In the story of India’s economic reforms, the revolutionary changes on the equity market stand out. In the early 1990s, the Indian stock market was opaque and riven with malpractice. It imposed substantial transactions costs upon the firms and households in the economy who were its users.
It is hard to overstate the magnitude of the change which has come about from 1993 to 2003:
- Physical share certificates have been replaced by depository settlement.
- Trading by open outry, primarily on the BSE floor, has been replaced by electronic trading, primarily on NSE.
- The settlement process is flawless and trusted worldwide.
- Derivatives trading has taken off.
- Numerous international rankings in finance now have something from India in the top 10 list: this includes the number of transactions per day at NSE and BSE, the number of contracts traded of derivatives on Nifty and the number of contracts traded of individual stock derivatives. Apart from the equity market, there is nothing from Indian finance that is found in top-10 global lists.
- A new governance model has come into place, with a three-way separation between owners of the exchange, the managers of the exchange and the member firms.
- The equity market has the full food chain, from investment in startups and unlisted companies by venture capitalists to a screen-based IPO auction to secondary market trading to individual stock derivatives to index derivatives, index funds and index ETFs. It has a rich ecosystem, with individuals, domestic institutional investors and foreign institutional investors, and without significant trading by the government or by PSUs .
It is fair to say that almost nobody in 1993 could have predicted that in a short ten years, India would achieve such far-reaching change, despite concerted political lobbying in trying to prevent change.
Alongside these immense changes, however, there has been a striking stasis in other parts of Indian finance . Banking in India looks much like it did in 1993. There are private banks, but their share in deposits and assets is below 10%. The behaviour of banks and bankers in India continues to be essentially the same as it was 20 years ago: mostly driven by a detailed rules-based system which prevents the information processing that is the essence of banking. The same is the problem with insurance or pensions, which are largely unchanged when compared with 1993 when we consider the facts on the ground, of where the assets are. Old-timers remind us that the bond market in 1990 and 1991 actually had more liquidity than what is found today; what has been achieved is actually the replacement of a crisis-prone vibrant market with a perfectly safe non-market. Policy-makers have pushed a great deal of electronics into the bond market and the currency market, and in some ways it has helped reduce risk. But the end-goal of a liquid and efficient market, with vibrant speculative price discovery, has remained elusive.
India is thus hobbled without a fully functioning financial system. An economy with only one success story in finance – the stock market — is like a plane flying on one engine. For finance to play its full role in fostering high GDP growth, other elements of the financial system have to come to life. A good banking system, a good insurance industry, a strong pension system, all these are important enablers of growth. Most of all, the deeply interlinked bond market and currency market – which has been termed the `Bond-Currency-Derivatives (BCD) Nexus’ by the Percy Mistry report  – is essential from many points of view. The bond market is required for financing public debt in a healthy manner, for financing long-dated infrastructure project, for enhancing the growth of companies through issuing corporate bonds, and for enabling loans to households.
A certain approach towards financial sector reforms has been tried for almost 20 years now. It is important to step back and ask why the reforms of the equity market worked while the reforms of other areas of Indian finance did not. If this question is not asked, and if incremental efforts are continued for the next decade in much the same fashion as has been done for the last two decades, then there is every likelihood of trundling along for one more decade and (in the end) only having an equity market.
What went right with the equity market in the early 1990s? A few critical elements can be identified:
- New law-making created a new regulator, SEBI.
- Critical elements of SEBI’s design were done right. SEBI does not own market infrastructure; it only regulates markets. SEBI has no view on whether prices should go up or down: it only worries about fairplay on markets. SEBI never trades on financial markets.
- SEBI was a brand-new agency, which created a team which was culturally and intellectually oriented towards the concept of financial regulation as applied in the context of a financial market comprised of private actors. The phrase `fostering speculative price discovery’ was absorbed into SEBI’s organisation culture, while it was alien to those used to a socialist vision of India.
- Government instigated the creation of critical elements of market infrastructure – NSE, NSCC, NSDL, CCIL – all of which embodied a new governance model with a three-way separation between the owners, the management team and the financial firms which became members and utilised the services. These organisations brought a new concept of highly efficient public utilities into Indian finance.
This process required a torrid pace of legal reform. The erstwhile Securities Contracts (Regulation) Act (SC(R)A) of 1956 and the new SEBI Act of 1992 are the most important documents which made all this possible. This required a sustained effort of steering the text of SC(R)A away from mistakes in the original drafting, and ill-thought out amendments of the intermediate years, towards a modern text. It also required a sustained effort from 1988 to 1992 to get the SEBI Act into place, and then to make numerous modifications to it reflecting a modern vision and the requirements of India of 2009.
The key lessons of the equity market concern fundamental change in the role and functioning of government agencies. The revolution of the equity market was not achieved by respecting existing structures and politely requesting them to catch up with the idea of India as a market economy. The erstwhile CCI was closed down; a new SEBI was created; acute pain was inflicted on BSE; all regional exchanges other than BSE went extinct in effect; a new governance model was invented and used for the creation of new agencies in the form of NSE, NSCC, NSDL and CCIL.
By and large, the agenda of establishing a world class equity market has been achieved. Progress has petered out as the implications of these changes have been fully worked out. Achieving further progress requires a new array of legal changes. The path for these has been mapped out by the Percy Mistry, Raghuram Rajan  and Jahangir Aziz committees. Three goals stand out:
- Establishment of the Debt Management Office (DMO), designed by the Jahangir Aziz committee. This will be the investment banker to the government, thus unburdening RBI of the three-way conflict of interest, of (1) setting the short-term interest rate while (2) trying to sell bonds for the government at the lowest possible interest rates and (3) regulating banks which are the prime buyers of government bonds.
- Unification of the regulation of all organised financial trading at SEBI. This involves merging the Forward Markets Commission, which regulates commodity futures  through legislation enacted in 1952, into SEBI. It also involves shifting the work being presently done at RBI (rooted in legislation enacted in 2006) in regulating the currency and bond markets into SEBI. Alongside this, further work is needed on editing the SC(R)A to reflect modern thinking about securities law.
- Enactment of the PFRDA Bill, which will give legal clarity to the regulation of the New Pension System (NPS).
These three elements are critically about lawmaking. Each of them represents a major advance in Indian financial sector reforms, and will not be achieved without legislation.
In addition, there is one area where critical progress does not hinge on legislation. This is the removal of entry barriers in banking. This includes removal of restrictions on domestic and foreign banks against opening branches , and a mechanism through which new private banks can come about. This involves aiming for a dynamic framework where every year, 5-10 new banks come about and 2-5 banks are closed down. As with airlines and telecom, bank privatisation is useful but not essential to obtaining progress: it is possible to obtain enormous progress by merely easing up on the existing entry barriers which uphold the prevailing stasis.
While the Bank Regulation Act (BRA) forced banks to take permission from RBI for the purpose of opening branches, it remains possible for RBI to setup a frictionless process through which approvals are automatically and immediately given, so that in effect, the entry barrier is eliminated. Apart from this, all these other elements of making progress on banking do not require legislation. This emphasises the glaring failure of economic policy in banking, where even though legislative activism is not the critical bottleneck, progress has not been achieved.
The last major achievement in Indian financial sector reforms was in 2001, when the equity market shifted to rolling settlement and derivatives trading came about fully. From 2001 till 2009, there has been little progress on financial sector reforms. There is an increasing gulf between the needs of India as a trillion dollar globally integrated economy, and the ramshackle financial system which is in place. The technical work that is required has been put into place, through the Percy Mistry, Raghuram Rajan and Jahangir Aziz reports. The UPA-II needs to now move on these legislative changes which will unleash a next phase of fundamental change, much like the legislative activism of the 1990s made the revolution of the equity market possible.
 For the story of India’s equity market, see : David and Goliath: Displacing a primary market by Ajay Shah and Susan Thomas, Journal of Global Financial Markets, Spring 2000.
 India’s Financial Markets: An Insider’s Guide to How the Markets Work by Ajay Shah, Susan Thomas and Michael Gorham. Elsevier, 2008.
 High Powered Expert Committee on Mumbai as an International Financial Centre, led by Percy Mistry, Ministry of Finance, 2007. This is often abbreviated HPEC-MIFC or called the Percy Mistry Report.
 Raghuram Rajan led a Planning Commission committee on financial reforms.
 On commodity futures trading in India, see Agricultural commodity markets in India: Policy issues for growth by Susan Thomas. In “India’s financial sector: Recent reforms, future challenges”, edited by Priya Basu, Macmillan, 2005.
 At present, all foreign banks, put together, are allowed to open 18 branches per year in India.