Regulatory capture or fair competition?

Charles M. Seeger

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Charles M. Seeger | 11 Feb, 2009
Capital markets require good regulation. From tax codes to anti-trust laws; from insider trading restrictions to reserve requirements. Governments establish laws that protect its citizens from exploitation and unfair business practices. Every nation with successful securities and commodities markets has effective regulators. So too India.

But regulation can go awry. Governments can over-regulate industries thereby stifling innovation and progress. Or, they can under-regulate industries, allowing firms to take on too much risk or rent seek. This is the precarious balance of the regulatory process.

In developed countries, good regulation is supported by solid legal institutions, good corporate governance, and transparency. In developing countries, however, these institutions are less common and weaker. It is a mistake to believe that âregulatory capture,â the process by which regulators charged with protecting public interests decide instead to favor special interests through the powers of their office, exists only in developing countries.

Two months ago, it was not the United States Securities and Exchange Commission (SEC), but his own two sons, that exposed Bernie Madoff as the biggest crook in American history. For more than twenty years, Madoff operated a Ponzi scheme which faked steady returns in order to draw in more investors, ultimately stealing US $50 billion from customers. Madoff was never fully investigated by the SEC nor the United States Treasury Department.

Why? Regulatory capture. Madoff was the chairman of the prestigious NASDAQ Stock Exchange and one of the biggest names in finance, which likely wedded him to many high ranking regulators.

The recent Indian dispute between the Forward Markets Commission (FMC) and the National Commodity and Derivatives Exchange (NCDEX) is far from the Madoff scandal. Yet some have asserted that âregulatory captureâ is at work. Agency efforts to protect markets must not be confused with regulatory capture.

NCDEX, Indiaâs second largest commodity exchange, is suing the FMC over a restriction on lowering NCDEX transaction fees. The FMCâs position can be based on any number of sound grounds: it wants to protect investors by ensuring that the financial health of the exchange is not put in jeopardy; it wants to prevent predatory pricing; it wants to avoid liquidity fragmentation; it wants to preserve its prerogative of regulatory oversight.

All of these are legitimate reasons for the FMC action. None of these reasons would even remotely suggest that Indiaâs largest commodity exchange, the Multi-Commodity Exchange of India (MCX), has somehow obtained âregulatory captureâ or pressured the FMC into their decision.

MCX understands that healthy competition between exchanges is goodâgood for India and good for MCX. While typically one exchange will dominate in a particular commodity and develop deep liquid markets, competition always furthers better market behavior and innovation. That is valuable to exchange users.

In 2006, NCDEX had more than 60% market share in commodity trading. Now however, due to the stunning growth of the MCX, NCDEX has less than 10%. There are plausible explanations for this result: NCDEXâs promoters were primarily bankers while MCXâs promoter, Financial Technologies Limited of India (FTIL), is a consortium of entrepreneurs and innovators; MCXâs trading system is user friendly; MCX has impeccable financial integrity, clearing and settlement, and guarantee fund; MCX demonstrates reliable profitability; and the Government of India has suspended trading in certain agriculture commodities. Exchange users have noted MCX strengths, and have migrated to MCX, which now holds 85% market share. This is a result of fair competition.

NCDEXâs move to lower its afternoon transaction fees may, or may not, be fair competition. But, even if NCDEX wins its case against the FMC, little will change. It is unlikely NCDEX will recapture its lost market share, because exchanges do not compete solely on the cost of their transaction fees. They compete on: ease of trading systems; liquid, high volume markets; financial integrity and clearing and settlement; the absolute soundness of the guarantee fund.

Indiaâs regulatory bodies must improve, as the Satyam scandal revealed. Efficient and reliable financial markets require sound regulation and oversight practices. Improvements in Indiaâs corporate governance practices, transparency, and regulatory strength will further this effort. But, Indiaâs regulators know full well the difference between regulatory capture and fair competition.

Note:

The author, Charles M. Seeger, is the Chairman and CEO of Financial Markets International, a Washington, D.C. based international consulting firm. He is an attorney specializing in capital markets development. He is an advisor to the MCX.
The views expressed by the author in this feature are entirely his own and do not necessarily reflect the views of SME Times.