Self-Regulation in Financial Markets - Looking Back and Looking Ahead
(Keynote address delivered by Shri M. Rajeshwar Rao, Deputy Governor, Reserve Bank of India -
March 05, 2023 - at the 17th FEDAI Annual Conference at Cairo, Egypt)
1. A very good morning to all of you. It is indeed a pleasure to be here amidst all
of you today at the 17th annual conference of FEDAI. These annual events of FEDAI
provide an excellent opportunity for the exchange of ideas and thoughts among the
foreign exchange market participants and I am sure this one will be no exception.
2. Today, as I speak to the market veterans assembled here in Cairo, it strikes me
that it is fitting perhaps that this conference is being held here in the year of India's
G20 presidency, the year of the "Vasudhaiva Kutumbakam" or "One Earth · One
Family · One Future". India and Egypt are arguably two of the world's oldest
civilizations. Both share a glorious past.
3. India was one of the largest economies in the world for about two millennia
starting around the end of the 1st millennium BC. Documented economic history
suggests that for most of the period since the first century AD, the Indian economy
was the largest in the world. At the beginning of the British rule in India, it accounted
for close to a quarter share of global GDP. Since then, there has been an inexorable
loss in India's share of global GDP. But we have not just arrested this decline, but
indeed have been able to reverse it. India's GDP2 is today the third-largest in the world
in PPP terms and fifth largest in terms of market exchange rates. India is today
considered as one of the fastest growing economies of the world with clear emphasis
on strong macroeconomic fundamentals and is recognised as one of the few bright
spots amidst current challenges and uncertainties.
4. The signs of these changes have been quite apparent for some time now. In
just over a decade, the country's nominal GDP has increased four-fold from ₹64 lakh
crore for FY 2010 to ₹273 lakh crore for FY 20233 . Its external trade has also increased
from ₹29 lakh crore to ₹137 lakh crore during the same period4. As a percentage of
GDP, external trade has increased sharply in the last two decades from about 26 per
cent at the turn of the century to about 45 per cent currently.5 Equally noteworthy is
the fact that the development has been inclusive with millions of people being lifted
out of poverty. According to a recent United Nations Development Programme update,
415 million people were lifted out of poverty in the decade and half leading up to the
COVID-19 pandemic while the incidence of poverty has more than halved.6
Concomitantly, the financial sector has expanded both in terms of depth and diversity
with differentiated niche banks catering to the differing needs of the economy and
society. A diverse set of NBFCs have also been operating, reaching the proverbial last
mile to the individual customers and, in fact, traversing beyond that. Fintech has
emerged as a potential force multiplier while India is today an acknowledged world
leader in fast payment systems.
5. The transformation in the world of foreign exchange and more generally in
financial markets over the years has been no less striking. As veterans in this audience
would be aware, the journey of exchange control in India began with the framing of
the Defence of India Rules,1939 by the British Government as a temporary war time
measure. These rules assumed statutory basis through the Foreign Exchange
Regulation Act (FERA), 1947. In view of an acute shortage of foreign exchange
reserves, FERA, 1947, was replaced by FERA, 1973 which sought to put in place
stringent controls "....for the conservation of the foreign exchange resources of the
country and the proper utilization thereof....".7 While this approach continued in the
1970s and 1980s, there was a paradigm shift in the approach to external sector
management in the early 1990s, when the Rupee was made fully convertible on the
current account and the lietmotif changed from conservation of foreign exchange to
the management of foreign exchange through facilitation of external trade and
payments as well as orderly development of foreign exchange markets. This change
was formalized through the Foreign Exchange Management Act (FEMA) enacted in
1999. The subsequent two decades have seen a calibrated opening up of the capital
account with significant liberalization in the regulatory framework related to foreign
direct investment (FDI), external commercial borrowing, foreign investment in
domestic debt markets and overseas investments.
6. In the broader financial markets too, policy measures during the 1990s set the
stage for the transition to market-determined interest and exchange rates and saw
significant development in different market segments. Initial policy efforts were
focussed on delivering a measured development of different market segments and
supporting market infrastructure with a view to reaping the benefits of deeper and more
liquid markets. As markets developed and lent confidence, the pace of reforms and
liberalisation picked up and continued despite the myriad episodes of turmoil over the
last decade and a half. With the policy priority of ensuring that financial markets are
sufficiently developed to meet the requirements of a growing economy and of users,
both resident and non-resident, the reforms were reconfigured to deepen onshore
financial markets, remove segmentation across market segments and increase the
efficiency of price discovery, within a robust infrastructure and conduct framework.
7. Several analysts and economist have predicted that this decade will be India's
decade and they have predicted that India's GDP will triple and per capital income will
almost double by 2031, powered by manufacturing and export opportunities. India is
all set to benefit from major global trends such as offshoring of manufacturing to
friendlier countries (popularly called "friend shoring") because of its geopolitical
alignments, technology-based services because of its adoption of increasing
digitalisation and a young population which is eager to excel. The Honourable Prime
Minister has set before all of us a goal of making India a developed nation by 2047 as
one of the "Panch Pran" for the centenary of the country's independence. Against the
aspirations, ambitions and opportunities, the theme of this year's FEDAI's conference-
"India - Back to the Future: Better, Bolder and Benevolent" is very apt.
8. When fundamental transformations such as the one we are witnessing takes
place, there are many moving parts which need to come together and move in sync.
There are many actors who have critical roles to ensure that each of these parts move
at the desired pace and efficiency. As stakeholders in financial markets, we all know
that it has a critical role to play in funding our growth aspirations and in supporting an
increasingly complex and inter-connected financial system. The key actors in financial
market development include self-regulatory organisations such as FEDAI. Given that
this is a FEDAI conference, let me focus today on the role of self-regulatory
organisations (SROs) in market development and market conduct and also set out a
few thoughts on the role played hitherto by FEDAI in the development of foreign
exchange markets as well as expectations from it going forward.
Self-Regulatory Organisations
9. Let me first start with a look at the evolution of SROs around the world. The
idea of self-regulation generally involves the members of a group coming together to
establish rules of conduct and voluntarily committing to follow those rules. Self-
regulation has a long history of existence in various professions as a means to
encourage and promote appropriate conduct by the members of the profession. In the
financial sector, elements of self-regulation by stock exchanges dates back more than
two centuries with the London Stock Exchange adopting such a system in the
eighteenth-century. In the United States, self-regulation by stock exchanges preceded
the creation of the federal regulatory agency, i.e., the Securities and Exchange
Commission (SEC). In Canada, the Bond Market Association of the Toronto Board of
Trade emerged as an SRO in 1920s. In recent times, SROs in the financial sector
have been delegated authority, formally or informally, by public authorities to frame
guidelines for appropriate conduct by its members and utilize tools such as voluntary
agreements, standards, charters, byelaws, handbooks of market practices, etc., to
ensure such appropriate conduct. Effective SROs complement the regulatory and
supervisory efforts of public authorities.
10. In any sector, financial or otherwise, there could be four categories, in terms of
rules that the players are subject to. The first category is the one where there are no
rules, explicit or implicit. This is a rare situation and feasible only in narrow businesses
where the sector imposes no or minimal externalities on the broader system. In the
absence of rules, however, industries do not always act in broader public interest and
their behaviour often tends to favour the powerful at the cost of equity, fairness, and
overall social development. As a sector grows, some form of rules become necessary
and are often agreed upon by the players themselves, primarily in a bid to impose self-
discipline among the members. An industry which operates only under self-regulation,
however, may not also always act in public interest. These concerns assume greater
importance as a sector / industry develops and starts to become systemically
important. Here a role for an external, neutral body which performs the role of an
umpire becomes necessary. Such an umpire in a business sector is typically a public
or statutory authority in the form of a regulator or the government which sets the rules
for an industry. The fourth category is one where self-regulation and state-imposed
regulation co-exist with the regulator or state institution explicitly or implicitly
recognizing the SRO. The co-existence of a regulator and a SRO is, in fact, the most
common framework or structure prevalent across the world in financial sector.
SROs - Roles and Responsibilities
11. The roles of SROs vary across jurisdictions, markets, and sectors that they
function in. Typically, in the financial sector, the broad objectives of SROs reflect those
of the financial sector regulator, viz., preservation of market and financial integrity and
protection of customers / investors. Within these broad objectives, SROs typically work
towards establishing minimum benchmarks as well as ethical and behavioural
standards. With the guidance received from the regulator, they help instill professional
market conduct amongst their members in order to ensure customer / investor
protection. SROs often get involved in the documentation of operational guidelines
that set out the rules of conduct and prescribe market conventions, standard
procedures and documentation, master agreements, etc., to be followed by market
participants. In some jurisdictions, they monitor adherence to codes of conduct and
regulations issued by the regulator and are also empowered to take appropriate action
in case of violations. SROs also establish dispute resolution frameworks to facilitate
early resolution of disputes. In their developmental role, SROs serve as the
representative of their members in various fora including in interactions with the
regulator. An integral part of SRO functioning is to impart training to the staff of their
member organisations and to conduct awareness programmes. Thus, SROs in the
current schema are expected to complement the regulatory / supervisory
arrangements in financial sector.
Functioning of SROs: Hits and Misses
12. The primary motivation for existence of SROs as an instrument of regulation in
the financial sector is to enhance effectiveness in regulations by drawing upon the
depth of technical expertise of practitioners. Involvement of market experts could also
enhance effectiveness in regulations by highlighting various technical and practical
aspects, nuances and trade-offs involved in regulatory policy. SROs are also likely to
have closer informal and formal contacts in the industry and have their ears to the
ground. They can, therefore, facilitate relatively more proactive, agile, and flexible
responses to changing financial conditions. As pointed out by William O. Douglas, a
former chairman of the Securities Exchange Commission, through developing code of
ethics and conduct, self-regulation could be persuasive and effectively influence
participants' conduct in the realms of morality and ethics compared to laws and
governmental regulations8. SROs acting as watchdogs against unethical or dubious
practices could foster greater confidence in the integrity of the whole ecosystem.
SROs also facilitate resolution of disputes among members within the industry rather
than taking recourse to an external body or the courts. SROs can thus complement
the regulatory framework and contribute to the effective functioning of the financial
system.
13. Despite potential benefits, concerns related to self-regulation have also
attracted widespread attention. Concerns arise from the fact that SROs largely
comprise of industry members and are hence subject to conflicts of interest arising
between latter's own commercial interests and former's expected public role. Such
conflicts can lead to weakening of the regulatory structure and potentially harm the
interests of the customers / investors. SROs could also find it hard to prevent collusive
behaviour leading to inefficiencies and dissatisfaction among consumers. They may
not be appropriately vigilant to issues around misconduct by their members. These
risks could be further accentuated in cases where the impact of activities is not
immediately apparent but could prove to be potentially harmful in the longer run. A
case in point from an environmentally sensitive sector is one of an industry causing air
or water pollution, the impact of which is not visible in the short run and may not invite
consumer or societal activism. The concern is that SROs may not be able to
adequately divest themselves from the interests of their members.
14. These aspects have come to light in various industries / sectors over the course
of the years. Over past few decades, the financial sector, both at the global as well as
domestic level has witnessed recurrent instances of unethical behaviour. The ability
of financial sector intermediaries to uphold themselves to high moral standards came
under the cloud in the wake of revelations about the irregular practices around LIBOR
fixing. The reliance on self-regulation of hedge funds and the derivatives markets was
criticized as contributing to the Global Financial Crisis. In fact, many of these events
led to a rethink in the approach towards regulatory framework with greater reliance on
regulations returning to public authorities.
15. For any SRO to remain relevant in this milieu, it is critical that it demonstrates
unrelenting efforts towards ensuring fair practices by its members and is seen as
contributing to the objectives of market integrity and customer protection. SROs must
display their willingness and ability to address concerns beyond the interest of their
membership, viz., to protect customers, participants, and other stakeholders in the
ecosystem. They must remain neutral and be seen to maintain objectivity. Putting in
place robust governance norms and internal controls, remaining abreast with market
innovations, proactively identifying, and acting on breaches and misconduct, and
continuously striving to keep in sight the big picture of balancing market innovation
with market integrity are some of measures through which SROs can ensure their
continuing credibility and relevance. History has shown us that an SRO is credible and
its role significant only when it is backed by a long track record of responsible behavior
under the oversight of public authorities.
16. With this background, let me share some thoughts on the experience in self-
regulation in Indian financial markets, the evolution of FEDAI and the role played by it
in the foreign exchange market in India.
Self-regulation in Indian Financial Markets
17. In India, the history of self-regulation has developed over the years, though
formal regulatory frameworks for SROs is of a relatively recent origin. In the foreign
exchange market, FEDAI was formed in 1958 to lay down the terms and conditions
for operations of Authorized Dealers in India. Similar to the developments in other
jurisdictions, stock exchanges in India also have historically performed functions akin
to SROs. In 2004, SEBI issued regulations on SROs providing guidelines on eligibility,
recognition, functions, and responsibilities of SROs. In the payments and settlement
space, RBI has recently (i.e., in 2020) issued a framework for the recognition of self-
regulatory organizations for payment system operators.
FEDAI: Evolution, Role, and a few Questions
18. Under FERA, 1947, only a handful of the foreign banks were designated as
Exchange Banks and were permitted to provide foreign exchange related services.
These banks carried out their business as per the guidelines laid down by the then
Exchange Bank's Association. As more and more banks were allowed to transact in
foreign exchange, this structure was formalized with the establishment of the FEDAI
on August 16, 1958. In the initial years of its formation, FEDAI's primary function was
setting the basic ground rules for the computation of rates and settlements for inter-
bank and customer transactions. Its primary objective was to bring about uniformity in
the rates offered by different Authorized Dealers in a bid to avoid unhealthy
competition and ensure uniform service to clients9.
19. As the foreign exchange markets developed, the roles and responsibilities of
FEDAI also evolved. FEDAI has been instrumental in conceptualising detailed rules
on the conduct of foreign exchange business among banks and its customers and has
hence contributed to customer protection and fair treatment. It has effectively acted as
a bridge between the market participants and the regulator and has contributed to the
development of the foreign exchange regime in the country over the years. I do know
that FEDAI has also been working towards the training and skill upgradations of
professionals working in the foreign exchange arena. It has also been facilitating the
implementation / adoption of the Global FX code which sets out principles that promote
a robust, fair, liquid, open and appropriately transparent market, underpinned by high
ethical standards. More recently, FEDAI took commendable measures during the
Covid-19 pandemic to ease the difficulties faced by the Authorised Dealer banks and
their customers in carrying out forex business.
20. But again, this is also a time to introspect and towards that end, let me flag a
few questions / issues to ponder upon. While I would urge upon you to introspect on
this fundamental issue concerning the neutrality of SROs, let me also outline a few
other specific areas where we in the Reserve Bank would like to see more efforts by
FEDAI.
21. One such issue is about fair pricing for the retail / smaller customers. We have
had many occasions of customers of Authorised Dealers, especially from the MSME
and retail segments, approaching us and expressing concerns about the "high"
charges for foreign exchange transactions levied by Authorised Dealer banks. While
large corporates are able to enjoy the benefits of tighter pricing warranted by the
liquidity in our markets, charges recovered from smaller customers do not appear to
be justified by higher cost of processing / warehousing small ticket transactions. The
FX-Retail platform was introduced in a bid to shift price discovery to an automated
platform. Banks do not, however, appear to have made efforts to encourage customers
to use that platform. What is worrisome about the higher charges levied on the smaller
customers, is the complete lack of transparency regarding the information on charges
levied for such customers. We would definitely like to see concerted efforts by FEDAI
and all banks in ensuring fair and transparent pricing for the less resourceful
customers of the forex markets.
22. While the regulatory framework for financial markets and the broader foreign
exchange system has been simplified and overhauled over the last few years, it would
be required of you individually or collectively through FEDAI, to make sufficient efforts
to ensure that the benefits of simplification, rationalization and procedural ease reach
every customer. An open issue is whether the changes in regulatory framework are
being reflected in the conduct of inter-bank and customer transactions. There has
been a continuous effort by the Reserve Bank to simplify the regulatory framework for
foreign exchange system. Most recently, "Regulations Review Authority 2.0" was
constituted in April 2021 to review the regulations and compliance procedures with a
view to streamline and rationalise them and making them more effective. But this
endeavor is incomplete without the FEDAI also undertaking a similar assessment of
its guidelines with a view to identifying and removing any frictions or impediments that
hinder the fulfilment of regulatory objectives or impede efficient operations of foreign
exchange markets. It would be pertinent here to refer to recent budget announcement
regarding undertaking a comprehensive review of existing regulations by the financial
sector regulators with a view to simplify, ease and reduce cost of compliance. While
we would be doing what is expected from us, this endeavour should be forthcoming
from the SROs as well.
23. The last few years has seen a proliferation of foreign exchange trading
platforms offering services to individuals in the country. These platforms have been
luring gullible people to undertake forex trading with promises of disproportionate/
exorbitant returns. There have been reports of frauds committed by such unauthorised
portals with reports of many residents losing money through such trading / schemes.
The Reserve Bank has been making concerted efforts to warn and sensitise the
general public about the pitfalls of undertaking transactions on such platforms,
including issuing an alert list of un-authorised entities / entities promoting transactions
on unauthorised platforms. It would be appropriate on the part of FEDAI to take a lead
here to safeguard the customers of the industry they are an integral part of and
sensitise public regarding entities which bring disrepute to the industry.
Random Thoughts - Imminent Threats, Emerging Opportunities
24. Against the backdrop of the issues flagged above and the theme of the
conference, let me also dwell on a few select themes relating to the recent
developments in the foreign exchange markets, the approach to foreign exchange
management as well a few areas of potential future changes. A few random thoughts,
so to say.
From a rule-based regulatory regime to a principle-based framework
25. First, as you will be aware, one of the most significant developments in the
regulatory framework for foreign exchange management and foreign exchange
markets has been a shift from a rule-based, prescriptive framework to a principle-
based framework. Let me cite just a few examples. The regulations for hedging of
currency risk have been simplified on a single principle - any entity, resident, or non-
resident, which has an exposure to currency risk, should be able to hedge that risk
using any product, subject only to an assessment of suitability and appropriateness.
The foreign investment regulations have been rationalized subsuming two original and
91 amendment notifications while broadly keeping the regulations principle-based.
The Overseas Investment Framework has also recently been reviewed
comprehensively in consultation with the Central Government. The new regime has
dispensed with most procedural approvals by adopting a principle-based approach
and has significantly enhanced the ease of doing business by reducing the compliance
burden and the associated transaction costs.
26. The case for this shift is evident. In a fast-changing world where ways of doing
business, the technology used for doing business and the ways of financing business
are constantly evolving, it is difficult for a rule-based regulatory regime to keep pace.
This raises risks of stymying useful innovations on the one hand and leaving gaps
which could add to risks to entities or the system, on the other. The case for simplifying
regulations, removing fine prints associated with procedural prescriptions and
elements of discretion are also important from the perspective of reducing compliance
burden and facilitating flexible and nimble footed responses by Authorised Dealers
and stakeholders.
27. But for a principle-based regulatory framework to work and work effectively,
there are certain "rules of the game". First, the shift presupposes that all participants
including Authorised Dealers accept and adopt the change in letter and in spirit and
ensure that the regulations are implemented in a fair and transparent manner and the
benefits of the flexibility provided in the regulatory framework reaches the end users
of the financial system. Second, there has to be trust. The regulator needs to be able
to trust that regulated entities will not abuse the flexibility provided in the regulations.
Third, the shift to a principle-based framework also entrusts a much higher level of
responsibility on the Authorised Dealers. In fact, the more we move towards a
principle-based framework, the greater will be the responsibility of the Authorised
Dealers. For instance, under the new Overseas Investment regime, all transactions
relating to ODI (or financial commitment) by an eligible resident entity in a foreign entity
is required to be routed through the designated AD bank. The AD bank is not only
responsible for ensuring bona fides of the transactions and compliance with KYC/ AML
guidelines, but also compliance with FEMA provisions. We had earlier come across
instances of AD banks permitting remittance towards overseas investment without
receiving the requisite returns from the investor entity. Though, it was always implicit
in terms of section 10(5) of FEMA, that such oversight by AD banks makes them liable
for penal action under sections 11 and 13 of FEMA, the new directions have stated it
unambiguously.
New actors, new products, new markets - A new playing field
28. The foreign exchange arena, in particular, the foreign exchange market, has in
many ways been a sheltered playing field for Authorised Dealers. But this is changing
and changing fast. As an Authorised Dealer, till recently, you had to deal in a small
suite of products. Simple. Easy to understand. Easy to price. Now that there is scope
for Authorised Dealers to innovate and design new products, there are challenges.
You need to think about whether a product is permissible. You need to understand the
product. You need to be able to price it independently. You need to assess the client
base to whom the product can be offered. And you need to be sure that the product is
being offered in a manner which is both suitable and appropriate for the client to which
it is being offered.
29. The flexibility embedded in regulations is easy appreciate. More products add
to depth and liquidity in financial markets. More importantly, they enable more efficient
hedging of risks. But there are risks on both sides of the spectrum. The introduction of
new products can get limited by the ability of market participants to offer them. Our
experience has been that only some of the Authorised Dealers are able to offer even
marginally sophisticated structured products to their clients which results both in lower
liquidity in products and incomplete markets, and in depriving segments of end-users
of benefitting from the flexibility provided in the regulations. But again, there are risks
of Authorised Dealers dealing in products which they do not understand or are not able
to price independently or of offering them to customers who do not understand the
product or where it is not suited for them. We are all aware of past such incidences
that teach us about the pitfalls to avoid. Of course, our Directions on Market Makers
in OTC derivatives seek to provide a principle-based regulatory framework to address
these risks. Hence it is imperative that these regulations are adhered to in both letter
and spirit.
30. There are also new players in the playing field. Traditionally, the foreign
exchange market was characterised by a closed user group with banks being the only
authorised dealers and a few domestic corporates being the primary clients. Exporters
and importers with small hedging needs and individuals with personal forex
requirements were marginal players essentially accessing the market as price takers.
The regulatory framework now permits non-residents to access the domestic foreign
exchange market to hedge their risks and also, in case of non-deliverable derivatives,
to access the market without the need for underlying exposures. Domestically, as the
economy is opening up with increasing capital account convertibility and getting more
and more integrated with the global economy, there are an increasing number of
domestic entities getting exposed to foreign exchange risk and hence may need to
access the foreign exchange market. Going forward, these trends are likely to
accentuate. With different players, there will be diverse needs and Authorised Dealers
will need to gear up to serve these needs. Illustratively, the hedging needs of an
exporter or importer are very different from that of a corporate issuing foreign currency
denominated bonds in offshore markets or setting up an overseas subsidiary.
31. As the economy grows and becomes more developed, the scope of
participation in foreign exchange markets would change. Till recently, only contractual
exposures could be hedged, the exception being hedging of exposures based on past
performance. Now, the scope of participation in the foreign exchange markets has
been expanded to include the hedging of anticipated exposures, of course subject to
safeguards to prevent excessive speculation. With the increasing integration of the
economy with the rest of the world, more and more entities are likely to, directly or
indirectly, get exposed to foreign exchange risks. There are likely to be demands for
permitting hedging of economic exposures. While this may be tricky given the current
extent of capital account convertibility, the possibility of such hedging being permitted
over a period of time as we progress further down the path of capital account
convertibility needs to be carefully evaluated.
32. A whole new market with a new set of market participants has been opened up,
with banks in India allowed to participate in the offshore non-deliverable market for
Rupee derivatives in a bid to integrate markets. This is a part of the overall effort
towards greater convertibility. Results of these measures are already visible. For
example, onshore-offshore spreads have substantially narrowed after allowing Indian
banks to access the NDF market. The move has opened up a whole new opportunity
for all of you assembled here today - an opportunity to make our markets larger, make
them more efficient and to access an entire set of new participants. These
opportunities have to be leveraged. It also needs to be ensured that the domestic
market scales up its efficiency and ensures that this opening does not result in flows
moving to the offshore market.
33. Further dynamics are likely to emerge as we progress down the path of
internationalisation of the Rupee. It is now widely accepted that while
internationalisation and a freer capital account comes with its own set of benefits, it is
not without risks and that freer capital flows comes with their own set of challenges,
the primary one being that of volatility and we need to gear up to manage that. We are
seeing a good amount of interest in the Rupee trading arrangements that we have
been endeavouring to put in place. If our efforts towards Rupee invoicing bear fruit,
domestic exporters and importers will not need to hedge, but there will be other
opportunities in the form of their non-resident counterparts who may need to hedge.
New technologies, new frontiers
34. Let me now talk a bit about how innovation