Bose committee on mis-selling

The policy discourse in personal finance in India has been shaped by two concerns. The first is that of the limited participation of households in finance. The second is the increasing evidence of mis-selling of financial products. At present financial products are regulated by multiple regulators who do not coordinate strategies. The sales channel sees different incentive structures emanating from different regulators for identical products. Product disclosures are often not transparent. Returns are not comparable, and costs get hidden. The standards of disclosures are different across regulators. This makes it difficult for customers to evaluate products. All of these contribute to mis-selling.

Mis-selling not only causes losses to customers, but also is likely to impact low participation. Consumer protection in finance has therefore become an important objective. The Ministry of Finance decided to set up a Committee, led by Sumit Bose, to go into these questions in detail. The Report of the Committee to recommend measures for curbing mis-selling and rationalising distribution incentives in financial products was released on 3 September 2015.

What the report says

The Report seems to have identified some core areas of concern, and made recommendations addressing each of them. These include:

Regulatory arbitrage

The key recommendation of the Committee is that regulation of financial products must be seen in terms of the product function and not form. These functions are Insurance, Investment and Annuity. The lead regulator, according to function, should fix the rules. In bundled products, the rules of each component should be set by the lead regulator. For example, in a bundled insurance product, the rules on the investment component should be set by the investment regulator, while the rules on insurance should be set by the insurance regulator. This will help remove distortions that result in investment oriented products from insurance being relatively expensive and opaque. The committee has suggested specific steps to create a level-playing field between all products, steps that are essential to curb mis-selling.

Improved disclosure

The Committee recommends that the way in which returns is computed should be standardised and should be a function of the amount invested. Returns in bundled products should be shown on the invested amount, and not on a third number such as sum-assured. Ongoing disclosure should show historical returns as an average annual number based on the IRR of the product. An average customer should be able to understand what the product costs, what the benefits are and for how long the product should be held. The norms of this disclosure for investment products should follow the rules set by the lead regulator. All disclosures should be machine readable. These measures are designed to help consumers compare products objectively and make appropriate choices.

Commissions and charges

Investment products and investment components of bundled products should have no upfront commissions. All investment products, and investment portions of bundled products, should move to an AUM based trail model. Upfront commissions on pure insurance products and pure risk portions of bundled products should be allowed, and should be decided by the lead regulator since pure risk is a difficult product to sell. Financial products should have flexible exit options. The cost of exit must be limited. The costs of surrender for each product should be reasonable. After deduction of costs, the remaining money should belong to the exiting investors. Lapsation profits, or profits from exit charges, if any, should not accrue or be booked by product providers. These measures will help align the interest of intermediaries with those of the consumers as the commissions will grow based on customer's tenure of investment, investment size and the returns earned.

Common distributor regulation

Regulators should create a common distributor (including employees of corporate agents) regulation. Each regulator may add rules specific to products regulated by them. Regulators should create a single registry of all distributors. Anybody facing the customer should be registered. The registry should identify each individual distributor with a unique number. The registry should have the past history of regulator actions and awards for each individual distributor. Strict penalties should be defined for distributors who are not registered. These steps will enable tracking of distributor actions across products and improve enforcement actions.

What is missing?

The report makes some important recommendations that should have a significant impact on the disclosures of product features, as well as incentive alignment between distributors and customers. Both these are fundamental to any regime that desires consumer protection in finance. There are, however, a few areas where the report falls short of going the full distance.

First, while the report recognises that regulation of products, and not of function, has led to regulatory arbitrage, and recommends regulations by the "lead" regulator, it does not go as far as to recommend moving away from product regulation. The only way to carry the thought process of the report through is to break with the present financial regulatory architecture, of having RBI/IRDA/SEBI as presently constructed.

Second, the report makes only cursory mention of the design of penalties on financial firms if they are found guilty of dubious sales practices. Regulation in India has focused on prevention, and largely ignored enforcement. This philosophy seems to have been carried over to the report as well. Only when bad behaviour is costly, will financial firms re-design their policies towards "good behaviour". Penalties designed by regulators are usually far too small compared to the benefits gained by firms and distributors through mis-selling. In addition, regulators are mostly reactive and impose penalties only after consumers complain. Regulators must establish mystery shopping programmes to find out the behaviour of regulated entities. Penalties should not only disgorge all potential profit from mis-behaviour but include some penal component which removes the incentive to repeat the behaviour. This component should be based on probabilistic models of getting caught and not on vague standards of "strict penalties." To implement such systems, regulators need to write detailed penalties regulations which consider the nature of the violation, the illegitimate gain and the probability of getting caught.

Third, the report does not adequately address the issue of composite products such as traditional insurance plans, which combine investment and insurance components. The management of assets of the pooled products make the product structure opaque. The way forward would have been for the assets of the investment portion of the product and the mortality portion of the product to be separately managed and kept independent of each other. This requires far-reaching change in the management of the investment pool for non-linked products. The report, sadly, has not been bold enough on this important aspect of the present retail market.

Fourth, the report should have placed a greater emphasis on requiring regulators and industry agencies to collect or create information in a way that supports downstream information processing and dissemination activities. While the report does require machine readable disclosures, it should have also stressed regulators to make publicly available disaggregated data to provide analysis to consumers and encourage creation of tools (mobile based apps etc) by third parties from the fintech industry, thus helping consumers make better choices.

Finally, the report leaves it to the regulators to frame a time-bound road map to implement the recommendations. This almost gives regulators a free pass at ignoring all that is in the consumers interest, as has been the case thus far. The report should have provided a road map with time lines for regulators to act upon.

The way forward

The report has attempted to address some of the basic issues and importantly has suggested specific measures that the government and the regulators need to take to address the same. These would be useful preparatory steps for the regulators and the industry as they gear up for the Indian Financial Code, which once enacted will provide for:

1. A single financial agency to regulate securities markets, investments, insurance, pension, and all other financial services except banking and systemically important payments.
   
   
2. A comprehensive framework of consumer protection to be implemented by financial service providers and the regulators. This framework would include rights and protections for all consumers, as well as some enhanced protections for individuals and small businesses. This consumer protection framework would seek to ensure adequate initial and continuing disclosures, minimising conflicts of interest, provision of suitable financial services, and protection against unfair conduct.
   
   
3. A fully articulated rule of law framework for enforcing against violations and giving out punishments to financial firms.
   
   
4. A single Financial Redress Authority to redress complaints of retail financial consumers in a speedy, inexpensive and predictable manner.
   

Payment bank entry process considered inconsistent with the rule of law

by Shubho Roy and Ajay Shah.

First best

Banking is the business of accepting deposits from the public with the promise of repaying such deposits on demand at an agreed rate of return. Payments is a distinct business from banking. A payment system is one which enables payment of funds to be effected between payer and a beneficiary. In the olden days, payments was primarily (though not entirely) the business of banks. In the modern world, banks should face competition from technology companies who will use modern telephony to do payments. These companies are bringing in a new business strategy of leveraging their client base and using analytical tools to provide a superior consumer experience.

The first best approach is to establish a regulatory strategy for payments which is not deferential to the business interests of banks,i.e. which has a level playing field between banks and non-banks.

Second best

The second best strategy is to invent the moniker `payments banks',which suggests some kind of entity which does payments and sounds like bank but isn't a bank. In this case, a mechanism is required through which new entrants will establish payments banks. Anything that we do in public policy in the Republic of India should be grounded in the rule of law. How would a rule-of-law entry mechanism work?

Under version1.1 of the draft Indian Financial Code, the legal process for considering an application for carrying out a new business is governed by Chapter 20. This induces the following procedure:

1. The regulator has to make clear regulations on the criteria on which an application will be judged.
2. Section 73(6) of the Code provides that before rejecting an application, the Regulator must provide a show cause notice to the applicant.
3. Section 91 provides the details of how a show cause notice is issued and its contents.
4. The Regulator must give an hearing, and provide all the material the Regulator relied on to come to its decision.
5. The hearing will be before a staff member of the regulator, who is not involved in the actual evaluation of the proposal (separation between executive and and quasi-judicial functions)
6. There will be detailed regulations on how the hearings will be carried out; the procedure will not be made up on the fly.
7. If the applicant is unhappy with the decision of the regulator, the applicant may appeal to the Financial Sector Appellate Tribunal (FSAT).

This procedure yields the rule of law in entry of new firms.

Third best

The RBI recently announced that it has given "in principle" approval to 11 applicants for payments banks licenses. These were chosen from 41 applicants who wanted to start payment systems. The manner in which 11 payments banks were short-listed is inconsistent with the rule of law. It is not clear how the RBI came to the number of 11 payments banks, or why licenses were denied to the others.

Right at the outset of this process, it is not clear why RBI chose to use the Banking Regulation Act, 1949 to license "payments banks" when Parliament has made a separate law for governing payment systems under the Payments and Settlement Systems Act, 2007. Since paragraph iv of the payment bank guidelines do not allow such entities to undertake any lending activities, it is not even clear why RBI is classifying them as banks.

The RBI states that an external evaluation committee chose the 11. The RBI claims that the committee determined its own procedure and analysed the applications. Without casting any aspersions on the members of the committee, this is, sadly, not a due process of law.

The RBI notification claims that the committee screened the applicants for financial soundness, fit and proper criteria, physical outreach, business model innovation, capability of volumes of transactions and money and their proposed business plan. Additional data was also requested from the applicants. While this may satisfy a casual reader, these phrases are vague and empty. There is no explanation on how the committee evaluated each criterion mentioned in the paragraph. Were marks given for each criteria? Was there a pre-decided cut off marks below which licenses would be denied? What was the basis/system of providing marks or comparative ranking? How was innovation adjudged and comparatively scored/ranked between the 41 applicants?

In addition to these process failures described above, the RBI guidelines provide no review or appeal provision for rejected applicants. This is also a violation of the rule of law.

Compare and contrast this with examples for the existing legal process for selection/short-listing in the government. If you apply for a driving license and it gets rejected, you get a specific reason for the rejection. The Motor Vehicles Rules specify what the department tests. The Motor Vehicles department does not state "the driving instructor will formulate his/her own procedure for determining the competence of the driver". Giving out licenses to payments banks is more important than giving out driving licenses; the quality of procedure at RBI should be even more thorough than what is done by Motor Vehicles departments all across India.

Look at the UPSC exams which select the senior most officials for all of Government of India and State Governments. There is a set syllabus. The rules about how marking is done are stated before the exam. There is a clear system of assigning ranks. After the examination, the answers are also published for examinees to determine their scores independently and more importantly to understand where they went wrong. The process has a subjective part of interviews; but that forms a smaller component of the overall evaluation which is predominantly objective.

The process used for the entry of payments banks is strikingly different from the quality of governance seen in main line government. It is, however, disturbingly similar to the process of allocating coal blocks through a Screening Committee, which the Supreme Court has held unconstitutional on the grounds that:

1. The allocation procedure followed by the Screening Committee was arbitrary.
2. No objective criterion was used to determine the selection of companies.

The Supreme Court found:

The approach had been ad-hoc and casual. There was no fair and transparent procedure,...

The Supreme Court judgment gives much insight into the governance problems of RBI, and the concepts that drive the draft Indian Financial Code. It should be noted that the much criticised procedure of the coal ministry was ahead of RBI on good governance procedures in that they released the minutes of the meetings of the Screening Committee while RBI did not.

So far, we have discussed how RBI has run the licensing process. Now we turn to the RBI concept of a scarce number of licenses. Entry problems in public policy fall into two kinds:

1. Allocation problems: Where the resource is a limited resource and the number of claimants are more. The system preferred by governments in these types of situations is usually auctions with allocation to the highest bidder. This is used for situations like coal mines or spectrum allocation.
2. Licensing problems: These are activities where the entity carrying out the activity needs to have certain minimum qualifications. If such qualifications are absent then there is a risk that the activity may generate substantial negative externalities. As an example, an untrained driver may kill innocent bystanders.

Some problems are combination of the two, like the UPSC exams where you need skilled civil servants and the number of positions are limited. In those circumstances, scoring plus comparative ranking is the standard method.

The payments bank licenses are not an allocation problem. There would be no problem if there were 30 payment banks instead of 11. It would have promoted more competition and reduced costs to consumers. The arbitrary setting of numbers of payment banks harks back to the days of the Aluminium Control Order or Steel Control Order or the other Control Orders and Industrial Licenses which plagued the Indian economy before 1992. These laws set arbitrary production quotas and licenses for manufacturing without any rationale. A crucial part of our reforms of 1992 was removing the quotas and industrial licenses. Anyone can start a steel mill now or produce aluminium. there is no limit to the number of steel mills the government will allow.

Even if you were to consider the entry of payments banks as an allocation problem, there is an important governance failure right at the outset. Nowhere in the guidelines for payments banks (or any document that we could find in the public domain) is there any mention of the magic number 11. This is akin to the UPSC deciding on the number of students to take in after the exam. The arbitrariness of the decision is inconsistent with the rule of law.

A climate of fear

One may wonder why no one stands up against these violations of the rule of law. The problem is, without a statutory or regulatory right to appeal, it is dangerous to go against a regulator in India. Even if you win in court, you would then be under the regulation of the same entity you vanquished in the High Court. In a non-rule-of-law situation, where the financial agency has wide and arbitrary powers, that is not a condition you would enjoy. Unlike other regulators (SEBI, IRDA, PFRDA) there are no statutory appeals under the RBI Act against the decisions of the RBI. Regulated persons feel safe dragging SEBI to SAT as SEBI operates in a rule of law environment and is not able to exact retribution through devious methods.

On this subject, see the recent article The rule of law in the regulatory state by John Cochrane. For an example of better governance found within India, consider SEBI. When a person applies to become a stock broker SEBI grants the broker a hearing before rejecting the application and even allows the broker to apply for a reconsideration (See Regulation 8 here). After that, the broker can appeal to the Securities Appellate Tribunal.

Subjects versus citizens

RBI gives hope to the industry through the following paragraph in the notification on approvals:

Going forward, the Reserve Bank intends to use the learning from this licensing round to appropriately revise the Guidelines and move to giving licences more regularly, that is, virtually "on tap". The Reserve Bank believes that some of the entities who did not qualify in this round, could well be successful in future rounds.

This has two shortcomings:

1. The minimum standard of objectivity required under Article 14 of the Constitution is not dependent on the convenience of RBI. A regulator has to meet a minimum level of objectivity under the Constitution. It may improve upon it, but that does not allow it to deny it to the applicants at the present.
2. The consolation to the "failed" participants is in itself an admission of the lack of faith of RBI in the process. A more inclusive and consultative mechanism may have developed a more objective criteria for selection. Even RBI itself seems not to be sure about the legality of the present process when it says that the failed entities may be successful in the future. It seems unsure about the reasons why these entities were rejected.

For an analogy, we would not accept a Coal Ministry which first gave out 11 coal mines through a clubby process, which violates the rule of law, and said that in the future it will adhere to the Constitution.

The promise of future "success" is clouded by dangers for the 30 unsuccessful aspirants. The first set of 11 may rapidly develop their business. In network industries, subsequent entrants face an uphill task of competing against the entrenched incumbents. In addition, RBI makes no promises about when the next round of licenses will be awarded. From 1949 till 2015, RBI was not able to learn how to do on-tap licenses for banks. Hence, there is no telling how many decades of a head start these 11 payments banks will get. The harm imposed upon the unsuccessful applicants could be arbitrarily large. Under the rule of law, State actors can only inflict harm after following certain sound processes.

The problem of learning

As emphasised above, the Constitution of India does not give rope to any part of the State to violate the rule of law while it is learning.

It is hard to see what was difficult about developing a sound rule of law framework. The steps required are quite elementary:

1. RBI staff could have read the Indian Financial Code and used the procedure there.
   
2. SEBI has long had sound entry procedures. RBI staff could have just studied SEBI and emulated them.
   
3. These procedures could have been validated against ample international experience which is on the web. UK regulations are available here, in the U.S. it is usually governed under state laws and the New York regulation process is available here. Australia regulates some payment systems under deposit taking regulations which can be seen here.

Saving capitalism from the capitalists

A nimble new set of technology companies want to challenge an inefficient incumbent: the existing sleepy world of payments as done by banks. Both industries have one regulator -- RBI -- which is captured by the interests of incumbents. It has not permitted the new players to compete with the incumbents. In an age of great concern about crony capitalism, uncomfortable questions are raised when six out of 11 new entrants are big business houses, and the competitive energy of technology companies has been largely shut out. Many names in the list of 11 which appear new to this field have partnerships with incumbent banks -- e.g. Reliance with SBI, Fino with ICICI Bank, Airtel with Kotak Bank, etc.

How do we save capitalism from the capitalists? The rule of law is a necessary, though not sufficient, condition for a competitive economy where rich families and dominant firms face vigorous competitive pressure. The Constitution of India is a great tool for addressing our problems of cronyism.

At the same time, mere emphasis on rule of law procedures is not a sufficient condition for doing sound economic policy. A great deal of thought and care needs to go into the work, so as to ensure that good outcomes are obtained. E.g. it's easy to do a formal rule of law process which insists that any applicant for a payments bank must be a software company with over Rs.1 trillion a year of revenue. All the formal processes can be easily run with this criterion. But it will give us the wrong outcome. The rule of law is a necessary, but not sufficient, condition to get sound outcomes.

While the RBI Act, 1934, predates free India, in 1949, the Constitution of India established the rule of law in India. SEBI has long had a more evolved system on the entry of mutual funds. In 2013, the draft IFC was released, and offered a substantial step forward where the rule of law was integrally brought into all aspects of financial economic policy. Sound entry procedures are in Chapter 9 of the FSLRC Handbook. In 2014, this critique of RBI permitting two persons to start a bank came out. In this backdrop, the process failures with payments banks constitute an avoidable failure.

Conclusion

It is better to have 11 new payments banks than to have none. However, there are important intellectual failures in what was done, on questions of economics and on questions of law.

References

Supreme Court of India, Manohar Lal Sharma vs The Principle Secretary & Others, judgment dated 25^th August, 2014

Ministry of Finance, Revised Draft Indian Financial Code for Public Comments

John Cochrane, The Rule of Law in the Regulatory State, The Grumpy Economist, 1 August 2015.

Ajay Shah, Rule of law and competition in banking, Economic Times, 9 January 2014.

How to think about one rank one pensions

• Renuka Sane and I have a column The way forward with one-rank-one-pension in the Indian Express today. We also presented related ideas earlier in the Mint and on CatchNews.
• Article from 7 July 2015, with associated computer code, which prices the three kinds of annuities at age 35 and at age 60.
• Article from 5 February 2015, about the three kinds of annuities, and the basic tension between high GDP growth and keeping up with the Joneses.
• How to strengthen the New Pension System, by Renuka Sane and Susan Thomas, 9 October 2014.

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.

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.

Commentary on the MPC question

• No need to worry about India's central bank, by Dhiraj Nayyar on Bloomberg
• In defence of the financial code, by Vivek Dehejia and Rajeswari Sengupta in Mint
• Letter by Ritha Khemani in the Financial Times
• Rajiv Kumar in The Times of India
• Note in the The Economist
• P. Chidambaram in the Indian Express
• Ashok Desai on CatchNews.
• Harish HV in the New Indian Express.
• Individuals vs. Institutions by Vivek Dehejia in Mint.
• Sanhita Sapatnekar and Mohit Desai in Mint
• My column in the Indian Express.

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.