An important case study while examining Jalan committee report

An important case study while examining Jalan committee report

United Stock Exchange of India (USE), which recently completed one year of operations, has hit a rough patch. According to a report in The Economic Times, its chief executive officer, T.S. Narayanasamy, has submitted his resignation. Citing sources in the exchange, the paper said that he was disappointed with some shareholders operating at the exchange, and that the work ethics being followed at the exchange are not congenial to him.

Sebi has put restrictions on the open interest that can be built in the currency futures and options market, but there are no such limits on trading volumes. Still, a 70-80% share is taking things too far. If the reports about Jaypee’s share of trading are true, what they essentially point to is that a large part of the trading on United Stock Exchange consists of circular trading between traders at Japyee. In other words, a large number of trades are artificial, done just to give the impression of high volumes and liquidity on the exchange. USE’s extremely low open interest positions also point to the existence of circular or round-trip trading. In July and August, its open interest/volumes ratio was just 0.12 and 0.1 times respectively. In comparison, National Stock Exchange’s currency futures segment reported an open interest/volume ratio of 0.75 and 0.7 times in July and August. What’s more, after having come to Sebi’s notice, trading volumes have dropped sharply, which again points to the existence of artificial trades earlier. In July and August, average daily volumes were as high as $2.9 billion and $3.5 billion, respectively. It has since dropped to $1.85 billion in September and less than $900 million in the first five trading sessions of October. Currency futures volumes have fallen on other exchanges as well, but that’s owing to their decision to levy transaction charges. USE has continued to waive transaction fees.

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If indeed Jaypee has been engaging in circular trading, it should have been easily picked up by the exchange’s surveillance department. But Jaypee is no ordinary trading member. It is the anchor shareholder of USE, with two of five board seats given to shareholders, according to an exchange press release last year. In other words, there appears to be a conflict of interest between Jaypee’s role as a shareholder of the exchange and its role as a user of the exchange. Many exchanges in India, including BSE Ltd, had to go through the process of demutualization, to get rid this very “conflict of interest" issue. The news report mentioned earlier also states that Jaypee strongly opposed a move to start charging users transaction fees, after both its competitors imposed trading fees. Clearly, it would have been silly to pay fees for artificial trades where no money was being made anyway. But again, this points to a conflict of interest, where the exchange’s business interest seems to have been sacrificed to protect the interests of a member-shareholder.

USE is a good example of what can go wrong when ownership and management of exchanges is not separated. In fact, USE is not an isolated case. Earlier this year, the Forward Markets Commission passed an order against Kailash Gupta citing criminal breach of trust against the National Multi-Commodity Exchange, where he was not only a shareholder but was also involved in management.

These cases vindicate some of the concerns expressed by the Bimal Jalan committee about ownership of exchanges. Critics of the Jalan report, who flippantly say that the “conflict of interest" issue should be brushed aside, in the larger interest of competition in the stock exchange space, should wake up and smell the coffee.

Having said that, even the policy response of restricting an individual firm’s ownership to 5% doesn’t seem to be a fool-proof mechanism to get rid of the “conflict of interest" issue. Jaypee, after all, is reported to have only a 5% stake in USE; but appears to have a large influence on its operations.

How does one work around these various concerns regarding ownership and management of exchanges? The most workable solution seems to be separation of the governance part of the exchange, either to an independent regulatory organization or to the markets regulator itself. When surveillance is done by a firm that’s neutral to all its members and is serious about market integrity, any instance of circular trading will be nipped in the bud. Similarly, a neutral, independent firm will have no obligations towards shareholders of exchanges and can focus on the main objective of maintaining market integrity.

Policymakers who are examining the Jalan committee’s proposals should consider these various factors before drafting changes to the norms on ownership and management of stock exchanges.

Illustration by Shyamal Banerjee/Mint

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