The Reserve Bank of India (RBI) has urged the government to ban FDI in proprietary trading as it is ?potentially detrimental to financial stability.? In a recent communication to the finance ministry, RBI contended that since proprietary trading is largely an unregulated activity and NBFCs doing this should not be allowed to build and leverage their positions in the Indian financial markets by using FDI or borrowed funds.
The central bank perceives a ?clear possibility of regulatory arbitrage? by foreign investors if FDI is allowed in entities interested in proprietary trading but not inclined to register with market regulator Sebi and subject themselves to regulatory rigour. ?Given the present macroeconomic scenario in India, specifically in the context of higher capital inflow which is exerting pressures on exchange rate and aiding asset price build up, it may not be an opportune time for further liberalisation of the FDI policy by allowing foreign investments in proprietary trading,? RBI said in the communication.
Currently, FDI in proprietary trading is allowed through the foreign investment promotion board (FIPB) channel while 100% FDI through the automatic route is permitted in 18 other NBFC activities.
Proprietary trading refers to the practice of a firm trading in stocks, bonds, currencies, commodities and derivatives with its own money as opposed to its customers’ money, so as to make a profit for itself.
?All three concerned parties, including finance ministry, RBI and Sebi, have to fast track financial reforms in a big way in order to check misuse of proprietary trade and at the same increase FII investment in India. The policy to discourage proprietary trade should not in any way be an obstacle for FIIs,? said Kishore Oswal, MD, CNI Research.
RBI has also called for stricter prudential regulations for firms, including Indian banks that leverage their balance sheets to undertake proprietary trading in the interest of financial stability. According to finance ministry estimates, during April-June 2010, around 24% of the total trading on the stock market was done through proprietary trading.
RBI said one of the primary reasons for the global financial crisis has been the proliferation of loosely regulated entities that bypassed the direct prudential and regulatory oversight.
Proprietary trading inherently involves leveraged positions and substantial borrowings from the financial sector. This leads to moral hazard problem because the firms undertaking leveraged activity are also involved in trading on behalf of their clients. In 2008, the failure of such leveraged entities, many of which were created as SPVs, in the US resulted in bankruptcy of multinational financial institutions. These SPVs had enormously traded in exotic derivatives and funded risky assets by volatile short-term liabilities.
Under the present banking regulations, banks in India are not allowed to undertake propriety trading as a standalone activity. Indian banks undertake this trading as part of their normal liquidity management and banking business and are governed by prudential guidelines on capital adequacy and risk exposures.
RBI has said it has been of late getting proposals from multinational banks for allowing them proprietary trading in India. But, the bank is steering clear of entertaining such proposals as it fears that the move would provide an avenue for clear regulatory arbitrage.
