There’s little doubt that the Securities and Exchange Board of India (Sebi), under chairman C.B. Bhave, favours competition. It processed the application of MCX Stock Exchange Ltd (MCX-SX) to launch currency futures fairly quickly and even relaxed ownership restrictions for a year to ensure that the newly launched segment would benefit from competition between exchanges.
But the decision to approve equity trading, for which MCX-SX has sought regulatory permission, is not as straightforward. Experts on securities market infrastructure such as J.R. Varma and Ajay Shah say that while competition is desirable, one must also ensure that the regulatory role of stock exchanges does not get compromised in the race for market share. Shah says that an overtly profit-focused exchange could consider turmoil on the market good simply because it increases turnover; or can make outright payments to produce fraudulent circular trades that yield fake turnover. As a result, market integrity would get compromised. Given the various stock market scams India has seen and the hue and cry they had provoked, it seems natural that policymakers would exercise caution when it comes to approving new stock exchanges.
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Not that this is an India-specific problem. World over, regulators have expressed this concern. A consultation report by a technical committee of the International Organization of Securities Commissions, titled Regulatory Issues Arising From Exchange Evolution, notes: “Although regulatory authorities have generally recognized that competition among market operators should offer market users efficiency benefits, most have also taken the view that a more competitive environment in general can create a number of risks in respect of the specific regulatory roles that exchanges perform in their jurisdictions.”
Varma says, “In other jurisdictions, the regulatory role of exchanges have been separated to non-profit entities to avoid conflict of interest. Such options could be considered in India.” A prime example is NYSE Regulation Inc., which was created as a separate not-for-profit entity to enforce marketplace rules and federal securities laws of the New York Stock Exchange (NYSE). Although it’s a subsidiary of NYSE Euronext, NYSE Regulation’s board of directors comprises a majority of directors unaffiliated with any other NYSE board. As a result, NYSE Regulation is independent in its decision making. In this model, the two entities are affiliated and in an Indian context it may be a challenge to maintain Chinese walls, especially keeping in mind the poor history of “independent” directors in the country.
An extension of this model of separating governance into a separate not-for-profit entity is the Financial Industry Regulatory Authority (Finra), which performs market regulation under contract for the Nasdaq Stock Market, the American Stock Exchange, the International Securities Exchange and the Chicago Climate Exchange. Even though Finra’s antecedent, NASD Regulation, was set up by an entity related to Nasdaq, it’s interesting to see that three other completely independent exchanges are being regulated by it. To have an independent body performing the regulatory role seems like the ideal solution. The question, of course, is who will set up the equivalent of Finra in India.
There have also been instances of the federal market regulator taking on regulatory oversight from exchanges. A case in point is the Financial Services Authority, which now performs the role of the listing authority in the UK. Earlier, this role was performed by the London Stock Exchange, which was stripped of the function due to a perceived advantage over competing exchanges that were emerging in the UK. Spinning off all regulatory functions either back to the regulator or to an independent body will be a mammoth task, considering the large volumes of data that are involved in monitoring the market. Currently, trade and post-trade data is monitored on an integrated basis to ensure margin requirements and position limits are adhered to. With an outside regulator, these functions would be separated, which could make things rather complex.
But in the interest of fostering competition in the stock exchange space, these are some of the difficult questions policymakers may need to address. Also, talking of governance, it is presumptuous to go with the belief that the National Stock Exchange of India Ltd (NSE) model is foolproof. Although its management is distinct from its ownership, nothing stops it from being overtly profit-focused. The current management may carry the legacy of founder R.H. Patil, but it’s foolhardy to just presume that his good values will be engendered in all leaders at NSE.
Already, there have been fingers pointed on the lack of transparency in the exchange’s functioning, one example being the company’s decision to invest in a front-end technology provider and remaining silent about it. Critics point out that the investee company, Omnesys Technologies Inc., competes with Financial Technologies (India) Ltd, with which NSE is locked in a legal battle.
Varma feels that getting exchanges to list will help. “Listing would improve accountability and lead to better disclosures,” he says. “Besides, inspections and enforcements by the regulator could be strengthened.” Currently, the penalty for offences is rather low and it’s well known that offenders can hide under political cover and a not-so-effective legal system. It seems best that policymakers address the governance issue in black-and-white, rather than just hope for the best.
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