Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Stock Exchange Ownership and Competition

I have a column in today’s Financial Express about a key committee report on ownership and competition in India’s stock exchanges.

The Jalan Committee appointed by Sebi has effectively recommended the back-door nationalisation of stock exchanges, clearing corporations and depositories (market infrastructure institutions or MIIs). If these recommendations are accepted, we will extinguish the essential spark of dynamism that has given India a world class equity market.

The Jalan report is permeated from beginning to end with the ideology of socialism and the command economy, but instead of overt nationalisation, it seeks to destroy private sector exchanges and other MIIs through a thousand small cuts. Let me list out just a few key elements of this strategy:

  1. The maximum profit that an exchange (or MII) can earn would be capped at a certain percentage of annual return on net worth of the previous year. Any excess over this would be transferred to the investor protection fund (IPF) or similar fund. The economic result of this would be that the existing equity capital of all exchanges would effectively become non-cumulative preference shares with a fixed rate of dividend, and the government (in the form of the IPF) would own the economic equity of the exchange.
  2. In keeping with the back-door nationalisation of the exchanges, it is proposed that their key executives should also be remunerated like bureaucrats—fixed salary with fixed annual increments, no variable pay and no form of stock options.
  3. The users of the market infrastructure (the members of the exchanges and clearing corporation) are prohibited from sitting on the board.
  4. Only public financial institutions and banks are allowed to become anchor investors in exchanges and other MIIs attenuating any residual chance of shareholder control.

The Jalan report also takes an essentially anti-competitive position in the field of exchanges and MIIs. The view taken is that there is sufficient competition already and that it would be undesirable to have more competition: “Sebi should have the discretion to limit the number of MIIs operating in the market, in the interest of the market and in public interest.”

There are two problems with this. First, the Indian MII industry (exchanges and depositories) is a near monopoly where the dominant players have been disciplined not by actual competition but by the threat of competition. In the jargon of the economists, it is a contestable market but not a competitive market. In this context, an attempt to limit new entrants will entrench the existing near-monopoly and remove the disciplining force of potential competition.

Historical experience tells us that we have got far better and cheaper telecommunications from competitive profit-seeking companies than from a monopoly state-run public utility. Competitive private players have given us cheaper and more convenient air travel than monopoly state players. It is the same story in industry after industry. The Jalan report is ignoring this overwhelming evidence from India and elsewhere, and propounding the belief that a cosy government-controlled monopoly or oligopoly would serve the market and the public interest better than a competitive industry structure.

The Jalan report seeks to limit competition by several means quite apart from the explicit limit on the number of exchanges and depositories. The regulated public utility model ensures that it is very unattractive for new entrants. Anybody seeking to challenge an entrenched incumbent faces a high chance of failure and the only incentive for entry is the prospect of large profit in case of success. The ceiling on profitability rules this out. Moreover, the new entrant would not be able to attract talented managers because of the inability to offer performance-based compensation.

As if all this were not enough, the proposed ownership norms rule out most strong strategic investors with deep pockets who have an incentive to enter the business. If only public financial institutions and banks are allowed to become anchor investors, the current incumbents are unlikely to be seriously challenged.

India, therefore, runs the risk of losing the competitive dynamism of the Indian equity markets. What is more tragic is that this is happening at a time when the stock exchange business in Asia is entering a period of regional, if not global, competition. The abortive bid by the Singapore Stock Exchange to buy the Australian Stock Exchange marked the first warning shot in this process. Asia is going to be one of the fastest growing equity markets in the world, and India’s world-class exchanges and depositories have a wonderful opportunity to occupy a pole position in this space.

At this critical juncture, when each exchange in Asia is deciding whether to be predator or prey in the emerging pan-Asian competition, the Jalan Committee is pushing India in the wrong direction. The recommendations, if implemented, would ensure that Indian exchanges never become pan-Asian institutions. Worse, Indian exchanges could even become completely unviable, if the business moves to exchanges outside India that may offer better service at more competitive prices.

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