Order in the matter of Bombay Stock Exchange Limited

1. The Bombay Stock Exchange Limited (hereinafter referred to as BSE) had submitted a proposal to the Securities and Exchange Board of India (hereinafter referred to as SEBI), vide letter dated July 2, 2004, to introduce a market making scheme in the derivatives segment. As per the said proposal, the market makers would be instructed by BSE to offer at all times, buy and sell quotes in the derivative instruments traded on it. It was submitted that the market making scheme would bring back the much needed initial liquidity in the derivatives segment and that the said activity would be discontinued as soon as reasonable liquidity was achieved. BSE further requested SEBI to consider the proposal and permit it to introduce the said market making scheme. The scheme also proposed to reimburse the losses sustained by such market makers indulging in market making in the derivatives segment. Thereafter, SEBI vide letter dated September 29, 2004 advised BSE that such a scheme would expose it to the risks of market making and therefore, had not allowed BSE from taking “commercial risks as insurance agency”. It was further informed that if, BSE intended to promote market making in the derivatives segment, it may submit a proposal which may include an incentive structure for market makers in accordance with international practices.

2. Thereafter, it was noticed by SEBI in November 2006 that BSE had implemented a ‘Market Development Scheme’ and had engaged Apollo Sindhoori Capital Investments Limited and Sam Global Securities Limited as market makers. The said market development activity had taken place between December 2006 and May 2008 and was limited to the futures contracts of Sensex and Reliance Industries Limited. The total expenditure incurred by BSE in the said scheme was to the tune of Rs.90 crore. In the intervening period (period between SEBI Letter dated September 2004 and the implementation of the market development scheme), BSE had not submitted any fresh proposal for the introduction of the market making scheme. It was therefore alleged that by introducing the market making scheme in the derivatives segment without the permission of SEBI, BSE had acted in contravention of the SEBI letter dated September 2004. In view of the same, a show cause notice dated October 30, 2009 was issued by SEBI to BSE inter alia calling upon it to show cause as to why action and directions in terms of Section 12A of the Securities Contracts (Regulation) Act, 1956 and Section 11(4) of the Securities and Exchange Board of India Act, 1992 should not be taken/issued against it. BSE filed its reply, vide letter dated December 5, 2009. Thereafter, an opportunity of hearing was granted to BSE on January 7, 2010, when Mr. Janak Dwarkadas, senior advocate made submissions in the matter on behalf of BSE. Mr. Madhu

Kannan, Chief Executive Officer & Managing Director, BSE, Mr. L.P. Aggarwal, Chief Financial Officer along with other officials of BSE were also present in the hearing.

3. I have examined the show cause notice issued to BSE, its written submissions, the submissions made by the learned senior counsel during the hearing and other relevant material available on record. The charge against BSE is that it had implemented a Market Development Scheme (the impugned scheme) in the derivatives segment in the year 2006 without submitting a fresh proposal, in contravention of SEBI letter dated September 29, 2004. In this regard, BSE had submitted that its derivative segment was launched on June 9, 2000 and since then, it had undertaken a number of initiatives to enhance market participation, increase volumes and improve liquidity and one such initiative was the introduction of market making schemes. According to BSE, the first such scheme was launched in the year 2002 and that it had launched three market making schemes before launching the impugned scheme. BSE stated that the existence and implementation of the previous schemes were informed to SEBI through various Monthly Development Reports. BSE claimed that despite its efforts, the volumes generated in the derivatives segment were not upto the desired levels and therefore as a further measure, it proposed to compensate the market makers depending on the amount of losses suffered by them.

According to BSE, as the proposed scheme of compensating the losses was not a typical scheme, it had approached SEBI, vide letter dated July 2, 2004, for consideration, as it considered the inputs of SEBI on the scheme were relevant and important. BSE also submitted that, having due regard to the concerns expressed by SEBI vide letter dated September 29, 2004, it had decided not to proceed with the scheme which provided for compensating the losses suffered by its market makers. BSE further stated that as a measure of developing and promoting the derivatives segment, it had decided to implement the impugned scheme which did not in any manner provide for the reimbursement of losses suffered by the market makers. During the hearing, the learned senior counsel submitted that the expenses incurred in relation to the impugned scheme were towards advertising and marketing expenses and that no part of the expenses or the incentives paid to such market makers were intended to reimburse any losses sustained by them. In this regard, he also referred to certain clauses of the agreement entered into with Apollo Sindhoori Capital Investments Limited (one of the market makers of the impugned scheme) which provided for the ‘targeted turnover’ and the ‘fees’ to be paid to such market maker.

He further submitted that the impugned scheme was discontinued with effect from June 1, 2008 as BSE had failed to achieve the desired effects. The learned senior counsel further contended that SEBI Circulars dated January 20, 2002 & August 5, 1992 and the Press Release dated November 10, 2009 on ‘market making’ applied to the equity segment and the ‘SME’ segment, and that there are no specific rules/regulations/circulars issued by SEBI which prohibit or otherwise seek to regulate the manner in which a stock exchange would implement market making in the derivatives segment. One of the arguments put forward by the learned senior counsel is that there was no legal compulsion on the part of BSE to seek approval (prior or post facto) from SEBI and that it had sought prior approval from SEBI for the implementation of the scheme (which intended to compensate losses of market makers) only out of abundant caution or purely as a measure of good governance. According to the learned counsel, the same would not mean that for a plain vanilla market making scheme, which is an incentive driven scheme based on volumes, requires prior approval or post facto approval from SEBI.

He contended that it is a well settled proposition that what is not prohibited is permitted and that if it is permitted, the question of prior approval would not arise. He drew my attention to the decision of the Hon’ble Securities Appellate Tribunal in the matter of Harinarayan Bajaj vs. SEBI, in this regard. The learned senior counsel further submitted that the earlier three schemes did not require such approvals and that the scheme launched in 2006 was similar to the previous schemes as it did not reimburse the losses. As regards the expenditure of Rs.90 crore, he submitted that they were marketing expenses and incentives and that the show cause notice was silent as to whether any prejudice was caused to BSE or to any investor in the market, by reason of the introduction of the impugned scheme. He strenuously argued that no direction can be issued against BSE on the basis of the present show cause notice.

4. I note the submissions of the learned senior counsel that the impugned scheme did not provide for compensating the market makers for the losses suffered by them while indulging in market making for the derivative instruments offered by BSE. According to him, even as per SEBI letter dated September 29, 2004, BSE was legally entitled to regulate and control dealings on the securities including derivatives. What was restrained, according to him, was the stock exchange taking commercial risks as an insurance agency. His submission was that BSE was entitled to launch a scheme which did not reimburse losses, without the permission of SEBI. The learned counsel contended that even as per the show cause notice Rs. 90 crore was mentioned as the total expenditure incurred by BSE in relation to the Market Development Scheme and that nowhere it was alleged that the said money was the reimbursement of losses sustained by the market makers. According to BSE, the letter dated September 29, 2004 was not contravened as it had not gone ahead with the scheme proposing to reimburse losses and that the impugned scheme did not provide for losses sustained by market makers. BSE stated that the impugned scheme was in existence till June 1, 2008 after which it was discontinued as it did not achieve the desired effects. The learned senior counsel placed reliance on the SEBI letter dated February 17, 2005, wherein SEBI, based on the recommendations of Advisory Committee on Derivatives and Market Risk Management advised BSE to work on certain aspects mentioned therein in the options market and to explore various ways of providing a market making scheme in the order driven market. According to him, in terms of the said letter, BSE was supposed to revert back to SEBI, only if required. I also note the submission that pursuant to the SEBI Letter dated September 29, 2004, BSE had decided not to proceed with the proposed scheme, which provided for reimbursements of losses suffered by the market makers.

5. BSE’s contention is that there are no explicit provisions that SEBI has mandated which required it to seek prior permission for launching the impugned market making schemes in the derivatives segment. However I am constrained to observe that since SEBI had issued a letter in a closely related matter, notwithstanding the stand of BSE that the subject matter in this instant case was different, it would have been in the fitness of things and would have been proper for BSE to have brought its new market development scheme to the attention of SEBI. For a market infrastructure institution of long standing like BSE, it should have seen that as a regulator for the securities market, SEBI has been and is at all times sensitive to the potential of any such activity or market making scheme jeopardizing the system and eroding the integrity of the securities market. I therefore, at this juncture, would advise BSE and remind it of its duty to bring such schemes which have wide and far reaching implications for the securities market, in future, to the attention of SEBI and seek guidance or approval wherever required. I however, stop short of prescribing what exactly a scheme would be or laying down yardsticks that would set apart schemes with far reaching consequences for the securities market, as I would still prefer to leave it to the better judgment of an Exchange.

6. Considering all the aspects of the case, I am of the view that this is not a fit case for issuing directions or take action as contemplated in the show cause notice dated October 30, 2009. However, this order shall not be interpreted as a comment on the merits or desirability of the impugned scheme or an endorsement of the expenditure incurred therein. Considering the case in its totality, the show cause notice issued to BSE is disposed of as ordered hereinafter.

7. In view of the foregoing, I, in exercise of the powers conferred upon me under Section 19 of the Securities and Exchange Board of India Act, 1992 read with Section 11(4) thereof and Section 12A of the Securities Contracts (Regulation) Act, 1956, hereby dispose of the show cause notice dated October 30, 2009 issued to the Bombay Stock Exchange Limited, advising them to bear in mind the advisory instructions above in this regard.

DR. K.M.ABRAHAM WHOLE TIME MEMBER SECURITIES AND EXCHANGE BOARD OF INDIA PLACE: MUMBAI DATE: APRIL 20, 2010