‘Large firms and their interests can dominate the narrative, even as smaller stakeholders and retail investors struggle to be heard.’ ‘Regulators therefore require deep subject-matter expertise to assess representations, recognise underlying incentives, incorporate the perspectives of less-visible stakeholders, and guard against bias or capture,’ notes Ananth Narayan.

Illustration: Dominic Xavier/Rediff

Every regulator faces an inherent tension: Act too softly and risk scams; act too harshly and suffocate legitimate business.

In navigating this tension, a securities regulator must achieve three distinct goals.

The first goal is investor protection. Large-scale frauds and market manipulation can severely damage trust in the markets.

When regulators fail to prevent or respond decisively to such misconduct, they commit a Type I error.

These failures make headlines, cause investors to pull back, erode confidence, and ultimately impair capital formation.

The second goal is ensuring regulation does not penalise honest enterprise. Rules that are onerous, disproportionate, or complex, raise costs, discourage new entrants, and stifle innovation.

These are Type II errors. The damage they cause is insidious; unlike Type I errors, they rarely generate headlines.

Instead, they manifest as ‘businesses that were never started’ or ‘the capital that went elsewhere’.

The third goal is improving efficiency and reducing system-wide risk.

Initiatives like the dematerialisation of shares and faster settlement cycles are examples.

While these provide long-term systemic benefits, they can face resistance from incumbents.

Meeting these objectives simultaneously lies at the heart of effective capital markets regulation.

Balancing different perspectives:

India’s capital markets have much to celebrate. Our digital infrastructure, settlement processes, and markets set global benchmarks.

Over the past five years, the number of individual investors has tripled, highlighting the ongoing financialisation of domestic savings.

In this context, any broad-brush calls for deregulation must be viewed with caution.

Our capital markets are in a different space compared to, say, our manufacturing.

A countercyclical approach – such as being cautious when small investors are ebullient – may be necessary in some parts of the capital markets.

That said, global uncertainty and rising retail participation increase the stakes for both under-regulation and over-regulation. Achieving the right balance is crucial.

Having been a trader, an academic, and a regulator, I have experienced the ‘truth’ from different viewpoints.

As a market participant, I often felt regulations were heavy-handed, slow to evolve, and focused more on the ‘form’ of compliance than the ‘substance’ of risk. From that perspective, there were many Type II errors.

My stint with the Securities and Exchange Board of India (Sebi) provided a counter-perspective.

Sebi oversees over 20 distinct classes of entities – from market infrastructure institutions and intermediaries to investment funds and listed companies.

Many entities grow at a pace that outstrips supervisory resources.

In this context, any instances of opacity or regulatory arbitrage weaken trust, stoking fears of larger Type I errors.

This can lead to actions that are viewed by industry as heavy-handed.

The limits of enforcement: A common, if simplistic, prescription is that regulators should stop making more rules and focus exclusively on ‘targeted enforcement’.

While this sounds logical, it has practical limitations.

Detecting misconduct in rapidly evolving markets can be difficult with finite regulatory resources.

Furthermore, even when violations are identified, well-funded defendants can prolong legal proceedings through technical and procedural challenges without ever engaging with the merits of the case.

Until the legal ecosystem decisively upholds principle-based regulation in a timely manner, regulators may feel the need to rely on prescriptive rules to address mischief.

From mistrust to co-creation

The AIF example: To bridge the trust deficit, market participants and regulators must speak to one another rather than past one another.

The recent evolution of the alternative investment fund (AIF) industry offers a constructive case study.

AIFs have grown at a robust 30 per cent annually over the last five years.

However, between 2022 and 2023, Sebi’s small AIF supervision team found that many AIFs, with investments of several thousand crores of rupees, appeared to be structured to circumvent banking, insolvency, and foreign exchange laws.

While segments of the industry were aware of these ‘sharp practices’, the burden of discovery fell entirely on Sebi.

Sebi responded with intensified supervision and restrictive rules – and legitimate AIF participants felt the sting of increased compliance burden.

Eventually, constructive engagement between Sebi and industry bodies like the Indian Venture and Alternate Capital Association helped achieve a better balance.

Through these bodies, industry began conversations on problematic practices and, crucially, proposed viable solutions.

As the regulator gained confidence that Type I risks were being jointly addressed, it accepted industry feedback and rolled back restrictive measures, reducing Type II errors.

Dialogue works best when the industry acts like a credible self-regulatory organisation (SRO), serving as a ‘trusted advisor’ rather than a lobbyist.

Regulations and enforcement are too important to be left to regulators alone.

Expertise and independence:

One challenge in co-creating regulations is ensuring all-round representation.

Large firms and their interests can dominate the narrative, even as smaller stakeholders and retail investors struggle to be heard.

Regulators therefore require deep subject-matter expertise to assess representations, recognise underlying incentives, incorporate the perspectives of less-visible stakeholders, and guard against bias or capture.

Greater movement of people between industry, academia, and policy institutions can help regulators better understand evolving market practices, provided conflicts of interest are transparently managed.

A regulator staffed only by generalists, however capable, may struggle to keep pace with increasingly complex and specialised markets.

Academia must step up as a practical bridge. At present, research is often viewed by practitioners as theoretical, while practitioners are seen by academics as overly short-term in their outlook.

Sustained engagement should help narrow this gap and improve the quality of regulatory decision-making.

Finally, achieving regulatory balance is not about winning a popularity contest.

In an era of noisy and often motivated opinions on social media, well-considered, clear-headed, medium-term thinking and regulatory independence are crucial.

Regulators must, of course, continue to remain completely transparent about the rationale behind their decisions.

As India’s markets grow, the quest for balanced regulations continues.

Industry bodies must ensure broad-based representation and act as trusted advisors around the risks in their own sectors.

Regulators must continue to consult openly, build expertise, and remain sensitive to the costs of over-regulation.

Academia should actively facilitate consensus building.

A better balance can ensure that the regulatory pendulum swings less wildly and more wisely.

Ananth Narayan is a former whole-time member, Sebi. The views are personal.

Key Points

• Regulators face a fundamental tension: Act too softly
• India’s capital markets are globally competitive
• Industry must act as credible self-regulatory organisations

Feature Presentation: Aslam Hunani/Rediff