No one can serve two masters, for either he will hate the one and love the other, or he will be devoted to the one and despise the other. You cannot serve both God and money”, Jesus had said in his famous Sermon on the Mount. The Bimal Jalan committee’s view on the functioning of stock exchanges is not very different. The underlying principle on which the committee has made its recommendations is this: Market infrastructure institutions such as stock exchanges may not carry out their regulatory goals with vigour if its main focus is profit maximization. These institutions are engaged in the business of producing a valuable public good for society, and their goal can’t be profit maximization, as their regulatory goals may get compromised.
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This explains some of the committee’s recommendations such as ownership restrictions, a cap on profit, disallowing listing of the exchange’s shares and forbidding variable pay and stock options for key management personnel in stock exchanges. Some experts and industry participants have dismissed the recommendations as retrograde, saying they will restrict the growth of the stock markets, as they impede greater competition in the exchange space.
The problem with most of these criticisms is that they brush the “conflict of interest” issue under the carpet. The concern that a profit-maximizing exchange may compromise regulatory goals isn’t a figment of the Jalan committee’s imagination. This is concern expressed by regulators world over. In fact, when the New York Stock Exchange (NYSE) went through the demutualization process and decided to get listed, the US Securities and Exchange Commission is reported to have expressed concerns that in the process of keeping its new shareholder owners happy, the exchange could get lax in its regulatory role. Eventually, this led to the carving out of NYSE’s regulatory functions into a non-profit organization called NYSE Regulation.
In a paper titled “Conflicts of interest in self-regulation: Can demutualized exchanges successfully manage them?”, John W. Carson, consultant for the World Bank, points to a similar separation between NASD and Nasdaq—“They decided that Nasdaq would be more successful as a business, and the NASD more successful as a self-regulatory organization, if their roles were separated.” He also gives the example of Hong Kong, which implemented a comprehensive set of conflict management safeguards.
The “conflict of interest” issue for a profit-maximizing exchange needs to be appreciated. But as argued in this column before, the need for greater competition in the exchange space can not be brushed aside either. The committee members may argue that there is scope for new exchanges to come up in the recommended framework. But with ownership restrictions, a cap on profits and by disallowing listing, the scope for investor interest in new exchanges should be limited.
Can the need for greater competition and a no-compromise approach to regulation be achieved simultaneously? One way to do this is by separating regulatory functions to a non-profit organization, akin to the model adopted by NYSE and the Nasdaq. That way, exchanges can focus on their products and services and make as much money as the system permits. The non-profit organization will perform the regulatory roles and can report directly to the market regulator. Both organizations would serve just one master and so the “conflict of interest” issue is taken care of. The committee, however, has rejected this model for the time-being, citing that it is premature to think of it for the Indian markets given its evolution over a period to its present state. While it may have good reasons for saying so, the single line explanation given above is woefully inadequate.
The committee’s report refers to the suggestion by some experts that some regulatory functions such as market surveillance should be shifted out of exchanges to the market regulator. The reason for this is that with trading becoming increasingly fast and integrated, there needs to be integrated surveillance of the markets. The committee has rejected this suggestion citing that it prefers the current model where exchanges act as the primary guardian and the Securities and Exchange Board of India (Sebi) adds a second layer of surveillance. It also says that entrusting stock exchanges with the surveillance function means that surveillance begins right at the interface between the client (through the broker) and the trading and settlement system, which provides a sounder basis for a well-regulated market.
But this can be achieved with the independent regulatory organization model as well. As pointed above, the committee hasn’t made convincing arguments against this model which has been adopted by some of the world’s largest exchanges.
Another problem with the report is that it proposes a policy flip-flop as far as existing shareholders of exchanges go. Sebi had pushed Indian exchanges to go through the process of demutualization—a process which involved member-brokers buying shares in the exchanges. Simultaneously, exchanges also sold shares to financial investors and both the National Stock Exchange and the Bombay Stock Exchange have seen shares change hands for millions of dollars.
According to one expert, these investors have actually ended up with quasi-bonds thanks to the proposed cap on profits. By disallowing listing, the valuation of the shares would be affected further. The problem is that the view of the committee has been part of policy thinking for years now and it’s now that it’s being articulated in such elaborate detail. If this had been done earlier, financial investors could have made more informed decisions. But then, policy makers seem to be least bothered about the interest of exchange owners.
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