Column : Dr Jalans right

Written by Shobhana Subramanian | Updated: Dec 22 2010, 09:20am hrs
Its not hard to understand why one would want to be in the stock exchanges business. Once the initial costs are out of the way, the operating leverage can be high, provided volumes are growing so that after a point cash flows are fairly secular. Globally, exchanges make an operating profit margin of anywhere between 60% and 80%, our own National Stock Exchange (NSE) earns something like 65%. As experts say, liquidity can act as a barrier to competition so that it becomes a quasi-monopolistic kind of business where the winner takes all. Thats pretty much how its turning out to be in India; in the derivatives space, for instance, the Bombay Stock Exchange (BSE) hardly does any business and, as a result, the NSE commands a 90%-plus share of the total market.

Despite this, the Bimal Jalan committee has chosen to keep the entry barriers high, although emphasising that its important to create enabling conditions that allow new entrants to enter the market. Thats not really such a bad thing because exchanges need credibility since they are also regulators. Like at the Chicago Mercantile Exchange, India has adopted the strong exchange SRO model. This means that a public authority is the primary regulator and it relies on exchanges to perform extensive regulatory functions that extend beyond its market operations, including regulating members business conduct. Therefore, it is essential that the ownership of the exchanges is of a high pedigree and that no one shareholder controls a disproportionate share. The current ownership restrictions seem to be in keeping with the pattern seen in other markets except that in most other markets one shareholder is allowed to hold more than 15% but less than 30% of the equity capital.

In India, currently, the maximum shareholding possible is 15% and that too has to be held by either a stock exchange, or a banking company, or a clearing corporation and so on. The committee is more or less staying with this structure; apart from suggesting that ownership be dispersedover time no investor can own more than 15%its clearly not in favour of any entity other than a bank or a financial institution owning a big chunk of equity. And it has stayed with the current prescription that individuals cant own more than a 5% stake.

The demutualised construct of the NSE seems to have worked well; it was set up with IDBI as the main sponsor and over time has attracted investments from the likes of a NYSE Euronext, which picked up a 5% stake for $115 million. Indeed, segregating management from ownership appears to have been the right way to go about it going by the results: turnover has grown at a compounded 65%-plus in the last 15 years and the enterprise is a profitable one. Its probably a good idea to leave the stock exchanges in the hands of anchor investors, typically banks or financial institutions with a net worth of Rs 1,000 crore, who are satisfied with reasonable profits and are driven more by the urge to play an institutional role rather than by commercial gains. Professionals could then run the business and even if these anchor investors are required to bring down their stakes from 24% to 15% over a period of time, a 15% stake is big enough to sustain their interest in the business. The question is whether four or five players would be willing to come together to set up an exchange; it doesnt really seem an unworkable model because the risk will be shared. Since the committee doesnt favour a listing of exchanges, the onus would be on the exchange to perform well so that shareholders can, if they wish, sell out to newer investors, through off-market transactions. Of course, the lack of an exit route through listing may inhibit potential investors but the committee has a valid point in that there is the issue of who would be responsible for monitoring whether the exchange is complying with the listing guidelines. Right now, the markets seem to be satisfied with two exchanges. To that extent theres no immediate need for competition. Sebi could, however, see to it that the incumbents do not misuse their clout.