activity by the use of the word "generally". In its response to a comment, FINRA noted:
    "although self-trades between unrelated trading desks or algorithms are generally bona fide, frequent self-trades may raise concerns that they are intentional or undertaken with manipulative or fraudulent intent".
  • FINRA issued guidelines for members to have policies and procedures in place that are reasonably designed to review their trading activity for, and prevent, a pattern or practice of self-trades resulting from orders originating from a single algorithm or trading desk, or from related algorithms or trading desks.

    FINRA noted that even if not purposeful, a material percentage or regularity of such transactions from related desks, may give a misimpression of active trading in the security. This can adversely affect the price discovery process. It is therefore recommended that members must put in place effective systems to prevent such trades. But it also stated:
    "the rule will not apply to isolated self-trades resulting from orders originating from a single algorithm or trading desk, or from related algorithms or trading desks, provided the firm's policies and procedures were reasonably designed".
    In defining "related", FINRA stated its understanding that discrete units within a firm's system of internal controls typically do not coordinate their trading strategies or objectives with other discrete units of internal controls, but that multiple algorithms or trading desks within a discrete unit are permitted to communicate or are under the supervision of the same personnel and thus, are presumed to be related. It also stated that the proposed rule permits firms to rebut this presumption, suggesting that a firm could demonstrate that "related" algorithms or trading desks are in fact independent or are subject to supervision or management by separate personnel.

Subsequently, after receiving comments from market participants on the proposed rule change, and minor amendments to the proposed law, the SEC approved the proposed rule change in May 2014.

The current rule reads as follows: Under the FINRA/SEC rule 5210(.02):

"Transactions in a security resulting from the unintentional interaction of orders originating from the same firm that involve no change in the beneficial ownership of the security, ("self-trades") generally are bona fide transactions for purposes of Rule 5210; however, members must have policies and procedures in place that are reasonably designed to review their trading activity for, and prevent, a pattern or practice of self-trades resulting from orders originating from a single algorithm or trading desk, or related algorithms or trading desks. Transactions resulting from orders that originate from unrelated algorithms or separate and distinct trading strategies within the same firm would generally be considered bona fide self-trades. Algorithms or trading strategies within the most discrete unit of an effective system of internal controls at a member firm are presumed to be related."

3.2   The UK securities law


The Financial Conduct Authority's (FCA) guidance also allows self-trades for legitimate cases. As per FCA MAR.1.6.2(2):

"Wash trades: that is, a sale or purchase of a qualifying investment where there is no change in beneficial interest or market risk, or where the transfer of beneficial interest or market risk is only between parties acting in concert or collusion, other than for legitimate reasons".

3.3   Self-trade prevention mechanisms by exchanges


With no information barriers and no technological limitations, it will be optimal that trading firms implement mechanisms to prevent self-trades at their own end. However, such an ideal world does not exist. In such a scenario, could we demand that trading firms establish systems to ensure that self-trading does not happen? Since matching occurs at the exchange's order matching platform, and hence, some degree of self-trades could be difficult to detect at the trading firm's level.

For example, when two separate dealers within the same firm send their orders to the exchange at different time points, those orders may still end up matching with each other if there are no other orders in the book. This can happen if one dealer sends a `buy' limit order at some point, while the other sends a `sell' market order at some later point of time. Similarly, if there is a large `aggressive' buy order sent by one dealer, and a normal sell limit order by another dealer which sits in the book, the `aggressive' buy order will first interact with the higher priority sell orders. If still some balance of this buy order is left, it may then end up matching with the second dealer of the same firm. In yet another case, it can also happen that one dealer sends a limit `buy' order at a point of time, but due to limitations in the exchange's order matching technology, it stands in the queue. After a point, another dealer from the same firm sends a 'sell' limit order and that order stands behind the first dealer's order. These two opposite orders can also ultimately end up matching with each other.

With no malicious intent, in all the above cases, these self-trades are inadvertent and difficult to identify at a trading firm's level. Several exchanges including the NYSE, CME, Euronext, Canadian Securities Exchange, ICE, NASDAQ have implemented self-trade prevention (STP) mechanisms that alert the traders to the occurrence of a self-trade from the same member, and let them make a choice to either, cancel the resting order, or the aggressive order. Some of the exchanges including the ICE and NASDAQ give the a choice to opt for the use for this service at either the company, group, or trader level.

In India, BSE introduced a similar system in January 2015 on its equity derivatives and currency derivatives segment. It extended the facility to the equity segment in March 2015. NSE will be introducing self-trade prevention mechanism in the currency derivatives segment starting August 3, 2015. The systems, on both the exchanges, however, only cancel the incoming (active) order of the client.

4   The current regulatory framework in India


Under the current regulatory framework, Regulation 4(2) of the Securities and Exchange Board (Prevention of Fraudulent and Unfair Trade Practices of Securities) Regulations, 2003 (SEBI (FUTP) Regulations) prohibits a person from indulging in a fraudulent or unfair trade practice.

The operative part of the regulation 4(2) reads as under:

"Dealing in securities shall be deemed to be a fraudulent or an unfair trade practice if it involves fraud and may include all or any of the following, namely:-

(a) ...
(b) dealing in a security not intended to effect transfer of beneficial ownership but intended to operate only as a device to inflate, depress or cause fluctuations in the price of such security for wrongful gain or avoidance of loss; ...
(g) entering into a transaction ...without intention of change of ownership of such security;..."

Since the buyer and seller in a self-trade are the same entity, there is no change in ownership of the shares. Clause (b) of Regulation 4(2) prohibits self-trades originated with manipulative intentions.

5   Issues with past SEBI orders on self-trades


We outline a case below and highlight how SEBI has failed to provide sufficient evidence of market manipulation, and refused to recognise co-incidental and unintentional self-trading activity which occurs (a) within a firm or (b) as a result of algorithmic trading.

In the case of Crosseas Capital Services Pvt. Ltd:

(a) The Adjudicating Officer (AO) said:

"It may be noted that these different CTCL ids belong to the same Stock Broker / legal entity i.e., noticee, therefore, matching of trades amongst them will have to be considered as a 'self-trade'."
...
"Further, the argument of the noticee that final trader id may be identified by CTCL id is not the right interpretation and the self-trades at the member level has to be considered because the UCC for each client is different in case of trading for clients whereas in the case of proprietary trading the trades are executed in member's 'PRO' code irrespective of number of dealers / traders employed to execute the proprietary trading."

The AO, here, considered a proprietary firm's trading activities solely from the viewpoint of the legal entity, and not at the trader id or dealer level.

As described above as legitimate cases, self-trades occurring from unrelated trading desks, and functioning independently may not be manipulative, and need to be considered separately. Exchanges themselves, register the user id and terminal ids for each dealer. It is therefore, inappropriate to not consider trades at the level of traders or terminals.

(b) The AO said:

"... the total self-traded volume is 78,927 shares at BSE and 38,229 shares at NSE which is very high."
...
"The number of instances of self-trades executed by the Noticee is extremely high i.e. 6,051 trades at BSE and 2,985 trades at NSE which is not miniscule by any stretch of imagination as contended by noticee."

The AO states that there was a very high scale of self-traded volume. The said volumes are respectively 0.53% and 0.10% of the total quantity traded that day on the security on BSE and NSE. SEBI failed to establish materiality by comparing these numbers to an appropriate benchmark.

6   Judicial treatment of unintentional self-trades


The Securities Appellate Tribunal (SAT) has, previously, refused to acknowledge unintentional self-trades that emanate from independent terminals and traders, and has obligated firms to prevent self-trading by all means.

  • In Systematix Shares & Stocks (India) Limited vs SEBI, SAT held:
    "..Trades, where beneficial ownership is not transferred, are admittedly manipulative in nature".
  • In Anita Dalal vs. SEBI, SAT held:
    "Self-trades admittedly are illegal. This Tribunal has held in several cases that self-trades call for punitive action since they are illegal in nature."
  • In Triumph International Finance Ltd. vs. SEBI, the Tribunal held:
    "The buyer and the seller were also the same. It is obvious that these trades were fictitious to which the appellant was a party. They were fictitious because the buyer and the seller were the same."

 

7   Solution


In India, FUTP regulations do not deal with legit self-trading activity which may happen within a firm without intent of manipulation. Since there is no clear law which deals with self-trades specifically, even genuine self-trades activity often falls under the "unfair trade practice" category.
In light of these issues, the following changes are proposed as a solution to deal with self-trading activity.

7.1   Legislative actions


The current SEBI FUTP regulation 4(2), 2003 should be amended as:
  1. Clause (g) of 4(2) treats all self-trades as manipulative and should be removed.
  2. The following clauses should be included in this section:
    • Transactions in a security resulting from the unintentional interaction of orders originating from the same firm that involve no change in the beneficial ownership of the security, generally are bona fide transactions. Transactions resulting from orders that originate from unrelated algorithms or separate and distinct trading strategies within the same firm would generally be considered bona fide self-trades.
    • Algorithms or trading strategies within the most discrete unit of an effective system of internal controls at a member firm are presumed to be related.
    • Members must have policies and procedures in place that are reasonably designed to review their trading activity for, and prevent, a pattern or practice of self-trades resulting from orders originating from a single algorithm or trading desk, or related algorithms or trading desks.


7.2   Improvements in SEBI processes on the executive functions


The following measures should be adopted by the regulator to deal with, and investigate self-trading activity:

  1. Before starting the investigation, the number of shares traded via self-trades should be significant i.e. above an appropriate benchmark, in terms of volume and value of transactions.
  2. The regulator should be able to reasonably demonstrate the impact of self-trades on the price.
  3. Patterns and practice of self-trades should be looked at before considering them as manipulative.
  4. Exchanges should implement Self-Trade Prevention systems and offer these services to its members on a voluntary basis.
  5. The regulator should issue guidelines regarding self-trading in line with the proposed changes to the law.

These rules need to be woven into the internal process manuals at SEBI on enforcement against market abuse.

8   Conclusions


At present, subordinate legislation by SEBI, enforcement actions by SEBI and rulings at SAT are unanimous in viewing all self-trading as being synonymous with market abuse. In this article, we have demonstrated that this presumption is incorrect. Some but not all self-trading is market abuse. Financial regulators elsewhere in the world have obtained greater precision in enforcing against market abuse while not punishing legitimate actions. We have shown actions that need to be undertaken at SEBI on the legislative and the executive side in order to address this problem.

The discussion above has been couched in the language of the equity market, which is the most sophisticated component of the Indian financial system. It is, however, completely general and pertains to all organised financial trading. As an example, if SEBI implements the above improvements, all this progress will immediately accrue to commodity futures as SEBI is now the regulator for commodity futures trading also. In the future, when the Bond-Currency-Derivatives Nexus moves from RBI to SEBI, similar gains will accrue there also.

Acknowledgements


We thank Pratik Datta, Shubho Roy, Anjali Sharma, and Susan Thomas for their valuable comments.

Thursday, July 23, 2015

Indian Financial Code v1.1 is out

When the Financial Sector Legislative Reforms Commission (FSLRC) produced the draft Indian Financial Code (IFC) in March 2013, the Ministry of Finance put it out for public review and comments. This version is informally termed IFC v1.0.

Hundreds of comments were received on this first draft. Justice Srikrishna and his team worked on these comments and have come out with a revised draft Indian Financial Code. This is informally called IFC v1.1.

Today, the Ministry of Finance has put this revised draft out for public review and comments.

IFC v1.0 was the result of a thorough and careful process. Even though enormous time and effort was put into it, with the benefit of hindsight, it had numerous blemishes. With the benefit of hindsight, I feel that within IFC v1.0 there were many projects running in parallel, and their inconsistencies of approach were visible in the final product.

IFC v1.1 is a polished product. With the benefit of 853 days of elapsed time, many blemishes have been found. The code is much more orthogonalised: general concepts are consistently applied. It now reads as simple and precise English. I can't think of many laws in India which match the quality of thinking and drafting of IFC v1.1.

Where does this fit into the Indian financial reforms?


India's financial reforms are working on three tracks:

  1. The first element is the legislative process that should, at some point in the future, lead to Parliament enacting the Indian Financial Code. The February 2015 Budget Speech by Arun Jaitley said he will table this in Parliament `sooner rather than later'. The release of IFC v1.1 today is an important milestone in this legislative track.
  2. The second element is building institutional capacity to enforce the new law. In India, building high performance institutions is difficult. As with SEBI or PFRDA or NSDL, it makes sense to build the institutional capacity ahead of time so that when Parliament passes the law, it can immediately be enforced. When the law is enacted without adequate planning for the institutional capacity, this can lead to difficulties as was seen with the Companies Act, 2013.
  3. The third element is to treat FSLRC as the strategy and chip away at incremental changes within the existing legal framework to move towards this goal. This also builds institutional capacity, and reduces the complexities after the law is passed. It front-loads the gains: why not reap the fruits of improved financial sector policy sooner rather than later? Elements of this include: (1) The FSLRC Handbook, (2) the SEBI-FMC merger (backdrop and then Budget 2015), (3) shifting regulation-making power on non-debt capital controls from RBI to MOF (Budget 2015), (4) inflation targeting as the objective for RBI, (5) Finance SEZs, (6) Appeals against all financial agencies other than RBI at a tribunal named SAT.

State capacity is about well drafted laws and sound institutions that enforce these well drafted laws. The Indian malaise with chronically malfunctioning institutions is as much about badly drafted laws as about badly designed organisations. A quantum leap in the law -- the IFC -- will not solve the problem by itself. A similar quantum leap in the working of financial agencies is also required. In order to do this in a systematic way, MOF has invented a new framework involving `task forces' which lay the foundations for a financial agency before the management team is recruited.

At present, five task forces are in motion -- to build the Financial Sector Appellate Tribunal (FSAT) that will hear appeals against all financial agencies, the Public Debt Management Agency (PDMA), the Resolution Corporation (RC), the Financial Data Management Centre (FDMC) and the Financial Redress Agency (FRA).

Each of these five projects would take over three years from start to finish. One one hand, this is frustratingly slow. We need the FRA or the  FSAT or the PDMA or the FDMC or the RC yesterday. But it's not possible to do these things in reduced time. The time horizons for these projects are consistent with the time horizons for IFC to go through the parliamentary process.

Wednesday, July 22, 2015

What is the role of WPI in monetary policy?

by Jeetendra.
 
The RBI just can't seem to catch a break. Try as it might, it just can't seem to escape controversy, even over issues that in other countries are not exactly controversial. Take the case of which particular inflation index the RBI should use as its target. For an entire decade, people debated ferociously over whether the target should be the  CPI or the WPI. Finally, about a year ago it seemed that all the arguments had been exhausted and a consensus had been reached that the CPI was best. So, Governor Rajan announced that henceforth the RBI would target the CPI.

Case closed? Not at all! It turns out that reports of the debate's death had been greatly exaggerated. On July 9 the Business Standard reported that a growing chorus of businessmen and analysts are complaining that CPI targeting has led the RBI astray, causing it to set interest rates too high. They want the RBI to target the WPI, which shows that prices are actually falling.

Did the RBI make a mistake? To answer this question one needs to go back to basics, and think about what monetary policy is trying to achieve.

The main goal of monetary policy is to provide a particular service to the population, the service of ensuring stable prices. This task is of such importance that the RBI was set up as a special institution, organisationally distinct and geographically separate from the government. When that set-up did not prove sufficient to safeguard low inflation, further reinforcements were put in place. The RBI adopted a formal inflation targeting regime, and the government in turn promised to provide the central bank with the operational independence needed to achieve the agreed inflation target. The Monetary Policy Framework Agreement, which was signed by Finance Secretary Rajiv Mehrishi and RBI Governor Raghuram Rajan on 20 February 2015, creates this formal arrangement. All this is being done because price stability is critical to the welfare of the population, especially the weaker sections who suffer badly whenever the prices of their necessities rise.

So far, so good. The problem comes when one needs to translate the universally agreed objective of price stability into a specific monetary policy stance. To do this, one needs three things. First, a specific measure of inflation. Second, a definition of what it means for this measure to be “stable”. And third, a framework (which could be based on an econometric model) for deciding what level of interest rates would best achieve the inflation objective.

In other countries, most of the debate has centred on the third issue, whereas the first two have proved relatively easy to address. Virtually all inflation targeting central banks define price stability as inflation somewhere between 2 percent and 5 percent. And they measure inflation using the CPI, because the objective is to improve consumer welfare, and the index that measures the price of consumption goods is the CPI.

In contrast, WPI is only distantly related to consumer welfare. For a start, it is unclear what the WPI is actually measuring. Its coverage is extremely limited, encompassing only the commodity-producing sectors and completely ignoring services, which constitute more than half of the economy. The few sectors that are included are then weighted according to their gross value of production, not their value-added. Consequently, the index is deeply unrepresentative of the economy.

But let’s suppose the RBI were prepared to ignore these theoretical issues. It would run immediately into some very practical difficulties. Since the WPI consists mainly of commodities, the movement of this index is heavily influenced by developments in world markets, which the RBI cannot control. The RBI cannot determine the dollar price of oil. And while it can influence the rupee price by controlling the exchange rate, this is a dangerous strategy, as the East Asian countries discovered at their peril in the late 1990s, when their exchange rate pegs collapsed in crisis. So, the reality is that the RBI cannot control the WPI, and should not try to do so.

Does that mean the RBI should just ignore the WPI? Not at all. Recall that achieving price stability – even if measured solely by the CPI – requires a framework for figuring out what level of interest rates is required to obtain this objective. And this is where the WPI does indeed come in, as do various other measures of prices.

Just not in the way that the analysts quoted in Business Standard argue. According to them, interest rates have been set on the premise that the economy and inflation are proceeding apace (as indicated by the rising CPI), whereas in reality manufacturers' prices are falling (as shown by the declining WPI). So firms are getting squeezed between high interest rates and low prices.

Firms may well be suffering from a profit squeeze. In fact, the corporate results suggest they are. But you can’t prove this by citing the WPI. That’s because the WPI does not measure output prices, the prices at which firms are selling their goods. The index that does this is the PPI, or producer price index, which unfortunately does not exist for India. Rather, the WPI is essentially a measure of input prices, because it consists mainly of commodities, which are largely inputs into production. Accordingly, a falling WPI actually increases firms' margins, improving their profitability. (Think: oil.) As a result, there’s no need, at least not from the falling WPI, to compensate firms in the form of lower interest rates.

That said, there is a kernel of truth in what the Business Standard analysts are saying. To see this, let’s go back to basics again. Very broadly, inflation occurs when aggregate demand exceeds aggregate supply. And aggregate demand is influenced by many factors, including many different price indices. Consumption decisions depend in part on interest rates adjusted for CPI inflation. Export demand depends partly on interest rates less export price inflation. And investment demand is influenced by the difference between interest rates and PPI and WPI inflation. Summing up all of these factors is impossible to do intuitively. That’s why central banks employ large econometric models to guide their policymaking.

So, in the end, the analysts quoted in Business Standard have a point. The WPI and its attendant data bank of price time series, should be taken into account, indeed perhaps is already taken into account, in the RBI’s policy-making framework. But it cannot be the object of this framework. The sole inflation target should be, indeed must be, the CPI. After more than a decade, it is really time to put this debate to rest.

Addressing mis-selling in Indian finance: Lessons from South Africa

by Sanhita Sapatnekar.

The setting


When a person seeks treatment from a doctor, he may worry about medical expenses or test results. What he probably does not worry about is a third party paying the doctor to actively damage his health, by providing unsuitable advice or administering an inappropriate medical product. In consumer finance, however, this happens all the time. Customers approach those perceived as finance experts for advice on financial products, or to buy these products. These experts often provide unsuitable advice or inappropriate financial products to the customers, because a third party is paying them to do so.

This problem is present across a large swathe of Indian household finance. As an example, a careful examination of one episode of one class of mis-selling problems has showen an estimated loss to investors of Rs. 1.5 trillion, or USD 28 billion from 2004-05 to 2011-12.

Three parties are involved in this problem:

  1. The product supplier, whose goal is to sell his products;
  2. The `middle-man', or the intermediary, who facilitates the product sale in
    return for a commission; and
  3. The customer, who may potentially buy the product.

While `financial intermediary' in general covers all financial firms, in the present context, it refers to the persons who engage in the front-end seen by customers, and not the financial firms such as mutual funds who produce the product upstream.

Just as the doctor plays both the role of providing medical advice to the patient, and occasionally that of distributing the medicine provided by the product supplier, intermediaries perform two roles in the Indian financial distribution system: they perform advisory services for customers and provide distribution services to product providers (such as mutual funds and insurance firms).

How is retail finance different from health?


The first key difference is that, unlike in the health setting, intermediaries in India sell financial products to customers but earn commissions from the product suppliers. Intermediaries are likely to focus on the potential commission they can earn when selling a particular product, rather than catering to the best interest of customers. In the health sector, this situation is less prevalent as the intermediary (i.e. the doctor) earns his income from the consumer (i.e. the patient), and not the service provider (i.e. the company providing the medicine); the doctor's financial incentives are driven by patient satisfaction. Several retail finance mis-selling episodes can be traced back to this arrangement. While advice may not be explicit, given the nature of the products, it is embedded in the distribution. The advisory role is particularly important considering that India has an estimated 65% of the population that is financially illiterate.

Second, unlike in the health sector where the type of doctor (and the type of service they are qualified to provide) is clearly defined, the retail finance distribution system in India lacks these definitions. This allows for gaps and overlaps in the type of intermediary, and therefore the service they provide (e.g. whether an intermediary is a qualified financial advisor, or just a salesperson, needs to be clearly defined before the consumer can make an informed choice on whether to take the intermediary's advice). While a patient would ordinarily not seek advice on a heart condition from a gynaecologist, a retail finance consumer may find himself taking advice from an intermediary not qualified to provide that advice, as regulations governing the type of intermediary, and therefore the type of services they are qualified to provide, are weak.

Third, a retail intermediary can play both the role of the salesperson and the advisor, because the retail finance advisory market is underdeveloped. Usually, a patient actively seeks medical advice from a doctor when he is in need of it. Medical products are therefore pull products. Under the present arrangements, the same patient may never seeks advice in the retail finance sector. This has made retail finance in India a zone of push products. This has given two groups of problems: The lack of demand for advice has hampered the development of the advice industry and the pervasive supply of advice by conflicted intermediaries is leading to bad decisions by households.

Fourth, grievance and redress mechanisms in the retail finance sector are underdevloped and inconsistently applied. Currently, each regulator is responsible for providing redress relating to products under their jurisdiction. As a result, there is no standardised service for redress, especially for consumers of complex products that fall under more than one jurisdiction. In the health sector, the ethical incentive to ensure a patient's health is maintained has resulted in enforced regulations aimed at curbing malpractice; if the doctor were to intentionally administer the wrong medicine, it is likely he would face consequences for his actions, as institutions that allow for redress are already established and developed. This factor leads to mis-selling as, unlike in the health sector, intermediaries know they are more likely to get away with selling an unsuitable product to a consumer, or giving inappropriate advice.

Mis-selling in South Africa


In the study of how mis-selling is being treated in other jurisdictions, we often turn to the UK or Australia. An interesting case study on this subject is South Africa, a country whose financial system is more comparable to India.

The South African financial distribution system has suffered from large scale mis-selling. The country's financial literacy rate is estimated to be 34% (comparable to India's 35%), and the financial distribution regulatory framework has not been effective in protecting consumers. The 2002 Financial Advisory and Intermediary Services (FAIS) Act made progress in raising intermediary professionalism, improving disclosure to clients and mitigating certain conflicts of interest. However, poor customer outcomes and mis-selling of financial products persisted. As a result, the South African Financial Services Board (FSB) initiated its own Retail Distribution Review, the findings and proposed recommendations of which were published in November 2014.

The RDR approaches the current landscape in South Africa from three perspectives:

  1. First, it looks at services provided by intermediaries. The RDR proposes clearly defining the types of services provided as advice (which is a service to the customer); intermediary services (which are services connecting product suppliers and customers); and other services provided by advisers and intermediaries (which are services to product suppliers). Further, the RDR defines types of advice an intermediary can provide. The RDR then sets proposed standards for each type of advice, including intermediary disclosure requirements and steps for mitigating and managing certain conflicts of interest.

  2. Second, the RDR looks at the relationships between intermediaries and product suppliers. In line with defining the types of advice offered, the RDR proposes definitions for the types of advisers, based on whether they are tied to one or more product supplier, or if they are independent. The RDR also sets proposes qualifying criteria for an adviser to be fully independent based on the products offered; the product supplier in connection with these products; and level of influence from product suppliers. Standards for product suppliers' responsibilities are proposed for each type of adviser as well as for non-advice sales.

  3. Third, the RDR looks at the remuneration earned for the services concerned. Among the proposals relating to remuneration, the most notable is the one banning commissions for all investment products, which comes only after the recommendations for reconstructing the retail distribution system. The recommendation states that: Product suppliers will be prohibited from paying any form of remuneration to intermediaries in respect of investment products, and from including any costs associated with intermediary remuneration in product charging structures, whether in the form of ongoing charges or early termination charges. Intermediaries will correspondingly be prohibited from earning any form of remuneration in respect of investment products other than advice fees agreed with the customer, in accordance with the applicable requirements for such fees.

Lessons for India


South Africa's financial distribution system is complex and lacks clear structure. As a result, creating legislation to address mis-selling without first restructuring the distribution system (including defining services provided and relationships between intermediaries and product suppliers) has failed as a solution, as demonstrated by the FAIS Act.

In countries such as the UK and Australia, where these definitions are already in place and redress mechanisms are well established, the focus of regulatory reform falls mostly on resolving conflicts of interest in relation to intermediary remuneration. The South African proposals also address intermediary remuneration, but only after first addressing the services provided by intermediaries and the relationship between intermediaries and product suppliers. In India (as in South Africa), the problem is twofold:

  1. A sound distribution framework needs developing before implementing changes to commission structures can be fully effective. This entails conducting a thorough review of the current retail distribution system in India, developing a clear understanding of retail distribution dynamics, and then establishing rules and regulations on the types of services provided by intermediaries; their relationship with product suppliers; disclosure norms; and qualifying requirements.
  2. Effective grievance and redress mechanisms that are consistently applied nationwide across the retail finance sector (regardless of which regulator's jurisdiction a financial product comes under) need to be developed.

In the short run, consumer protection thinking will need to be grafted on top of the present legal framework in India, which was not designed with consumer protection in mind. Financial agencies are in the process of adopting the FSLRC Handbook where Chapters 2 and 3 are about consumer protection. This article should feed into this work process.

The fuller solution, however, requires the Indian Financial Code (IFC). The IFC approaches retail finance with consumer protection as an objective, making it the regulator's responsibility to create regulations for these consumer protection provisions. The IFC defines "advice" as a "recommendation, opinion, statement or any other form of personal communication directed at a consumer that is intended, or could reasonably be regarded as being intended, to influence the consumer in making a transactional decision". Further, it defines a "retail advisor" as a "financial service provider or financial representative that gives advice to a retail consumer".

The draft law then gives the regulator powers to discharge its functions with the objective of protecting and furthering consumer interests, and promoting public awareness of financial products and financial services. The IFC then places the responsibility of making regulations for these provisions to the regulator. Under the IFC, the regulators could thoroughly review and reconstruct the retail distribution framework within these bounds.

The Ministry of Finance has established a task force aimed at creating the Financial Redress Agency (FRA) of India, as envisaged in the IFC. The FRA will be a nationwide independent agency providing redress for financial consumers across all sectors, with the ability to handle large volumes of relatively low value complaints. While this addresses the grievance redress aspect of the problem, other provisions in the IFC facilitate the second aspect, and allow for the retail distribution system to be reconstructed.

Acknowledgements


I thank Renuka Sane for valuable discussions.