Contrary to Rajesh Chakrabarti’s assessment of the Jalan Committee Report on the key issue of systemic stability (EPW, 8 January 2011), this comment critiques some of the report’s recommendations by discussing the JCR on the types of regulatory and market structures, and the nature of competition.

This is a slightly annotated version of the comments on the Jalan Report submitted to SEBI and the Ministry of Finance.

B B Chakrabarti (bbc@iimcal.ac.in) teaches finance and Mritiunjoy Mohanty (mritiunjoy@ iimcal.ac.in) teaches economics at IIM Calcutta.

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1 Exchange Evolution and Regulation

An efficient secondary market in equities provides liquidity and facilitates price discovery, aiding the corporate sector in raising capital and providing the wider economy a benchmark to assess corporate sector performance. As with other aspects of financial markets, over the last couple of decades, this critical piece of market infrastructure has evolved in response to changing markets and technology. Globally, the evolution of exchanges has been characterised by two phenomena – demutualisation on the one hand, and concentration on the other. As the International Organisation of Securities Commissions (IOSCO 2006) notes, in developed countries demutualisation has been driven by increased competition and technological change, whereas in developing countries it has been seen, at least partially, as a way of getting around various conflicts of interest.

Exchanges, however, continue to be largely self-regulated organisations (SROs)

sub-prime financial crisis of 2008-09.

The IOSCO Report (2006) noted the following areas of potential conflict of interest following demutualisation: (i) Lowering of regulatory standards as a result of focus on profits; (ii) following from the above, insufficient allocation of financial and other resources towards regulation; (iii) misuse of regulatory powers to disadvantage competitors; (iv) faced with a crisis, either due to internal reasons (excessive risk-taking) or external circumstance (contagion), a stock exchange may find it diffi cult to raise capital when it needs it most; and

(v) in the case of self-listing, who regulates the regulator?

The report also noted that members responded to the above conflicts of interest using a variety of options including (i) governance mechanisms; (ii) a tighter separation of functions within the stock exchange; (iii) removal of regulatory functions; and (iv) restrictions on ownership. Further, a large number of members had chosen tightening of governance mechanisms to deal with conflict of interest situations. In that light, IOSCO (2006) emphasised the importance of ensuring that the regulator within the stock exchange be as independent as possible of commercial interests.

Listing, Clearing and Settlement

Demutualisation is of course a global phenomenon, a response to changing dynamics of stock exchanges, in itself an outcome of changes in technology and, perhaps, vastly increased capital outlays. As capital requirements for stock exchanges continue to grow, listing becomes an attractive mechanism to get risk capital because it promises investors an exit option, potentially making the investment more liquid.

In a large number of countries, demutualisation has been followed by listing with

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due care being taken to deal with listingrelated concerns, some of which have been discussed above. For example, on listing, the New York Stock Exchange (NYSE) and National Association of Securities Dealers Automated Quotations were required to float a separate subsidiary to take care of the regulatory function. In the United Kingdom (UK), on demutualisation, regulators decided to take listing away from the London Stock Exchange. All listing responsibilities, including the enforcement of standards, were transferred to the Financial Services Authority. The IOSCO (2006), which explored some of the regulatory issues arising out of demutualisation, did not report any objection to listing subsequent to demutualisation.

Besides listing, trading and regulation, the other important activity carried out by stock exchanges is that of clearing and settlement. Traditionally, clearing and settlement has been carried out internally by stock exchanges or what is called the vertical silo model. Even in this instance however, institutional evolution – horizontal integration, has kept pace with changing technology and consequent opportunities. In Australia for example, stock exchanges have floated two separate subsidiaries – Australian Clearing House and SFE Clearing Corporation – to handle clearing and settlement. In the United States (US) an independent entity handles clearing and settlement functions of multiple stock exchanges. In India the debt market has an independent clearing and settlement agency (Clearing Corporation of India). Stock exchanges in India however follow the vertical silo model. Settlement is carried out by clearing corporations owned by stock exchanges, all of which have settlement guarantee funds to ensure that adequate funds are available in the case of default.

Regulation in India

In terms of regulation of stock exchanges, India is well regarded. Out of 134 economies, the Global Competitiveness Report (WEF 2009) ranked India 11 in this regard, ahead of a number of developed country stock exchanges. In India, demutualisation was initiated by the Securities and Exchange Board of India (SEBI). Acting on the recommendations of the Kania Committee,

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the SEBI framed the Manner of Increasing and Maintaining Public Shareholding (MIMPS) in Recognised Stock Exchanges notified in the Securities Contracts Regulations, 2006, which required that the public hold a minimum of 51% of the stockholding of stock exchanges and that no individual stockholder owns more than 5%.1

Indian stock exchanges are SROs2 and the SEBI too has chosen governance mechanisms to deal with issues related to conflicts of interest – rule-making is in the domain of the board of directors of a stock exchange and not of shareholders; 50% of the board of directors comprise SEBI-approved independent members; and fi nally, SEBI retains the right to alter these mechanisms such that independent oversight is enhanced. Despite the use of the SRO model in India, SEBI plays an important role as overall regulator. For example, the chief executive officer of the exchange (who is also the regulator) is appointed by SEBI and senior executives in charge of risk surveillance and related activities report to the board. SEBI’s model rules and byelaws play an important role in shaping stock exchange rules and norms, which in any case can only be changed with prior SEBI approval. Further, SEBI screens exchange shareholders so that they meet the “fit and proper person” criterion and mandates, as do many other jurisdictions in the world, a maximum limit of 5% so as to ensure a diversifi ed pattern of shareholding. Finally, the integrated market surveillance system (IMSS) is quite unique in allowing SEBI to deal directly with market abuse.

In the recent past, India has seen a tendency towards both increased competition and increased concentration. The establishment of the National Stock Exchange (NSE) changed the competitive landscape dramatically and effectively challenged the dominance of the Bombay Stock Exchange (BSE). On the other hand, introduction of new technology in trading represented the death knell for regional exchanges as a result of which, in effect, we have a duopoly in the trading market today. By all accounts it is a very profi table duopoly.3 In 2008-09, as reported, the Earnings Before Interest, Taxes, Depreciation and Amortisation (EBIDTA) margins of

the BSE and the NSE were 70.1% and 73.1% , respectively.

2 Key Assessments of the JCR

First, we agree with the JCR (2010: 6) that as a result of the recent global fi nancial crisis, ...almost all world economies in some manner, have subjected their historically settled views on financial stability to a rigorous reexamination. In the process, many of them have critically revisited the role of important financial institutions and the risks arising to

the economy from the operations of such institutions (emphasis ours). In their “re-examination of historically

settled views”, the JCR has been very innovative on four counts. First, it characterises stock exchanges and related institutions as “market infrastructure institutions” (MIIs) (p 7). Second, it notes that MIIs are characterised by network externalities and related switching costs as well as economies of scale, as a result of which “a single trading system, clearing corporation and depository is likely to gain and keep market power in the provision of services in any one market” (p 11). Third, it also characterises MIIs as being “systemically important” where “any failure of such an MII could lead to even bigger cataclysmic collapses that may result in an overall economic downfall” (p 12). Finally, therefore “price signals produced by the MIIs partake of the character of public good as these are something that must be provided and accessible to every one and cannot be withheld from anyone who seeks it” (p 12). Broadly, we accept all of these characterisations.

As we have already noted above, it also recognises:

Internationally, as a best practice, stock exchanges have chosen to segregate the regulatory functions from their commercial functions and have put in place measures to ensure autonomy to the regulatory departments (JCR: 57).

In addition it agrees that,

Ideally, from a regulatory perspective, it is felt that it is important to have complete segregation of commercial activities from the regulatory activities. However, it is not an easy task to identify cases where commercial and regulatory functions are joined or overlapping. Especially in the case of confl icts that arise due to competition, the commercial activities are sometimes so commingled with the regulatory function that they are

DISCUSSION

difficult to separate into watertight compart

ments (pp 57-58).

It therefore argues that “the Committee is of the view that it is not possible to sever the regulatory role of the MIIs from their more obvious role of serving as providers of infrastructure of the market” (p 13). Finally, “Unlike typical fi nancial institutions, the number of stock exchanges/ depositories/clearing corporations in an economy is limited due to the nature of its business, although catering to the entire marketplace” (p 12).

When all of these are taken together, i e, that MIIs serve as a public good; that it is not possible to separate regulatory and commercial interests; that the number of MIIs required is limited, the JCR recommendations are perfectly logical: enhance regulatory scrutiny, dampen profi t expectations, and, finally retain the SRO model.4

Underlying these assessments are two key discussions in the JCR – types of regulatory structures (pp 21-23) and market structures (pp 33-36; 44-46). We now analyse both these discussions.

3 Regulation and the SRO Model

While we agree with the JCR that MIIs are systemically important and might have a public good characteristic, the variance arises on the other issues – separation of regulatory and commercial functions, market structure, and in this particular instance, the need or the feasibility of dictating market outcomes.

Regulators across the globe have used a variety of mechanisms to deal with regulatory conflict – the government (statutory) model, the limited SRO model, the strong exchange SRO model, and fi nally the independent SRO model (JCR 2010: 22). The report also notes that India has followed the strong exchange SRO model. Following this, it makes a very critical assessment (p 23):

It is premature [emphasis ours] to think of the ‘independent SRO model’ in the Indian context given its evolution over a period to its present state; the government model may not be entirely possible in the Indian context considering the size of the market (emphasis ours).

There is no further elaboration of this critical assessment. What aspect of the current stage of evolution makes it premature to consider the independent SRO model? What does the JCR mean when it says that the government model may not be possible “considering the size of the market”? Is the size too big? Both the UK and France follow the government model and the UK market is several times that of India.

As we have already noted, SEBI has been an effective regulator and therefore both the independent SRO model and the government model are open to us. Given that MIIs are systemically important, it allows us the deal much more effectively with signifi cant confl ict of interest issues. Moreover, as the JCR itself notes, international best practice does suggest that it is not necessary to follow the SRO model. In not exploring these options more fully, the JCR hamstrings itself and, as we will discuss below, chooses a structure that neither achieves systemic de-risking nor potentially attracts capital.

Market Structure

The report recognises that there are two types of market structures – vertical silos and horizontal integration. Stock exchanges historically began as vertical silos but in the face of changing technology and competition have begun to drift towards horizontal integration. The JCR specifi es the distinctive feature of horizontal integration as “designed to interact with multiple providers of trade and post-trade services”. After a discussion on the merits of each market structure and noting that India follows vertical silos, the report goes on to argue:

It is evident that both trade execution and post-trade services have proven to be competitively viable in the Indian scenario … It appears that there is no pressing need to alter the existing market structure of arrangement between stock exchanges, clearing corporation and depository solely to address the issue of competition [emphasis ours] (JCR: 34).

First the JCR argues that the market is “competitively viable”. While we agree it is viable, its competitiveness is questionable. The JCR provides no evidence in this regard. Indeed as we have noted earlier, the market is a duopoly and a very profi table one at that. If anything, there is a lack of suffi cient competition.

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DISCUSSION

Finally, in a discussion on clearing corporations, it notes:

One view that has been held by some experts in this field is that stock exchanges and clearing corporations should be completely separated. This view would entail that stock exchanges thereafter should be freed without any restrictions on their ownership” (JCR: 45-47).

The JCR does not support this view:

It has to be first recognised that on a value chain consideration, from the trading transaction to clearing and all the way to settlement of the trades, the most risky element (and therefore, the highest in value as a proportion of the total transaction costs) would have to be attached to the clearing and settle ment function. Shorn of the clearing and settlement function, the stock exchange is merely a provider of an electronic trading platform (JCR: 45).

The JCR seems to suggest that stock exchanges should own clearing mechanisms because these add value on account of being risky, and thus are a source of profitability for stock exchanges.

In our understanding, the whole point of the JCR was to look at ways to systemically de-risk MIIs. From that standpoint, to completely separate stock exchanges and clearing corporations would be appropriate. Moreover, international best practice suggests that we can separate these out as stand-alone corporations. The JCR is concerned that “from a market power perspective, a single clearing corporation may levy excessive charges on its users”. There are however, ways of dealing with this issue of market power. For example, the regulator can decide the settlement fee. In India’s debt clearing mechanism (CCIL), the Reserve Bank of India approves the fee. Indeed, given the JCR’s view that from a systemic view point, clearing and settlement is the most risky element within MIIs, it might be worthwhile considering that an independent clearing and settlement corporation be owned by the government or the public sector. If that is considered infeasible, at least it can be jointly owned by all stock exchanges.

Finally, unlike what the JCR implies, we are of the opinion that the comparative advantage of stock exchanges are as trading platforms and price discovery mechanisms. Once the systemic stability issues that the JCR has highlighted are taken care of, that is what they should be

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allowed to do with minimal restrictions in terms of entry and exit. Separating trading and clearing is therefore optimal.

Number of Market Players

The JCR argues that because of technological change a limited number of MIIs might be able to service the entire marketplace (p 12). We are less certain about this observation. We agree that network externalities, switching costs and economies of scale can create significant barriers to entry; and as noted, the Indian stock market operates more like a duopoly. Therefore, while agnostic about the optimum number of players in the market, we think it is much more important to make the market contestable.

We could do this in two ways – reducing the barriers to entry by having an independent clearing and settlement corporation; and letting market dynamics decide whether competition in trading platforms will come in the shape of new entrants, new products or both. The key is to allow competition to drive an efficient price discovery process. Therefore, what is important is to allow players in the trading market the flexibility of choosing their competitive strategies in a way that increases market competition while ensuring systemic de-risking at the same time. We believe that horizontal integration allows us do both.

4 Conclusions

Therefore we are at complete variance with the JCR on the issue of regulatory structure, market structure and the nature of competition. We believe that a move from vertical silos to horizontal integration would be in line with the international best practice. As the JCR itself points out, according to World Bank (2009), “India is the only case (emphasis ours) with several clearing houses for the same assets (for private securities) among the group that includes developed market and the largest emerging markets”.

We therefore propose that we move away from the SRO model and that SEBI take on enhanced regulatory powers; that clearing and settlement functions be separated from stock exchanges; and fi nally cross-listing be allowed. It would also allow us to remove needless restrictions on anchor investors and the cap on profit. Given that

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