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Governing Market Infrastructure Institutions: The Way Forward for Exchanges, Clearing Corporations and Depositories

Sandeep Parekh

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I have a piece with Sudarshana Basu and Lipika Vinjamuri on Governing Market Infrastructure Institutions in the Financial Express.

Institutions such as stock exchanges, clearing corporations and depositories, are also known as market infrastructure institutions or MIIs, precisely because they form the backbone of the capital market. They provide the necessary infrastructure for trading, clearing, settlement and record-keeping and thereby play a crucial and significant role in ensuring that capital market transactions are carried out smoothly and efficiently. Additionally, they are vested with supervisory and delegated regulatory powers over key market participants, which extend beyond their commercial interests and make them ‘frontline regulators’. Consequently, a failure in governance of these institutions could have a domino effect on capital market transactions as well as the economic infrastructure of the country.

In line with the above objectives, and in light of recent governance lapses, the market regulator constituted a working group to strengthen governance standards at MIIs. The committee, which released its report on November 2, suggested key recommendations for strengthening the framework for MIIs, after consultation with various stakeholders, including MII representatives. While the committee was aware the duality of the roles of MIIs, that of profit-making and public utility, was conflicted and required legislative intervention, the recommendations seek to streamline the existing ecosystem to facilitate robust investor protection.

With respect to the organizational structure and accountability of MIIs, the committee recommended that the functions of the MIIs should be divided across three verticals; i.e. critical operations, regulatory compliance and risk management, and business development, with each vertical being headed by a designated key managerial personnel to ensure accountability. It was highlighted that while infrastructure and technology should support all core functions, as far as resource allocation was concerned, more importance should be given to the first two verticals so as to effectively discharge statutory requirements. Moreover, disclosure of utilisation of resources per vertical has been recommended. To further ensure accountability within MIIs and an objective assessment of the implementation of governance standards, the committee has recommended a periodic review by external agencies every three years in addition to internal review processes. To aid such assessments, clear indicative parameters have been suggested for each category of MIIs. Such exhaustive recommendations in terms of not only allocation of resource but also periodic review of it, put a step forward towards optimal resource utilisation and fosters progress in the right direction.

This is not the first time that SEBI has stepped up the regulatory infrastructure for MIIs. Considerable deliberations have been held over the past decade with respect to ownership and governance of MIIs and to achieve a balance between the business and regulatory functions of such institutions. With respect to compensation for KMPs of MIIs, the Bimal Jalan committee had recommended that compensation should not include any form of equity or equity linked or stock options in the MII, to ensure that autonomy is maintained in the regulatory departments. However, the present committee has deviated from such position and recommended that ESOPs be made part of the compensation meted out to KMPs. While regulatory autonomy may be necessary, there is a need to balance it with incentives to bolster performance of the KMPs. Providing incentives in the form of ESOPs would not only incentivize KMPs but also ensure talent retention. ESOPs would also bring in long termism in the governance of the exchange and bring in skin in the game for the management.

In addition to the above, considerable emphasis has been laid down on the role and appointment of public interest directors, appointment aimed at ensuring both independence of the board and due representation of investor interests. The committee not only recommends that at least two-third members of the board of MIIs should comprise PIDs, but detailed proposals in respect of their qualification, experience and skill-set requirements have been laid out. The role of PID, however is debatable and may in fact introduce a false comfort and moral hazard besides that fact that it has never really worked in the past. Further, the roles and responsibilities of the board of directors, should be clearly outlined to help affix accountability in case of future governance lapses. Minutes of the board meetings should be recorded, including video and audio recordings of the board meeting, and should be disclosed, to ensure transparency in decision-making procedures. The videorecording should however be only accessible to the regulator, to ensure that honest and blunt discussions are not omitted.

Presently, the regulatory norms prescribe a code of conduct for directors and a code of ethics for directors and KMPs. Additionally, provisions for non-compliance or breach of such internal policies are prescribed. However, with a view to strengthen the penalty mechanism and to provide an exhaustive list of all breaches and contraventions, the committee has recommended that a list of non-compliances and penalties should be prescribed which would also provide SEBI with more range to take penal action in case of such defaults.

Additionally, to enhance efficiency in functioning of the board of the MIIs, it was recommended that the roles and responsibilities of all the directors should be outlined. The members of the MII play a crucial role in efficiently carrying out the operations and functions of the MII. Thus, holding members of the MII liable and accountable and highlighting consequences against each default is essential given the significant position they enjoy with regard to safeguarding investor interest. Furthermore, proposals such as external assessment of performance of the board in addition to self-appraisals, indicative parameters to assess the effectiveness of the board, reporting of wrongdoings by KMPs to SEBI, etc. would go on to achieve timely corrective actions to prevent any disruption in the operations of the MIIs. In fact, to emphasize on the continued and efficient operation of the MIIs, the committee has also recommended that the net worth of MIIs should have a variable component to cover operational risks, legal risks, credit risks and cybersecurity risks and that a percentage of profits should be transferred to the investor protection fund to cover such risks.

The committee has also recommended that the board of directors meet twice a year and submit a periodic report outlining the performance of the MIIs to SEBI. Apart from achieving transparency and accountability goals, these proposals would induce a sense of trust and confidence amongst various stakeholders, which is essential for the proper functioning of the MIIs and the market.

With rapid digitalization and surge of usage of the internet, capitalizing on the use of technological resources could be key to improve the functioning of the MIIs. The committee however is mindful of the issues that entail with rapid technological advancement, such as risks associated with data sharing. Keeping this in mind, the recommendations encourage the users of technology to implement a transparent governance framework. It is recommended that MIIs should develop a system to ensure confidentiality for sharing of sensitive information. The committee has recommended that confidential and sensitive information should be shared for legitimate purposes only and all methods of sharing of data through emails or social media, should be done within permissible boundaries.

Overall, the recommendations become increasingly relevant at a time when the market has witnessed a significant increase in trading volume, investor base and both legal and operational risks. Given that these institutions are the backbone of the economy, the above recommendations are welcome. That being said, a framework enacted in this respect should typically aim at easing transactions for both the institutions and the users. In a hypermetropic view, the market will function efficiently and will flourish only when comfortably regulated, in a way that all parties are able to access it and use it easily.

(This article was first published in Financial Express)