A Competitive Threat or a Wake-up Call?
Rules to open up competition in Indian stock exchanges may not bring new entrants, but they may nudge the market leader to shape up.
Earlier this month, the Securities and Exchange Board of India (SEBI) published a consultation paper in which it proposed changes to ownership and governance rules of stock exchanges. If adopted, the new rules would facilitate new entrants.
The current rules prevent the entry of new players and large acquisitions in existing entities. To promote a diversified ownership structure, the rules cap the shareholdings of individuals and institutions in stock exchanges at 5% and those of select financial institutions at 15%. The proposed rules would make it easier to set up a new exchange by allowing resident individuals and institutions to own the entire company. Foreign entities could own up to 49% of its shares. The founders of the new exchange will have up to 10 years to bring down their shareholding to at most 26% (or 15% in the case of foreign entities).
According to the SEBI consultation paper, the rationale for the changes in ownership rules is twofold. First, the regulator is concerned about the dominant position of the National Stock Exchange (NSE) in the trading and depositary space. NSE accounts for 92% of trades in the cash segment and nearly all of the trades in the derivatives segment, and its clearing arm accounts for more than 90% of the transactions. The dominant position not only could lead to abuse but also to institutional tardiness in responding in a timely manner to the changing dynamics of the capital markets ecosystem. The second reason is to incentivize innovative fintech firms, which are deploying blockchain technologies to improve trading processes and supervisory mechanisms, to set up exchanges in India.
The proposed changes in governance cover the composition of various committees. Today, a nomination committee and a risk management committee consist entirely of Public Interest Directors (PIDs), who are different from independent directors. Under the proposed changes, the committees would consist of a majority of PIDs and the rest of the members would be drawn from among shareholder directors. The changes would bring much-needed diversity to the decision-making process, which is in line with the recognition that a balance must be struck between independence and expertise in areas such as risk management.
The concerns surrounding NSE’s dominant position may seem surprising now, considering NSE was the original innovator and disruptor. For years, Indian exchanges, owned and operated by stockbrokers in a mutualized structure, were plagued by outdated, opaque, and fragmented trading and settlement systems. Measures to improve the transparency and efficiency of stock exchanges were resisted by the broking community, which loathed to lose high commissions and wide bid-ask spreads.
To change the status quo, a group of financial institutions, with the support of the government, set up NSE in 1993 as a demutualized, for-profit company. NSE’s advantages over other exchanges were threefold. First, as a demutualized exchange (whose ownership is separated from its operations), it had less incentive to prioritize its members’ interests over those of other stakeholders, that is, owners and end investors. Second, it operated a national network of terminals from inception, whereas other exchanges were regional monopolies that were not allowed to set up terminals outside their region until late 1997. This helped NSE to generate large trading volumes and network externalities and allowed it to reduce its brokerage commissions over time, furthering its dominance that continues today. Third, as a new entrant, NSE could set up state-of-the-art terminals and trading services from the start, making it difficult for competition with legacy systems to catch up.
Globally, the clear trend is toward consolidation of stock exchanges, so that they can compete better in data, cross-border listings, and order flows. Major exchanges in Asia Pacific, such as the Australian Securities Exchange, the Singapore Exchange, and the Stock Exchange of Hong Kong, are all dominant in their respective markets, whereas the United States and China have more than one dominant exchange.
The scrutiny over NSE’s dominant position is perhaps not so much a matter of principle, but rather a practical outcome of a series of missteps by NSE in recent years. In 2019, SEBI levied fines on NSE and its directors for failing to exercise due diligence when it put in place a tick-by-tick architecture for high-frequency trading (HFT). This led to “a trading environment in which the information dissemination was asymmetric, which cannot be considered fair and equitable,” even though more serious allegations of fraud could not be proven. Globally, HFT has become an important source of revenue for stock exchanges, but the benefits of market liquidity need to be weighed against the potential for market abuse. There also have been several instances of technical glitches in NSE’s trading systems in recent years, prompting concerns from both SEBI and the Ministry of Finance.
The proposal to reduce barriers to entry is a sensible move. But would it result in a dilution of NSE’s dominance? It is conceivable that new players are waiting in the wings, or a large foreign entity could bring capital and expertise into one of the smaller exchanges. But it is more likely that the threat alone will spur NSE to clean up its act, invest in operational improvements, and experiment with newer technologies. Either outcome would be welcomed by Indian investors.
The real question is
whether competition would spur market efficiency. When it comes to exchanges,
there are two forms of competition: competition among trading venues and
competition for individual orders. The former, the focus of the SEBI
consultation paper, might lead to improved trading services or newer
technologies; but the latter, where orders flow to venues based on best prices
and liquidity, is more important for market efficiency. India lags when it
comes to the so-called best-price execution. As recently as June 2020, SEBI
directed stock exchanges to remind trading members of their responsibility to
provide best price execution and observed that “trade default preference”
embedded in trading systems directed orders to a “particular trading venue or
exchange” in violation of the members’ duty to investors as outlined in SEBI
Stock Broker Regulations (1992).
SEBI would do well to follow-through and fix the plumbing of order flows, even
as it seeks to incentivize competition among trading venues.
 SEBI, “Order in the Matter of NSE Colocation,” 30 April 2019, https://www.sebi.gov.in/enforcement/orders/apr-2019/order-in-the-matter-of-nse-colocation_42880.html.
 BSE, “Guidelines for Execution of Client Transactions at the Best Available Market Price,” 26 June 2020, https://www.bseindia.com/markets/MarketInfo/DispNewNoticesCirculars.aspx?page=20200626-7.
Photo credit @ Getty Images / Sean Gladwell