A potentially risky trade-off for markets

Sebi’s proposal on concentrated holdings could disrupt the balance between the supervisory and business roles of stock exchanges

On January 6, the Securities and Exchange Board of India (Sebi) released a discussion paper on the review of the current ownership and governance norms regulating stock exchanges and depositories. Market infrastructure institutions (MIIS), such as exchanges, clearing corporations and depositories, occupy an unusual place in the market economy. While there is a great game afoot, of trading on financial markets, the MIIS are the entities which build and run the playing field. Their smooth and harmonious functioning is a pre-requisite for achieving a capable financial system. Indeed, a great deal of the achievements of Indian finance from 1991 onwards came through the remarkable work that was done in building the current landscape of MIIS.

Can we view MIIS as just a business? In what ways are MIIS special? There is a small problem and there is a big problem. The small problem is that exchanges tend to be a natural monopoly. In most countries, the bulk of activity has coalesced into one main exchange. Orders tend to go where orders are, and it is hard to have multiple competing exchanges that compete for orders. The big problem is that an MII is the front line of regulation. It is itself akin to a regulator, with rule-making functions, enforcement of the rules that it makes, and some enforcement of the rules that the securities regulator makes. The MII is the front line of supervision; it plays a major role in market integrity.

For the shareholders of an MII, revenues are proportional to trading volume. There are, unfortunately, many ways in which managers of MIIS can cater to the objective of higher turnover by cutting corners on market integrity. Consider a situation where something is wrong with a given security, e.g. some fake news, or a cartel that is trying to corner the stock or execute some manipulative scheme on it. From a market integrity viewpoint, managers need to intervene, but from the viewpoint of increasing turnover, these problems are fine. Managers can go lax on how rules are created or enforced, thus helping a greater buoyancy of trading. The top 20 securities firms tend to account for a large proportion of the turnover; managers could choose to be lax in enforcement against them in return for more turnover.

In the 1990s, we saw a class of problems at the BSE, which illustrates these issues. At the time, the BSE was controlled by stock brokers, who derived revenues from trading and from activities on the exchange. These same firms had management control at the BSE. Their incentives were to obtain higher turnover even if this involved sacrificing market integrity. This gave poor and sometimes dangerous outcomes. Alternatively, consider a focused shareholder, one who stands to gain profit or market capitalisation when the turnover of an exchange goes up. If this shareholder has a substantial say in the management of the exchange, we run into the problem of “high powered incentives”. Large sums of money are involved in the profits or the market capitalisation of an exchange. When the managercum-shareholder has high powered incentives, this tends to generate a bias in favour of turnover and against market integrity.

In order to address these problems, the financial economic policy community evolved the concepts of enshrining “low powered incentives”. The essence was to have no focused shareholder, avoiding managers who are shareholders (or stock brokers), and avoiding share ownership or stock options for managers. The extant framework caps the ownership of Indian MIIS at a shareholding limit (not more than 5 per cent) for individuals (domestic or foreign) and institutions (domestic or foreign) in general and permits up to 15 per cent ownership by a select category of institutions (domestic or foreign). This has been done so that ownership is not concentrated in the hands of a few.

These ideas laid the foundations of the shareholding structure of the National Stock Exchange and BSE. Subsequent events in the world of commodities served as important validation of this approach.

It is in this context that we should see the recent Sebi discussion paper on the review of ownership and governance norms regulating stock exchanges and depositories. The purpose of the move is to facilitate entry of more entities and, thereby, increase competition in this space. To enable this, the regulatory framework for these MIIS is proposed to be changed to allow:

(1) A higher ownership for resident and foreign promoters at the initial stage with a gradual dilution in shareholding over time and

(2) resident and foreign individuals/entities to merge with and acquire existing MIIS subject to approval by Sebi.

Changes to governance norms to ensure further diversification of statutory committees at MIIS are also mooted.

At present, there are concerns about monopolistic pricing by MIIS. These concerns are important and need to be addressed. However, the prices charged by MIIS are tiny values, compared with the activities of their customers, and even if the mark up is excessive, the damage caused to the economy is small. In contrast, the big scandals of the markets have rocked the economy, and are worth avoiding. There are regulatory mechanisms through which excessive prices by MIIS can be reined in, most notably by going closer to a cooperative model, where the bulk of the shareholding of MIIS is with the biggest users of the exchange, i.e. the institutional investors. These organisations stand to gain more from inexpensive transactions, with market integrity, when compared with the small flow of dividends from the MIIS.

Dispersed shareholding, and low powered incentives for managers in MIIS, is based on a cautious approach, where we balance the large impact upon the economy of a stock market scandal against the potential gains from concentrated ownership. The question that we have to ask ourselves is: Do we have high confidence in the enforcement of the regulations, so that citizens and markets are convinced that the regulator will be able to overcome the conflicts of interest that arise, when the managers of an MII have high powered incentives? The writer retired as a secretary to GOI and is now a professor at the National Council of Applied Economic Research