Has Jalan got it right on exchanges

Written by Sandeep Parekh | Updated: Nov 27 2010, 02:38am hrs
The Jalan committee report on stock exchange ownership and governance disappoints.

Particularly given the stature of its chairman, who is often regarded as amongst the best central bankers of free India. The committee recommendations fight economics tooth and nail. They seek to disconnect ownership from management, disconnect performance from pay and continue the disconnect between the competition and

existing exchanges.

The first problem with the recommendations is a marginal opening of the window on ownership of stock exchanges. Todays regulations permit only a 5% (15% in limited cases) ownership of exchanges by a single person or persons acting in concert. This has meant that no one wants to give birth to an exchange. The only way for a new exchange to form would be if 20 people meet in a room and all spontaneously think of starting a new exchange (they cannot act in concert) at the same time. This has meant the chilling of competition in the exchange space and some of the juiciest margins in any business. The committee recommends allowing anchor investors to invest up to 24%, but the definition of such investors is so narrow and limited (to large banks and public financial institutions) that the opening up is meaningless. It also means the Rural Electrification Corporation, with no competence, is eligible to promote a new exchange but a commodity exchange like MCX cannot invest over 5% and thus promote an exchange.

In addition, the committee contradicts its reports own annexure. It says, Annexure C & Annexure D of this report depict the ownership restrictions in select countries and details of ownership of stock exchanges in select countries, respectively. It is seen that the existing shareholding restrictions in India generally are similar to that of most other countries. In fact, the annexures, if read carefully, show that not one of the countries in the world cited in the report has this perverse 5% cap on ownership, with the exception of India. The annexure merely shows countries require either disclosure or permission on crossing the 5% or 15% threshold, not a bar.

The second problem is that while the committee recognises that the real risk of exchanges as commonly understood is actually borne by the clearing corporation (the exchange is only of a limited order matching computer system), its insistence on a net worth for exchanges is not reasonable. Similarly, the committees recommendation of a Rs 300 crore net worth for clearing corporations is absolutist rather than scientific and probably grossly inadequate. Remember that the clearing corporations/houses handling of equities alone exceeds Indias GDP.

Third, the cap on profitability of exchanges, bans on listing and divorce of performance with pay of senior management are inexplicable and destructive. If the public sector ONGC can seek profits, why shouldnt exchanges that are privately owned The correct way to eliminate monopolistic pricing is by taking appropriate anti-competition action or by encouraging competition, not by passing a fiat against profitability. With a ban on listing, whatever possible exit opportunity for investors and governance check against management could exist, will also vanish. A bar on disconnecting performance from pay will disincentivise good performance by management. This recommendation cannot be adequately condemned.

Overall, the recommendations further a cause that neither existing nor potential exchanges will support, and will take India back to the dark ages of exchange governance.

Disclosure: I have advised MCX-SX, which would be adversely affected by these recommendations.

The author is the founder of Finsec Law Advisors

Prithvi haldea

The Jalan Committee Report will be debated extensively. I will limit my comments to the stock exchanges, and that too to some critical aspects. The entire set of recommendations are based on the premise that stock exchanges are for the 'public good'. In other words, these are essential facilities and are extremely critical vehicles for economic growth. The report establishes this premise with well-reasoned arguments. For those subscribing to this view, the recommendations instantly appear laudable.

The report suggests the continuation of dispersed ownership so that no single private entity becomes a dominant shareholder in an entity that is entrusted with vital economic and regulatory functions. It is true that instead of thinking of the good of the public, and many a times at its expense, exchanges may focus on such activities that would maximise profits, as the main objective of shareholders is precisely to maximise profits.

The report instead suggests the introduction of anchor investors, with a long-term commitment. What pleases me the most, being a nationalist, is that dominant holding will be permitted only by the domestic institutions (public financial institutions and banks). So, we will not let this public good go into foreign hands and let our markets become vulnerable to them. (Our markets already are, but our exchanges will not be.)

While the restructuring of the stock exchanges through corporatisation has made them for-profit entities, and though profits are essential for survival and growth, the main pursuit for a 'public' entity cannot be profits.

The report has, therefore, come out with a very interesting proposition of putting a cap on profit. If for reasons of efficiencies or because of a near-monopolistic situation, a stock exchange does make larger profits, the excess profits would not belong to the exchange but would go to the public investors through the Investor Protection Fund or the Settlement Guarantee Fund; Sebi would monitor utilisation of these funds.

Flowing from the same logic of 'public good' is the recommendation that the exchanges should not be listed. In India, exchanges are the front-line regulators and they indeed perform that role. Simply speaking, regulators cannot be listed, even if they have a revenue stream. In any case, listing is not the only exit route. But this recommendation will put off a lot of current investors who have taken stakes in the exchanges. Most of them are not strategic investors but had invested for trading gains. Worse, with the cap on profit, they would feel short-changed as they had invested based upon valuations derived from existing and potential profit.

Conversely, there is an equally strong argument that stock exchanges are and, therefore, should be treated like commercial entities. I find nothing wrong with this logic. But the exchanges should first be converted into pure commercial entities by taking out their regulatory functions and turning them into pure product design and trading platforms. This is why the Central Listing Authority (CLA) was mooted in 2003to divest exchanges of their regulatory function. The idea was, however, buried. Once there is a CLA in place, exchanges should be given freedom in terms of entry norms, multiple players, dominant private ownership, listing, etc. The report does recognise that competition is good for the market and investors. Nothing prevents the several Sebi-approved regional exchanges from coming up with a business model, getting the backing of anchor investors and competing. Nothing prevents new players either. I hope that strong competition does come in the near future.

The author is chairman and managing director, Prime Database