Home / Opinion / Online Views /  Rethinking regulation after the NSEL crisis

The ongoing liquidity crisis at the National Spot Exchange Ltd (NSEL) has reignited the debate on the conflict of interest between the commercial and regulatory roles of an exchange. It also seems to have led policymakers to revisit the issue of exchange regulations to find ways to minimize, if not eliminate, such a conflict.

A working group set up by the government in the wake of the crisis has called for ownership restrictions that prevent one corporate entity from dominating any one exchange or even a group of exchanges across different segments, Mint reported on Friday. The working group has also recommended the creation of Chinese walls between the owners and managers of the exchange in the case of NSEL, as well as other exchanges.

The renewed policy focus on the inherent conflict of interest in the exchange business—the exchange derives its income from members it regulates—is welcome. Yet, the current focus on ownership restrictions and the creation of Chinese walls are a sub-optimal response to this challenge.

The genesis of the current thinking lies in the 2010 report of a committee on market infrastructure institutions, appointed by the Securities and Exchanges Board of India (Sebi) and headed by former Reserve Bank of India governor Bimal Jalan. The Jalan committee report correctly identified the conflict of interest between the regulatory and commercial roles of an exchange as a major systemic risk. But its solution involving severe ownership restrictions, cap on profits, and a ban on public listing drew flak for closing the door on new entrants in the exchange space.

Last year, Sebi relaxed some of Jalan’s recommendations (it allowed listing, for instance) but maintained stringent norms for diversified ownership and put caps on executive compensation. It also mandated separation of the regulatory and other exchange arms. In the wake of the NSEL crisis, Sebi has renewed efforts to erect stronger Chinese walls.

There are several problems with the current approach. First, efforts in other markets at erecting Chinese walls have only demonstrated how porous they turn out to be in the hands of clever practitioners. Second, even ownership restrictions can be rigged by manipulative owners to their advantage, on their own, or in collusion with other owners. In the case of the United Stock Exchange (USE), the anchor investor, which was also the largest trader on the bourse, had an overwhelming influence on board decisions despite being a minority shareholder, according to the Sebi showcause notice that was issued later to the bourse. Third, such an approach throttles competition by making it virtually non-viable for an honest entrepreneur to float an exchange.

Could there be a more efficient alternative? A note submitted to Sebi and the finance ministry in response to the Jalan committee report, by two professors of the Indian Institute of Management, Calcutta offers one possibility. The duo suggested separating the clearing operations of exchanges into a separate entity to de-risk the financial system. A central clearing house for equities similar to what we have for debt markets will then allow exchanges to compete on speed and products. To reduce risks further, Sebi will eventually have to take over the role of real-time surveillance of trading members from exchanges. Such an approach will eliminate the need for stringent ownership norms and profit caps, encouraging competition even while lowering risks.

There is a view that we may not need competition in the exchange space, since network effects tend to concentrate liquidity on one bourse in each market segment. But recent history shows that argument may no longer be valid. In the past few years, upstarts such as Chi-X and BATS have edged out once-dominant bourses such as the London Stock Exchange and the New York Stock Exchange in Europe and the US, respectively. Even in Asian markets such as Japan and Australia, alternative platforms have given incumbents a run for their money. Change in technology and proactive regulations that actively sought to encourage competition have led to fragmentation. And on balance, the change seems to have been positive for market participants who are able to execute trades faster and cheaper.

The threat of fragmentation lowering liquidity was blunted by compulsory smart order routing that forced market intermediaries to route trades to the location that offered the “best" deal. The evidence so far seems to suggest that new risks stem from dark pools and unregulated exchanges rather than the regulated ones.

The systemic risk posed by the conflict of interest in the exchange business is too large to be ignored but that still does not justify a monopoly in the exchange space. The NSEL crisis can serve us well if it leads to fresh thinking on these issues, and results in a more robust and dynamic framework for financial regulations in India.

How should competition be encouraged without compromising systemic risk? Tell us at

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