Mumbai: MCX Stock Exchange (MCX-SX) has applied to the Securities and Exchange Board of India, or Sebi, the capital market regulator, to offer trading in equities. If it wins approval, it would be the first greenfield equities exchange in India since the National Stock Exchange (NSE) started about 15 years ago.
The proposed new stock exchange would compete with NSE and the Bombay Stock Exchange (BSE). It would also be the first stock exchange with a common ownership and management in the post-demutualization era.
Globally, when stock markets moved from being broker-owned mutual associations to shareholder-owned entities—a process known as demutualization—concerns arose over the governance of for-profit equity exchanges. In most cases, the regulatory function has been spun off to a different entity to remove any conflict of interest.
Blind emulation: The Bombay Stock Exchange building. Replicating the National Stock Exchange kind of structure hasn’t worked for the 133-year-old stock exchange, either in terms of preventing governance problems or in terms of fostering effective competition. Madhu Kapparath / Mint
MCX-SX’s proposal has revived governance concerns and looks likely to set off a debate on the benefits of competition in the stock trading space. “When the leadership of an exchange is overtly profit- or valuation-focused, there is a temptation to undertake actions which maximize trading volume but are not in the interests of the market as a whole,” said Ajay Shah, an expert at the National Institute of Public Finance and Policy.
A stock exchange’s responsibilities include surveillance of market participants and ensuring that a robust risk management mechanism is in place. It does this by monitoring position limits and collecting adequate margins on time. When the owners of the exchange oversee such regulatory functions, there could be a conflict of interest, some analysts say.
Jignesh Shah, vice-chairman of MCX-SX, said there was no issue over the lack of separation between management and ownership. “We are a duly recognized stock exchange by Sebi, conforming to all compliance norms,” he said. “Sebi has given us the recognition after proper scrutiny. We have a strong professional team with domain knowledge to run the business.”
The 133-year-old BSE, Asia’s oldest exchange, and many regional stock exchanges in India have got demutualized, but policymakers sought to address the governance problem by putting restrictions on ownership. No single shareholder can own more than 5% in a stock exchange and for certain categories of financial institutions, the cap is 15%.
J.R. Varma, a professor at the Indian Institute of Management, Ahmedabad (IIM-A), is not convinced that a cap on the stake of a single shareholder alone would limit governance problems. “Even with a low ownership stake, one entity can control an exchange. And with an ownership cap, the threat of takeover is diminished, giving the entity in control a free run,” he said.
Indeed, some news reports suggest that a string of resignations from BSE’s board last year were linked to some governance issues. This was well after the demutualization process was over, indicating that ownership restrictions alone won’t ensure the smooth functioning of an exchange.
The current policy on ownership restrictions comes from the comfort with NSE model, where ownership and management are distinct. NSE is owned by a number of financial institutions, and is governed by an independent management team that isn’t controlled by any of the shareholders. Also, broker members have no stake in the company.
Since its launch in the mid-1990s, NSE has functioned free of governance-related issues. Besides, it has been the leader in introducing the more efficient practice of electronic trading as well as trading in equity derivatives.
Meanwhile, BSE continued to be saddled with controversies and governance-related issues. When the time came for BSE’s demutualization, policymakers wanted to have an NSE kind of structure for BSE’s demutualization process. But replicating this in BSE hasn’t worked, not only in terms of preventing governance problems, but also in terms of fostering effective competition.
NSE, during its creation, had adequate government support. A number of government-owned institutions lined up to fund the company and one in particular, IDBI Ltd, deputed key people such as R.H. Patil to run the exchange. Besides, government policy on extending countrywide reach favoured NSE over BSE.
A number of executives in the exchange business feel that the current restrictions on ownership are anti-competition. The question being raised is, with a mere 15% stake, which entrepreneur would have the motivation and the incentive to take on an entrenched player such as NSE? Even if a new player were to take away meaningful market share, the rewards from such an effort would be restricted to 15% of the company’s profit.
In MCX-SX’s case, Sebi allowed the Financial Technologies (India) Ltd and Multi Commodity Exchange of India Ltd combine to hold 100% stake last October, with the caveat that the group’s stake should be brought down within a year to meet the limits on ownership by a single entity. This is better than starting off with a low ownership, but there is still the pressure of finding outside shareholders at the right valuation within a short period. Policymakers have been wary about overseas exchanges too, although they are widely held companies and their ownership and management is distinct. This has hindered credible competition in the exchange space.
Some observers say NSE’s high pre-tax profit margins of at least 70% prove that the exchange is taking undue advantage of its near-monopoly status. But while NSE’s cash profit increased by Rs180 crore in 2007-08, its capital expenditure rose by Rs130 crore. In other words, much of the increase in profit was put back in the business, the benefits of which are available to the exchange’s users.
It’s not the same with its clearing and settlement subsidiary, National Securities Clearing Corp. Ltd, or NSCCL, where a tiny portion of the incremental profit has been deployed. But then the profit of NSCCL is a function of the return on the cash margins paid by members, which in turn is mandated by Sebi. Again, 2007-08 was exceptional in terms of market turnover. Profit margins were lower in the preceding year and can drop to that level owing to the drop in trading volumes this year.
There’s little doubt that the market participants are missing out due to lack of competition for NSE. The four major areas where experts feel there is room for improvement are: product innovation, better use of technology, cost cutting and customer satisfaction.
In India, new products in the equity markets are approved by Sebi, but greater competition would result in exchanges pushing the regulator for new products, to gain more market share. Currently, there’s no pressure on NSE to innovate. The last successful product it introduced in the equity space was single-stock futures, at least seven years ago.
Besides, most brokers say that NSE ranks poorly in terms of customer service. “NSE has a dominant position in the market; it has a monopoly in derivatives; and its approach to investors largely reflects that. In the name of more regulation, it becomes bureaucratic. While it is transparent in terms of operations, it’s largely autocratic and opaque in terms of policymaking. It does not consult brokers or investors,” said a broker, who did not want to be identified.
All this can be expected to change if there is effective competition. There’s not much leeway with costs and margins, as a big portion of trading costs, the securities transaction tax, is determined by the government. Also, Sebi lays out the margins that exchanges need to collect from members. A new entrant can be expected to slash transaction fees to gain share and members can be expected to benefit to some extent.
Indeed, competition is desirable but at the same time, issues of governance can’t be ignored. Varma of IIM-A puts it succinctly: “Competition is always good, but in the exchange space one must also ensure that this doesn’t go in a totally different direction, where the competition is on who’s the least governed exchange.”
In some jurisdictions, owner-managers perform the regulatory function as well. Those who favour this model say that for-profit exchanges will carry out their regulatory duties to keep their reputation intact, because this in turn will ensure long-term sustainability.
“Privately operated and owned market places do not stand in any opposition to high regulatory and supervisory standards required by the market and the authorities,” Olof Stenhammar, founder and chairman of Sweden’s OM Group, said in a past speech at an International Organization of Securities Commissions (IOSCO) annual conference. “It is not just a question of morality. To me, it is a question of being a good businessman,” he said.
Some experts take this with a pinch of salt. Says Varma, “Where one trades is driven by liquidity more than anything else. People want the ability to trade and will chase liquidity. An exchange with a near-monopoly in a particular contract can raise margins and transaction charges significantly without losing much market share.”
In other words, traders may overlook governance issues as long as they are given access to a liquid market. In any case, the key governance worry is about ignoring excesses by traders, and so reputation risk may not be the factor one can bank on to ensure robust regulation.
An IOSCO consultation report states, “Most regulators have focused on governance arrangements as the primary means of ensuring that exchanges have robust arrangements for maintaining a proper balance between the exchange’s commercial interests and its regulatory responsibilities.”
Ravi Krishnan in Mumbai contributed to this story.