My experiments with truth in the Indian capital markets

by C. B. Bhave.

Thank you, Bangalore International Centre, for the invitation.

I joined SEBI in 1992. SEBI was given statutory status in that year and was facing huge hostility from brokers. They thought that their freedom would now be curbed by the new regulator. In any case, they did not think that SEBI knew anything about the markets. Some parts of Government were also hostile to SEBI since they thought that their turf was being encroached upon. In 2014, SEBI is a respected regulator nationally as well as internationally. You must have recently read that according to a study carried out by IOSCO and BIS, Financial market regulation in India was rated among the top 6 in a study of 27 top markets.

In 1996, I quit SEBI and the administrative service to set up NSDL - a depository for keeping share ownership records electronically and for facilitating easy settlements. In 1998, the magazine Global Custodian described the Indian market settlement system as the worst in the world (in a study of more than 80 markets) but facing stiff competition from the Russian market for the last place! By 2001, the same magazine placed India in the top 10 markets in the world. These rankings are in sharp contrast to India generally being placed between 100-120 when 150 countries are compared internationally whether it be on health parameters or on poverty or on corruption. The examples of SEBI and NSDL show that we don’t always have to be among the worst, even though we may be starting there. SEBI’s journey from being a fledgling institution to an internationally respected regulator is both fascinating and instructive. It tells us first and foremost that notwithstanding the enormous challenges, reform and overhaul of huge structures is possible in India.

It appears to me that our resistance to change is on account of our being a risk averse society. We are quick to agree that the existing state of affairs in a given area is no good, but each suggestion for change meets with such a multitude of objections that the status quo appears to be the best option. We need to develop tolerance for failure. By trying to keep away from failure, we miss out on valuable learning. We overdo this to an extent that we lose faith in ourselves. We persuade others as well to lose faith in us.

In 1996, I made the decision to give up the administrative service and set up NSDL, the depository. It was an exciting challenge and it was crucial to further reforms in the market. It is amusing to recall what people said to me then. There were many who believed that the depository would fail in India. The conversation would run like this: "The US and Europe have depositories: we cannot be compared with them. That is a developed world. Singapore has a depository: Oh, it is also more developed and is just a city-state. Even Sri Lanka has a depository. It is a developing country. Yes, but it is again just a small island nation. China is setting up a depository. Where does China have democracy? How can you compare China and India?"

India seemed to be in a peculiar place where the problems associated with paper certificates could not be handled. At least do not give up the Service was the last argument. I had a problem there. If the depository was so likely to fail, how would I carry any conviction with the people I was to recruit? Would they be comfortable with a boss who had a safe harbor or one who would sail and sink with them? I had to burn my boats. The irony was that these were my well wishers telling me why the depository would not work. We, in India believe that we have a problem for every solution. There is a lot of truth in this humour. There is hope, however. Young people are an exception by and large. The India we see today is different from the India of 1996. We seem to be well on our way to `can do' from a position of `cannot happen'.

In July 1993, I was invited to a seminar to be on a panel that was to discuss some fundamental changes that the panelists expected to see in their respective areas. One CMD of a nationalised bank was presiding over the panel. I was the last person on the panel before lunch. As is usual in our seminars, I had very little time because earlier panelists had been generous with their interpretation of the time allotted to them. NSE was expected to start its operations that year and automation of trading was, to my mind the most exciting thing that would change the shape of things in the capital market. I was barely five minutes into describing the changes and the presiding officer declared that I needed to wind up in the next two minutes. I was disappointed but wound up saying that time does not permit me to say more. While the rest of the audience and the speakers made their way to lunch, a group of 15-20 youngsters sat me down and said they wanted me to complete what I was saying and wanted to interact with me. There is hope in the young.

Let me give you another example of how young minds work. We needed to set up our mainframe in September 1996 in order to meet our deadline of starting depository operations in November 1996. This was to be done in a building that was still incomplete. We needed to take the mainframe to the fourth floor. The lift was installed but did not have the lift inspector’s permission to be made operative. We did not want to bribe anyone. The mainframe could not be carried via the staircase. Youngsters in NSDL found a solution. We operated the lift mechanically to load the mainframe. We did not break the law and yet kept to our principle.

Reform can be a long and painstaking process. It is almost never a one shot exercise. SEBI identified `Badla' (a particular method of carrying forward the settlement of a trade by getting a lender to intervene) as one of the structural issues in the trading system in India. SEBI’s initial attempts to do away with Badla met with fierce resistance. So much so that the then SEBI Chairman was moved out! Badla was eventually reintroduced. Most people thought that the issue had been buried forever. It appeared that there would be no way that the Indian Market would ever be rid of Badla. However, there were many reasons why the Badla system was popular. These related to lack of many other legitimate facilities needed in the market. SEBI kept working on these issues. Finally, when Badla was done away with eight years later, there was hardly any murmur. Reforms need persistence.

The proponent of a new idea must take into account the reasons why the existing idea came about in the first place. It may have come into place because something else did not work. These linkages are important. If we act to take care of those aspects as well, reform will be so much the easier. Our market used to have very long settlement periods. Long settlement periods introduce avoidable risk in the market. Despite SEBI’s best efforts we found that delays could not be reduced to less than ten days. A modern depository system was a must before any further reduction could be attempted. Today India has a settlement system that matches with the best in the world. There are less than ten countries in the world that settle as fast as the Indian Market.

In capital market regulation, the regulators find that they will not hear the voice of the retail investors unless the regulator makes a specific attempt to hear them. The big corporations have access to media and the powers that be. They can make sure that their difficulties reach your ears. The intermediaries and the institutional investors are similarly placed. If special efforts are not made to reach out to non-institutional investors, there is a danger of missing out an important piece. This is a difficult job. The non-institutional investors are not very well organized. There are investor associations that serve as a fair proxy for this work. It can sometimes be a thankless job. If, in the process of securing the interests of investors, market intermediaries are hurt, you can face a lot of criticism and voices would be so loud that it would appear that your judgment was altogether wrong. It is important not only to stand firm but communicate your view effectively.

Acting for investors can be a difficult task sometimes. Let us say I am serving one lakh clients and I find a clever way of charging my clients Rs. 10 extra every month. The clients do not feel the pinch of that extra money and if I am clever they do not even know about it. In any case what does Rs 10 buy today? But my gain is Rs 10 lakhs a month. Now if a regulator comes along and stops this practice, I have a huge incentive to cry foul. I would brand the regulator market unfriendly, would advise it not to interfere in small matters and focus on issues of policy. What is the incentive for the man who gained Rs 10 to argue the opposite? Very little. So this may appear a thankless thing to do. Regulators need the will to go the extra mile and do it all the same. When we questioned banks about the float money in IPOs and tried to eliminate it, the situation was similar.

The intermediaries act as agents of investors. One would imagine that their interests would be aligned. That need not be the case. The regulator has to be alert to this. Once interests are misaligned, there will be mis-selling. Brokers routinely take the power of attorney from clients to trade in the clients' account and to debit their accounts when required. The broker gives an incentive fee to his employee based on the brokerage revenue generated by the employee. It is easier to maximise brokerage by churning a client portfolio, than by acquiring new clients and convincing them to invest in the market. This is not in the client’s interest. One might argue that regulators should not micro-manage by getting into the nitty gritty of incentive structures of the employees of an intermediary. It is a good argument, but fails to address the issue of misaligned interests. If the regulator does not address this issue, there is little chance that investors will be able to do much about it.

At times there is confusion about the role of agents. Let us look at mutual fund agents. Whose agents are they? They are agents of the fund manager because they earn their commission from the fund manager and the fund manager appoints them. They claim that they are also agents of the investor because they give advice to the investor on the appropriate scheme to invest in. But the investor does not appoint them nor does the investor control their payment on the basis of quality or quantity of service delivered. When you are the agent of both the investor and the fund manager, and the fund manager has appointed you, in whose interest will you act? It was clear that the whole theory of the agents acting in the interest of investors was just a theory. When SEBI abolished the entry load, we faced criticism even to the extent that we were killing the mutual fund industry. We had thousands of schemes, and constantly new schemes were being floated. This whole operation definitely worked well for the agents and the fund managers. It was not in the interest of the investors. It was like churning a client portfolio for generating brokerage.

One of the lessons we learned in NSDL was that changes like a depository system affect different elements in the market in varying ways. Unless one listens to these carefully and understands the affected party, we may end up with wrong answers. We used to address investors seminars all over the country to explain demat to them. One question used to come up frequently: "If your system is good and will provide excellent audit trail, why will people who have bought shares with unaccounted money join you?" Our initial reply used to be that we were setting up the system for law-abiding citizens of the country. We did not care if people who employed unaccounted money could not use the system. This reply satisfied us but some how did not seem to satisfy the audience though they would keep quiet. We decided we needed a better answer. We brainstormed. Our reply in the next seminar was that if all people with clean money came to the depository the tax department will just have to ask the companies the list of those shareholders who still have shares in paper form. They would be sitting ducks. This drove the point home. One has to speak the language of the consumer to win him over.

We quickly realized that while implementing such a large scale system you cannot achieve your ultimate goals by following a predetermined path. While you need to have an idea of how you intend to get to your goal, you must have the flexibility and humility to change course. On reaching one lakh accounts, when we analysed the pincodes in the addresses of the investors, we found that a vast majority was from Kerala. This was counterintuitive. Mumbai or the state of Gujarat would have been the logical candidates. We realised the reason. We changed the language of our literature and seminars from being merely in English to Hindi and eight regional languages as well. In a couple of years the balance was restored.

The moneyed and the powerful form a cozy club in India. The first rule is that you should mouth the principle of equality before law but must understand that this does not apply to the members of this club. If you act tough with small fry, there will be all round appreciation. If you, however, try to enforce the rule of law on the members of this club, there will be public appreciation and private anger. Retribution will follow. Lack of ethical values and morality in our public life has degenerated so much in the recent decades that it threatens our very core. Citing examples of aberrant behavior in other countries is just fooling ourselves to believe that here the problem is not all that severe. Earlier the unethical needed a place to hide. They carried out their activities covertly. Now, any talk of morality or ethics is seen as a mere fetish, an impractical virtue, an impediment in the path of the getting things done. It is not just that. We first transited from tolerating the corrupt to tolerating the honest. The corrupt are now saying that the honest are too much of a nuisance in this cozy world of give and take. Let us harass the honest. Even if they are foolish enough to fight back and win, the dishonest would still have achieved their goal. After seeing the harassment caused to these honest people, they hope that the succeeding people will not entertain any thoughts of behaving in this odd honest manner, Am I exaggerating? No. Things are so bad that one of the Supreme Court judges who recently retired had this to say:

There are matters pending with the court, but the pressure, tension and strain both of us have undergone is unimaginable. I can't explain. The pressure was reflected on my wife and family. I can't speak much on the Sahara case.

What would one's reaction be, when one hears this? We would be shocked, horrified and wonder `How dare anyone do such things vis-a-vis a Supreme Court judge?' Not one eminent lawyer. His comment was that the judge should not have said this!

A two judge bench had delivered a judgment in that case just a few days prior to this. The entire judgment is instructive and should be read in full. I am just referring to para 147 of the judgment:

The number of similar litigants, as the parties in this group of cases, is on the increase. They derive their strength from abuse of the legal process. Counsel are available, if the litigant is willing to pay their fee. Their percentage is slightly higher at the lower levels of the judicial hierarchy, and almost non-existent at the level of the Supreme Court. One wonders, what is it, that a Judge should be made of, to deal with such litigants, who have nothing to lose. What is the level of merit, grit and composure required, to stand up to the pressures of today’s litigants? What is it, that is needed to bear the affront, scorn and ridicule hurled at officers presiding over Courts? Surely one would need superhumans to handle the emerging pressures on the judicial system. The resultant duress is grueling. One would hope for support for officers presiding over Courts, from the legal fraternity, as also, from the superior judiciary upto the highest level. Then and only then, will it be possible to maintain equilibrium, essential to deal with complicated disputations, which arise for determination all the time, irrespective of the level and the stature, of the Court concerned. And also, to deal with such litigants.

If Supreme Court judges are saying this, you can imagine the circumstances under which regulators work.

That brings me to the point of the recent investigation launched by the CBI regarding the license granted by SEBI to MCX-SX for running an exchange to trade in currency derivatives. They say it is a preliminary enquiry so there are no charges; they are merely investigating. When I asked them what they meant by `a PE against Bhave and Abraham', they said it is an unfortunate use of words. Unfortunate indeed, but by whom and for whom? They leak news all the time. The only time they have come on record is to say `Why all this fuss when there have been no arrests or raids!' Do we expect the citizens of a free country to protest only after they are raided or arrested? The second statement on record is `Thousands of crores of investor money have been swindled by MCX and it was incumbent on the agency (CBI) to look at the very procedure of registration of MCX' by SEBI. This is ill informed and if not ill informed then ill intentioned. The money was lost in NSEL and not in the entity licensed by SEBI. To date, CBI has not revealed whether they are investigating anyone who sanctioned NSEL, the exchange in which people actually lost those thousands of crores. What is our remedy against this arbitrary behavior of an investigating agency? What does one do when they publicly say that the PE is against Bhave and Abraham and privately tell me that it is an unfortunate use of words?

I believe there is no remedy because CBI is an autonomous investigator and no one can question them. In our effort to free CBI from the clutches of the political executive have we gone too far and forgotten the issue of accountability? At last count, CBI’s rate of successful conviction on launching prosecutions is less than 5 per cent. Who questions them about this? We cannot, in a democracy, have an institution exercising coercive powers of the State without any accountability. This question needs the attention of the Government as well as the judiciary.

Is investigation and successful punishment to wrongdoers such a difficult thing? At SEBI we found that investigation and successful conviction is not a rocket science. Robust common sense, and an unbiased evaluation of the material gathered, can help you reach the right conclusion. We need to proceed not because we want to fix someone but because the evidence is against the entity concerned. I do not believe that competence is an issue. People can be trained. It is usual to blame the courts: that they are unreasonably strict in terms of the standard of proof required. That was not our experience. We did not lose a single high profile case launched by SEBI in those years. The inevitable conclusion is that lack of will and objectivity, and not the lack of skill, is the problem.

With such low conviction rates, the general public has lost any faith that the moneyed and the powerful will ever be punished. They, therefore, rejoice when raids are conducted and arrests are made. The society has come to see raids and arrests as a proxy for convictions. In the process we do not realize that if the agency raids or arrests an innocent person, he or she will also be seen as a black sheep by all of us. A raid or an arrest is only an aid to gathering credible evidence and not an end in itself. The agency has to be accountable for the rationale and the timing of the raid or the arrest. Such questions are rarely asked. The NSEL scam came out in the open in August 2013. CBI raided NSEL in March 2014. Our anger against the scam is such that, to us, the raid was the right thing to happen. Nobody asked the question as to what was gained by raiding an entity 8 months after the scam. Was CBI of the belief that the entity would have preserved incriminating documents for full 8 months so that CBI would discover them in a raid?

The whole system is so vitiated that pendency is used as a potent weapon. As long as CBI is investigating something the concerned person better not speak up, otherwise he will face the consequences. He will be denied promotions. If it is an entity there will be no permissions or licenses for the entity. If the government finds some officers’ honesty or outspokenness too uncomfortable, why not start a CBI enquiry or an income tax investigation against him? The chances are that the officer will keep shut. Attempts have been made and they continue even today to harass my colleague Abraham. Fortunately, he has spoken up, refusing to be cowed down. The investigation can remain pending for months or years and no one is answerable for the delay. Procrastinating is not only the norm today but CBI seems to be taking it to a new level. One of the questions they have of us is `Why did we not keep license pending when an income tax raid had been conducted against a related entity'! They want to elevate procrastination from a level of the tool of the timid or the crooked, to being a virtue. They suspect criminality when you do not procrastinate!

There is a section in the Prevention of Corruption Act that is the cause of most of the mischief. The government's attention has been drawn to it. There was some attempt at amending this section. Let us hope that the newly constituted Parliament will take it up as a priority.

Such is our fascination with raids and the details of what was found that we do not see beyond the raid itself. About a decade ago, there was a raid on a senior officer of the central excise department. There were details about how much cash was found in the raid and how it was difficult for the raiding party even to count the cash. There was also description of the moveable and immoveable property discovered in the raid. The officer was suspended. This is not uncommon. We needed to go beyond that. Firms had obviously paid off this officer for getting illegitimate concessions. How about reviewing the major cases decided by the officer in (say) five prior years and getting the firms to pay up what was legitimately due to the public exchequer? I made this suggestion to who ever I could approach in the Government. (I was not in the Government at the time). There was no appetite for this. Why? Your guess is as good as mine. Should we give up? I have not. I still make this suggestion to who ever will hear me. You are my captive audience today, so I am making this point to you.

When you are in authority and people appreciate you for meeting them at the appointed time, when they thank you for returning their calls and when they compliment you for your honesty and for owning up responsibility for your decisions you might feel happy. But may I submit to you, that these things should be a cause for deep reflection. The first two tell you how feudal our mindset is and how free citizens of this country still expect to be treated with disdain by the authorities. They are surprised and thankful that normal courtesy is extended to them! The other two make us wonder if our expectation of ethical behavior is so low that what should be normal behaviour is treated as a great virtue. Should public servants not normally be honest and ready to own up responsibility?

Despite all the gloom around us there are many in the country that have not given up. The recent appointment of the SIT on black money is a case in point. There were some people who did not give up the idea of bringing the tax evaders to book. They used the PIL route to get the attention of the Supreme Court. After some dithering and a change of Government we have an SIT in place. Notwithstanding some pundits who have already declared that nothing worthwhile will come out of this, I have no doubt that a process has been set in motion that will solve at least a part of the problem.

To sum up, ladies and gentlemen, I have tried to make the following points. The state of ethical standards and moral behavior in our society is really down in the dumps. We are in bad shape but we do not have to be that way. There is no reason for us to give up. Reform and improvement is possible. The progress made by us in the area of capital market regulation and infrastructure shows that things can be changed dramatically. Reform is a long and painstaking process. We can make our contribution by standing up for the right causes.

This talk was based on my own experience and observations. The challenge was to talk about my own experience but stay focused on ideas and issues. If I had talked merely about issues and ideas it would have sounded like homilies. If I had talked excessively about my own experience I would have committed the mistake of self-projection. I have tried to achieve a balance. I leave it to you to decide if the balance was right. Thank you for your attention.