Two lessons from the scandal at NSE
India’s governance structure for stock exchanges has an inherent conflict of interest, and while limited State involvement in the financial sector has unleashed innovation, it has failed to stop malfeasance
The bad news seems never ending for the National Stock Exchange (NSE), India’s largest bourse. After NSE’s former chief executive Chitra Ramkrishna was accused of taking decisions under the influence of a “Himalayan yogi” by the market regulator, she faces fresh allegations about snooping on NSE employees with the aid of a former Mumbai top cop.
This marks a dramatic turnaround in fortunes for both Ramkrishna and NSE. Ramkrishna and her former boss, Ravi Narain, now in the crosshairs of multiple investigating agencies, were widely seen as the saviours of Indian finance once. Both were part of NSE’s founding team led by the legendary economist and institution builder RH Patil.
When Patil set up NSE in 1992, India desperately lacked a professionally run bourse. The economic reforms of 1991 had awakened global interest in India, but the lack of a fast and transparent trading platform was widely viewed as a major impediment to foreign fund flows. The century-old Bombay Stock Exchange (BSE) was run by a close network of stockbrokers, who were indifferent to victims of stock price manipulation and forged share certificates.
Officials at the finance ministry and at the newly established market regulator Securities and Exchanges Board of India (SEBI) agreed that the only way to break the BSE cartel’s stranglehold was to incubate a new exchange. Patil led this mission, setting up the country’s first automated screenbased trading platform that could be accessed by terminals across the country. Electronic settlement eliminated the need for paper certificates, bringing down fraud.
Backed by State-owned financial institutions, NSE soon eclipsed BSE in trading volumes, attracting a new breed of domestic and foreign investors. Three decades down the line, life seems to have turned full circle for the younger bourse. Beset by scandals, NSE’s board has now appointed the current BSE chief, Ashish Chauhan, to take over NSE’s reins.
NSE’s swinging fortunes offer two key lessons. One relates to India’s flawed governance structure for stock exchanges. Stock exchanges work as frontline regulators in India, keeping a tab on trading members and listed companies, alerting the regulator when it spots any emerging risk or fraud. So, the exchange business model in India involves an inherent conflict of interest, since the exchange derives its income from the very entities it regulates.
The regulatory approach to deal with this problem has largely centred around ownership norms. A diversified ownership structure, where no single entity controls the exchange board, was viewed as the solution to the conflict of interest conundrum. It was assumed that restrictions on ownership patterns would automatically prevent mismanagement of a bourse. The NSE saga has shredded that assumption.
An alternative regulatory approach is possible. Stock exchanges derive their financial and regulatory powers from their role in clearing trades. If this role is carved out of stock exchanges and vested in an independent clearing house, the conflict of interest problem becomes much less severe. It derisks the exchange business while allowing exchanges to compete on trading products and services. In such a scenario, SEBI would have to take over much of the regulatory role performed by exchanges.
Two economists from the Indian Institute of Management, Calcutta, BB Chakrabarti and Mritiunjoy Mohanty, had suggested such an approach more than a decade ago when SEBI and the Union finance ministry were reframing exchange regulations. Stock exchanges lobbied hard against this idea to protect their profit margins. SEBI, too, preferred the status quo since it gets to pass the buck to exchanges when things go wrong. Vested interests stymied the Chakrabarti-Mohanty proposal. Public interest demands that it be reconsidered.
The second big lesson is about rethinking the role of the State in India’s financial sector. If the early Indian State simply took over existing financial institutions (banks and insurance companies, for instance), the post-liberalisation State has relied on less-direct methods. The setting up of the NSE in 1992, and the launch of the National Payments Corporation of India (NPCI) in 2009 reflect such indirect efforts at catalysing financial transformation, with State-backed entities taking the lead role.
Such State interventions aimed at fostering innovation can have economy-wide benefits. But we need to debate when such interventions are justified and till when such initiatives should continue to depend on Statebacked institutions. The challenge is to ensure that financial innovation has State support but financial malfeasance doesn’t occur under the cover of State patronage.
NSE played a stellar role in modernising India’s financial markets when it began its journey as an innovative upstart. After it became the dominant incumbent, it began lobbying to keep out new entrants. Key officials such as Narain and Ramkrishna seem to have treated the institution as their personal fiefdom, enjoying the fruits of NSE’s near-monopoly. The continued patronage of State-owned financial institutions allowed them to do so.
Unless State interventions in the financial sector are rethought, such mistakes will recur, posing a threat to India’s financial stability. Without a robust financial sector, it will not be possible to sustain rapid growth in the country. Hence it is important that the design of India’s financial architecture be thought anew.