Public purpose and for-profit entities: The next challenge in regulation

NSE IPO rekindles debate over exchange ownership, profit motive and Sebi's deep regulatory control

The National Stock Exchange (NSE) has been in the news because it is at the edge of its initial public offering (IPO). The three big exchanges [the NSE, BSE, and Multi Commodities Exchange (MCX)] will then all be listed. The draft Securities Markets Code (SMC) proposes a formal legal framework for stock exchanges as market infrastructure institutions (MIIs), a designation that carries profound regulatory weight. 

It appears the questions around the ownership and governance of exchanges are all sorted. That is not the case. Listed exchanges raise a host of questions — some operational and tactical — but others strategic and regulatory. The dilemmas we face today regarding the governance of MIIs are good problems to have, and certainly better than the existential crises of the early and mid-1990s. One must first understand how we got here, for ownership and governance of exchanges was a core issue in the great reforms of the equity market. 

Three features of an exchange stand out. An exchange is a set of information-technology (IT) systems, processing thousands of orders per second. Running this requires a modern Indian technology-capable organisation with modern Indian management practices, eg on questions like compensation. But equally, an exchange is a front-line regulator and enforcer of rules. Moment by moment, as trading takes place, only the exchange has the ability to watch what is going on, look for malfeasance and block it, and demand compliance with leverage rules. Finally, an exchange is generally a natural monopoly, and lacks the normal market-based incentives to deliver high-quality services. 

At the start of the Indian equity market, there was the BSE. It was managed and owned by brokers. This involved a conflict of interest: Broker-managers were inclined to be lenient to brokers. This worked out poorly. 

The reformers of that age understood that the solution lay in a new exchange, the NSE, with an ownership structure where incentives were properly aligned. There were three big ideas in the NSE of old. First, it was led by remarkable people, who could be trusted to do regulatory work well. I recognise this sounds quaint in the modern world, and that achievements grounded in good persons will not last over long time horizons. But it is impossible to deny the importance of the key persons who led the NSE in the optimism that the exchange would do well on regulatory functions. 

Second, brokers had no shares in the NSE. This helped ensure that rules would be enforced against brokers. 

Finally, the shareholders of the NSE were big institutional investors, who had the most to gain from a deep and liquid Indian equity market. These shareholders were gently pushed by the Ministry of Finance into founding and owning the NSE. This aligned the incentives of the shareholders of the NSE with the mission of the NSE (a deep and liquid market for India, of which the biggest beneficiaries were the big institutional financial players) and not dividends or valuation. 

Where are we now on that journey? Two big things have happened over the last decade. First, the exchange has increasingly become a simple for-profit company, betraying less of the public interest. Second, the Securities and Exchange Board of India (Sebi) has achieved a de facto nationalisation of the exchange, whereby the regulator has extreme control over appointments, the board, and products/processes of the exchanges. So we have ended up with a monopolistic and highly profitable organisation that works for the profit motive other than intrusive control by Sebi. 

This is a strange new place, which was frankly never anticipated by any of the thinkers about exchanges 20 years ago. When the first exchange listing (MCX) was under debate, there was much thinking around this, but this subsided along with the main energy of financial-sector reform. 

Profit motive is supposed to be good for innovation, but we don’t get innovation because the regulator is a central planner that controls all aspects of products or processes (to the point of controlling the names of senior managers). The monopolistic nature creates high profits and takes away the need to innovate. This creates the worst of public-sector lethargy. 

Profit motive gives management the incentive to maximise revenue, which creates conditions for poor or outright harmful behaviour on regulatory functions. When there is great market turbulence through malpractice, trading volumes tend to go up with increase in the revenues and profits of the exchange. 

The intrusive control of the regulator in the exchange undermines the very regulatory process. When Sebi is deeply complicit in running the NSE, it is hard for it to think straight in making rules and enforcing them. In an essential way, we are back to the owner-manager-regulator fusion of the old Department of Telecommunications of the government or the Reserve Bank of India (RBI), which is both the owner and the regulator of the Negotiated Dealing System-Order Matching (NDS-OM), the trading platform for government securities! 

What is the way out of this mess? Three ingredients are required. 

Element 1 lies in returning to the ownership of MIIs in the hands of large financial institutions, which must see this as their self-interest — to have a deep and liquid market — rather than as a source of dividend or valuation.

  Element 2 lies in the ownership and board structure establishing rules for regular price cuts, so the supernormal profits go away, so that the exchange drops from its present 60 per cent margin of profit after tax (PAT) to the normal Indian PAT margin of 6 per cent. This would involve big price cuts, which benefit all users of the exchange and particularly the big institutional investors.

 

Element 3 lies in Sebi retreating into a regulatory function and not a public- sector-style fusion

with exchanges. 

It is not easy to get back to this. There will be an intricate lock-step of stepping stones that take us there. But there is no running away from the problems of the present arrangement. Finance occupies the commanding heights of the economy, and the exchanges occupy the commanding heights of finance. This is too important a problem to ignore.

 

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The author is an honorary senior fellow at the Isaac Centre for Public Policy, and a former civil servant