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Thursday, May 18, 2006

Arguments on publicly traded exchanges

I got some fascinating responses on my previous posting on policy questions associated with publicly traded exchanges.

The comment by `Arb' (on the previous post) says:

Why this double standard? Why does every one think free markets are good for everything but the institutions in their field. Everyone from dairy farmers to financial theorists cite "unique problems" to protect their field from the free market. The listed financial products market in India is incredibly hidebound. Look at the innovation in markets like the US with the coming of players like Island, ISE etc. The NSE employes ancient technology both for its matching engine and market data dissemination. The pace of introduction of new products is glacial - why bother when there is no innovation. The BSE does not bother since management has no incentive. Look what happened to the CME and the NYSE since they have gone public. The floors are on their way out and they are aggresively laying out plans to attack other markets - bringing innovation and lower costs to investors. The various reputational issues that you outline are non-starters. Since when is it an exchange's job to track down rumours? No manager will risk the reputation of the exchange in exchange for short term profit especially when his options vests over a multi year period. The various public exchanges world wide - LSE, Deutsche Bourse - are great examples of that. In fact the Deutsche Bourse mounted a great attack on the CBOT forcing it to cut prices and innovate. We need more learning from the worldwide experience of exchanges that are private/public for-profit institution and dynamos of innovation and efficency instead of promoting the hidebound lame NSE as some paragon of the exchange model. In a race between the blind (BSE) and the one-legged (the NSE), the one-legged will win. It does not follow that the one-legged will excel in the Olympics. We need Olympians, not protection of the one-legged.

A response from He-who-won't-be-named (in email) says:

You are right about contrasting the Indian governance environment with that in UK or US. If Sanjay Kumar of Computer Associates had done in India whatever he did in USA, he would not have had to face life in prison. In our environment, it is best to avoid the kind of conflicts that would come from listing an exchange on itself. The problem is not limited to exchanges. Every broker and fund manager in the market routinely faces this conflict of interest. If I can make more money by churning my clients portfolio, there is nothing that stops me from doing it, other than the fear of having my licence cancelled. If I don't need to bother about that eventuality, then the temptation to take the easy path to earnings will be too hard to resist. If I am listed and my CFO has to give earnings guidance every quarter, it only makes it worse (imagine the CFO of a listed exchange giving guidance to a bunch of analysts). Wherever we deal with "other people's money" we need to deal with these conflicts. Lastly, even without listing, shareholders can try to milk dividends and put pressure on exchanges to increase revenues. The board of directors of an exchange have responsibilities that go far beyond those exercised by the board of a normal firm, and necessary checks and balances should be part of the structure of rules under which the board operates. Ethics and governance are a big topic. Despite all the advances of the past few years, we have only scratched the surface so far. Shifting away from the ethics, I think the neglect of small cap stocks is already a case in point on the problems with what exchanges are maximising. The contribution to turnover from these stocks is minimal for the exchanges, and that results in insufficient attention to what really needs to be done to create an effective marketplace. If it is made one of the stated objectives at the board level, and if we can identify appropriate measures to judge efforts and results, we may see more concerted efforts to tackle the problem.

I am acutely aware of the pace of innovation and competition that we see in Europe and the US amongst exchanges, and the lack of innovation / competition in India. One element of a diagnosis is the weaknesses of regulation. India is weird - the central bank bans trading of currency futures. The limitations of RBI and SEBI are surely one important hurdle leading to slow progress in India - I can tell you a million tales of innovation which got blocked by regulators. The second facet is competition. I am all for more competition. I have supported the idea of entry into India by global exchanges in the past. I believe that the more exchanges are competing in India, the better.

My concerns are about governance. I simply do not believe that a simple EPS-maximising exchange-as-listed-company works well. At the simplest, I will point out that even in settings like the US, where NYSE or CME are listed, there has been special work done in terms of separating out regulatory functions into NYSE Reg (and there is some movement towards completely taking NYSE Reg out of NYSE).

In India, FMC has little experience with financial regulation, so MCX seems to have got a free pass out of them. SEBI appears to be headed for an MCX IPO or a regional stock exchange IPO without understanding these conflicts of interest. The reason I wrote that article was to put these issues on the table for the people who make these decisions. My view is that a minimum set of strictures that SEBI, as the regulator of India's securities industry, should impose on listed-exchanges is:

  • An NYSE Reg structure for separating out regulatory functions from a profit-maximising entity,
  • A limit on shareholding by any one party at 5%,
  • A ban on self-listing (NSE can list on BSE; BSE can list on NSE), and
  • A management team that has no ownership, stock options or profit-linked bonuses.

But even if SEBI did all this, I unfortunately believe it does not get the job done. This brings us to judgment about the governance environment in a given country. A Calcutta Stock Exchange will setup a CSE-Reg, a separate non-profit ostensibly for performing regulatory functions. Do you believe that there will be a genuine separation of regulatory functions, a distinction between the maximisation of CSE as opposed to CSE-Reg? I expect CSE will setup CSE-Reg to look independent on paper but in reality it will perform the bidding of CSE. My intuition in India is that a genuine separation of CSE-Reg is not possible in India. I suspect `Arb' lives outside India (He-who-won't-be-named' lives in India).

More generally, I do not think "free markets are good for everything". I think free markets are a means to an end. They are an enormously powerful tool, but they are only a means to an end. The end is to have efficiency, productivity, and to get to $10k of per capita GDP in the shortest time. There are many, many situations where a focus on free markets works wonderfully (and I have written on these situations repeatedly). But we have to grapple with the genuine puzzles of creating market institutions that actually deliver the goods.

In the exchange context, I think the only sensible governance structure is the NSE model, where the owner is a wholesale customer of the services of the exchange, where the sound functioning of the exchange is much more important for the owner than the flow of dividends from the exchange, and the management team has no ownership in any form - whether shares, stock options or profit-linked-bonuses.

Such reasoning is not limited to exchanges. As an example, many people - including myself - believe that the private market for fund management is fundamentally broken. The Indian situation with mutual fund agents and insurance agents, and huge fees and expenses, is simply dysfunctional. People like Keith Ambachtsheer have been increasingly radicalised in thinking about this situation, to a point where today Keith says that there is a fundamental governance problem in fund management when the owner is not the investor. He advocates cooperatives or public sector structures. As an example, Vanguard (a cooperative) is a fantastic story of what you gain when you remove profit maximisation as a motive for the top management team for a fund management shop.

India's New Pension System, which I have consistently advocated for almost a decade now, is a whole bunch of intrusive interventions into the fund management market, designed to give customers low cost and to avoid the problems that come from profit-maximising pension fund managers placed in an ordinary "unfettered market". If you wanted an unfettered market for private pensions in India, you already have it - it's the pension schemes sold by insurance companies. It's a free market solution, backed by enormous government subsidies in the form of preferential tax treatment. But there isn't a worse deal for customers that can be imagined.

In short, we have a problem with Indian exchanges. We need more innovation, more competition. Half the problem is in regulation. More exchanges in a competitive landscape will only help. But we need to worry about the unique governance problems of an exchange, which is not an ordinary firm.


  1. 1)Given the huge problems that you have pointed out about fund management in India, why haven't ETFs taken off in a big way. Are you aware of any regulatory issues that are preventing this product from taking off? I checked the NSE website and found just 3-4 ETFs that have been launched..ETFs can also play an important role in the pension system that you propose so that the transaction costs of fund management are minimized to a great extent...

    2) Is the criticism by "Arb" in the previous post about the functioning of the NSE in terms of its technology correct? I was always under the impression, after hearing and reading from many sources, that the NSE uses technolgy that is right up there with world standards and that has been one of the key features in attracting FIIs towards the NSE...

  2. The fund management industry is a problem because the typical customer does not understand how bad the proble m is. You can't sell a customer shoddy shoes. But you can sell him a shoddy financial product. ETFs and index funds do exist, but the trouble is that most customers listen to their agents, who peddle the stuff that pays them 7% fees.

    NSE and technology - the glass is half empty/full. On one hand, NSE is right up there, after NYSE, as the 3rd biggest number of transactions in the world. That's cool, coming from a 3rd world country with a per capita GDP of $800. But when you actually look at the technology, it's pretty bad. A lot of design decisions were taken in ~ 1993, and it's hard for a big site to change. NSE is particularly bad on openness of data and feeds. But as `Arb' says, with no serious competition, BSE hasn't done better on these things either.


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