The marketplace itself being a monopoly is a delicious irony. It’s one that the Bimal Jalan committee’s brilliant report gets. Unfortunately, most critics don’t.
I know a little bit about this stuff. I began my career working for an exchange — the National Commodity and Derivatives Exchange (NCDEX). By the way of full disclosure, I own no stock or options of NCDEX but I do have pleasant memories and an abiding passion for market design.
Let’s first lay out what is at stake in this debate. It’s efficient price discovery. Better price discovery is the litmus test for deciding the optimal ownership structure of exchanges. The Jalan Committee believes exchanges are natural monopolies and regulating them like monopolies improves price discovery. I agree.
Everyone but Mr Karat and his missus agrees that price discovery is a wonderful thing. Think of exchanges as firms that produce “discovered prices”. The problem is that no one can quite tell how marvellously you’re doing your job. For unlike other products, say shoes or cars, no metrics exist for the “quality” of price discovery. Finance theory is agnostic as long as there are willing and well-informed buyers and sellers. Who is to say whether Reliance Industries should trade at Rs 1,058 a share or Rs 2,000.
We may not know what constitutes good price discovery but we do know of some enablers. Four that come to mind are: liquidity, disclosure/governance, risk-management and technology. The first three enablers are not improved by subjecting them to the discipline of market competition. (For derivatives there is an additional enabler, settlement mechanism. We can leave the settlement mechanism out without comprising the argument.)
The most important thing about exchange liquidity is that it is a monopoly. I will limit myself to briefly explaining the idea of impact cost. It is the dominant reason liquidity tends to concentrate in one market place. Impact cost is a simple idea: It is the move in the market per unit trade volume. The greater the liquidity, the lower the impact cost, which, in turn, attracts liquidity, creating a virtuous cycle.
The available evidence supports the non-contestibility of exchange liquidity. In the last two decades, there is no instance of a major online exchange losing liquidity to a competitor. Only three have succeeded — Deutsche Borse’s successful assault on Liffe for the German Bund Futures contract in 1998, the ongoing tussle between International Securities Exchange (ISE) and the other American options exchanges and the National Stock Exchange (NSE) taking market share from the Bombay Stock Exchange (BSE) in cash equities. All three involved the transition from open outcry to online trading.
Our experience in India bears this out. BSE has tried heaven and hell to break NSE’s monopoly in derivatives. To no avail. MCX and NCDEX have also tried to poach liquidity from each other. Unsuccessfully. MCX’s initial advantage in metals and energy has stayed. So has NCDEX’s in agriculture markets.
So the critics of Jalan Committee have failed to account for the nature of liquidity. An exchange will almost never face the market competition that they so cherish. The joys of the marketplace will never be available to the marketplace.
The effect of market competition on good governance and risk management is less contentious. Everyone who has not been hiding on Mars since 2008 will agree that regulatory oversight is needed to deter exchange managements from diluting governance and risk-management standards to attract liquidity.
Which brings us to the fourth enabler — technology. It’s used in two distinct senses. The first is the hardware, the software, the connectivity and so on. Let’s call it information technology. The second is the new products that the exchange lists — derivatives like futures and options, indices, ETFs and so on. Let’s call these financial technology.
I claim, somewhat boldly, that though market competition has been a huge factor in the progress exchanges have made in information technology in the last 20 years, it is unlikely to be a factor in the next 20. I also claim, less boldly, that the jury is out on the effect of financial technology on price discovery.
Up till circa 1995 members of the New York Stock Exchange (NYSE) traded pretty much like their forebears who had gathered under the Buttonwood tree in 1792. Sure they got a roof and eventually central heating but the business was still about showing live prices to clients, executing trades on their behalf and offering advice. The Internet changed all that by giving clients direct access to price information and liquidity. Broker commissions were under threat so the exchanges they owned tried their best to hang on to the old ways. The democratisation of investing is one of the most unheralded advances in finance in the last two decades. And, yes, threat from market competition ultimately persuaded all exchanges to move from open outcry to online trading.
We must be careful about drawing too strong a conclusion from the experience. The advent of the Internet (informational technology) was a singularity in the five centuries of the markets’ existence, a disruptive force doesn’t come around too often. Now, all major exchanges have to move to online trading. If anything, the centrifugal nature of liquidity has been re-enforced. The spate of mergers in the exchange space over the last few years stands testimony to that fact. Regulators don’t have the luxury of letting markets keep exchanges in check. Like all other monopolies, the profits of exchanges must be regulated to prevent an abuse of market power.
And finally, a quick word about financial innovation. It’s true that market competition has spurred financial innovation. Exchanges are offering newer products like derivatives and ETFs to attract liquidity. The question is: are these products improving price discovery? The credit crisis has given us reason to suspect financial innovation as an unalloyed good. The Jalan Committee proposes that their recommendations be reviewed in five years. If the West could achieve the Industrial Revolution without ETFs, I think we’ll survive five years.
The views here are personal