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Last updated: 26 Sep, 2014  

Charles M. Seeger THMB Regulatory capture or fair competition?

Charles M. Seeger
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 “regulatory capture,” 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 “regulatory capture” is at work.  Agency efforts to protect markets must not be confused with regulatory capture.

 NCDEX, India’s second largest commodity exchange, is suing the FMC over a restriction on lowering NCDEX transaction fees.   The FMC’s 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 India’s largest commodity exchange, the Multi-Commodity Exchange of India (MCX), has somehow obtained “regulatory capture” or pressured the FMC into their decision.

MCX understands that healthy competition between exchanges is good—good 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:  NCDEX’s promoters were primarily bankers while MCX’s promoter, Financial Technologies Limited of India (FTIL), is a consortium of entrepreneurs and innovators; MCX’s 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.

NCDEX’s 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.  

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

  • 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
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Tenali | Tue Mar 3 08:30:07 2009
Dear Sir, Its a very nice article about regulators. Often it is seen that regulators are autocratic and regulatory authorities lack professional experience in their field (atleast in India). In the latest tussle between NCDEX and FMC both are evident. FMC has "no business" in regulating transaction charges as that is the only variable available with the exchange to promote itself. If FMC wants to regulate everything that an exchange does, then let regulator runs exchanges. Board members of exchanges can resign and can become a monk. Also when commodity futures market was started in India, it was primarily aimed at promoting farm futures, a mandate that FMC has comfortably forgotten. FMC should be concerned about defaults, risk management practices etc... and not about transaction costs. I wonder why FMC allows trading in certain metals and oil where there is no delivery. No refiner in India use WTI yet it gets traded. I guess there is some serious problem within the regulator and it lacks vision. The recent spat is a typical case of washing dirty linen in public. I have serious reservations against FMC's views.

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