Turning to securities markets, the major lesson of 2008 is the vulnerability of OTC contracting, where counterparties talk to each other on the phone or on a chat system, where the transparency of an exchange is absent and where there is counterparty credit risk. When Bear Stearns approached death, the US Fed was forced to help JP Morgan buy the firm owing to the repercussions in the OTC market where Bear Stearns was active. When Lehman died, repercussions in OTC markets were Lehman was active were critical in generating panic. The collapse of the money market in London and New York was critically about the use of OTC contracting on this market.
In India, for more than a decade, RBI has championed a big role for OTC contracting, driven by considerations of turf: exchange-traded products are regulated by Sebi, while the vaccuum in OTC contracting has been utilised by RBI to grow its influence. Wise men in India have long warned about the problems of OTC contracting. The Percy Mistry report has an extended rumination on why it makes sense for India to emphasise the discipline and safety of the exchange and the clearing housewhere trading takes place with the transparency of a fish tankas opposed to the great wide ocean of OTC contracting.
The currency futures market is a litmus test of how much RBI has learned. So far, it seems that RBI has learned nothing, for the transparent currency futures market is hobbled by restrictions while the opaque OTC currency trading gets a free pass. Those who fail to learn from history are doomed to relive it. The third key lesson concerns the fragmented and byzantine regulatory architecture of the US which led to failures of financial regulation, particularly of home loans. The US Fed is ultimately a central bank and is not focused on financial regulation. In a structure with multiple regulators, a lot of regulation was getting done but the right things were not getting done. It is a telling comment that in the UK, Northern Rock ran into trouble when its funding on the money market dried upbut Northern Rock had an NPA rate of only 2%. The UK model delivered sound practices at Northern Rock for giving out home loans as opposed to the US model. Fundamental change in regulatory architecture in the US might now come about. The rules-based SEC might be merged into the principles-based system. Banking and insurance regulation might come into unified agencies. In India also, there is a substantial task of clarifying regulatory architecture. Market functions of RBI need to be placed at Sebi. Banking regulation needs to come out into a separate regulator.