The last date for submitting comments to the Securities and Exchange Board of India on the Bimal Jalan committee report is long gone. But comments in the financial media continue to trickle in. While most initial comments were critical of the report, recent ones are more supportive.
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In fact, two financial market commentators writing in the Business Standard newspaper go so far as to say that stock exchanges are natural monopolies and benefits from competition in the space would be limited. Their argument was that exchanges are natural monopolies because traders tend to gravitate to the venue that offers the highest liquidity. This will further increase the liquidity at the trading venue and thus attract more traders, creating a virtuous cycle. Indeed, there is a lot of empirical evidence that proves liquidity attracts liquidity. But the argument goes further that as a result of network externalities competition doesn’t stand a chance. Therefore, expected benefits from competition will not be realized.
But this is clearly a case of taking the argument too far. There’s ample empirical evidence available globally that established exchanges have lost significant share to new entrants, but more on that later.
The words of the Jalan committee are apt here: “The word natural in the phrase natural monopoly is misleading, as it implies that a particular structure of the relevant industry is natural and inevitable. This has frequently been shown to be not true. Economies of scale need not give rise to monopolies inevitably. A competitor may be able to enter the relevant market and force the incumbent firm to exit; the threat of potential entry, too, can impose a significant competitive discipline. Technological developments also have allowed competition to threaten many monopolies previously considered natural.”
And while the committee says exchanges share several characteristics of natural monopolies, it does so to justify special regulatory arrangements so that the safety and integrity of the market is not jeopardized. It doesn’t come to the same conclusion about competition as the argument made earlier. Instead, the report states, “It is desirable to ensure that fair competition is available to avoid perverse monopoly.”
But while the committee makes this passing mention about the benefits of competition, its recommendations essentially shut out prospective competitors. As if shareholding restrictions weren’t a big enough disincentive for an entrepreneur, the committee has recommended a cap on profits of stock exchanges. With such restrictions, hardly anyone may be interested in taking the effort to set up a new exchange. J.R. Varma, professor of finance at Indian Institute of Management, Ahmedabad, says the recommendations remove even the threat of competition.
This would be a dangerous place to be because the incumbent exchange would know its monopoly position is secure. Currently, even if there’s no effective competition on the ground in the equities exchange industry, just the threat of competition has kept the incumbent exchange on its toes.
Thus far, it does look like the National Stock Exchange (NSE) hasn’t abused its monopoly position by charging users high fees. As this column pointed out last week, the large majority of fees paid by a trader are accounted for by taxes and levies, primarily securities transaction tax. NSE’s charges are a fraction of the taxes and levies on each trade. Of course, if the Jalan committee’s recommendations are implemented, the exchange wouldn’t be able to raise its fees and abuse its monopolistic position, even if it wanted to, because of the cap on profits.
Even so, market participants would lose out in terms of product innovation, service quality and better trading technology.
Coming back to the argument that competition doesn’t stand much of a chance since the exchange business is a natural monopoly. One just needs to look at the plethora of examples in global markets where new entrants have taken away market share from incumbents. One may argue that this has happened in cases where the new entrant brought in an online trading platform to compete with the incumbent’s open outcry trading platform, such as NSE’s success in taking share away from the Bombay Stock Exchange.
But even incumbents with online trading platforms have lost share. In the US cash equities segment, the Nasdaq has lost share to a number of alternative trading systems and electronic communication networks. In the equities options market, International Securities Exchange and Chicago Board Options Exchange are losing market share to new entrants, despite having electronic trading platforms. In the market for crude futures, Intercontinental Exchange has taken considerable share from the Nymex, the leader in energy futures.
And in a delicious irony, the Chicago Mercantile Exchange, which now owns the Nymex, has recently waived fees on Brent crude products to effectively compete with ICE’s benchmark crude futures product. According to a report in the Financial Times newspaper, banks including Morgan Stanley and JPMorgan have advised clients to shift their oil exposure to Brent, dropping WTI, which is benchmark product on the Nymex.
As the Jalan report itself states, “Economies of scale need not give rise to monopolies inevitably.” In this backdrop, it is imprudent to say there are limited benefits from competition for Indian markets. Of course, this is not to make the case for unbridled competition. As Varma has stated earlier in this paper, “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.”
But there are other ways to deal with this problem, like separating the governance function of exchanges, rather than stifle competition.
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