Regulatory dilemma: Scams vs suffocation

As India’s capital markets deepen, Sebi, industry and academia must work together to strike the right regulatory balance

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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.

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.