Stock exchanges: Why Jalan report is being bashed

In January 2010, the Securities and Exchange Board of India appointed a committee under the chairmanship of former Reserve Bank of India governor Bimal Jalan to recommend changes in ownership and governance of stock exchanges, depositories and clearing corporations.

The committee submitted its report on November 22 last.

A welcome feature of this submission is that the report has been put up for public discussion on the Sebi website. Which means that Sebi will act on the recommendations, if at all, on the basis of the report as well as public feedback.

The committee not only met stakeholders during the process of writing the report, but has also participated in public meetings thereafter. Of course, at this stage there is no question of revising the report, but at least these public discussions give a chance for the committee to explain its rationale and thought process.

All this is quite remarkably transparent, especially when it comes to government (or regulator)-mandated committees, and it deserves some praise.

Committee reports in the past have had a tendency to get buried or disappear from public gaze.

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In the era of Right To Information, that may be changing but a thorough public scrutiny is always welcome.

Dr Jalan's letter to Sebi also asks that a fresh look be taken after five years by a new committee at all the recommendations of his committee.

All this is part of the good news about the Jalan Committee report. But as for its substantive recommendations, there are far too many misgivings among many stakeholders of capital markets.

The report has ruffled many feathers (and not just of the usual suspects), and there have been numerous and strident protestations in the press already.

The two most contentious recommendations relate to:

(a) Prohibition on listing of stock exchanges; and

(b) Restrictions on ownership of stock exchanges.

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Both these are likely to have a dampening effect on the valuation of the many stock exchanges in the country, which have been waiting eagerly for a piece of the action.

Capital markets remain almost like a greenfield opportunity in India due to their huge untapped potential, and any restriction on entry is surely a dampener for entrants as well as the industry itself.

So, why has the Jalan Committee put these perceived roadblocks?

The backdrop for the two controversial recommendations is that the committee views stock exchanges as market infrastructure institutions (MIIs), which need a special treatment.

This is because presumably MIIs are systemically important, are public utilities, are natural monopolies and enjoy economies of scale.

Unfortunately, each of these characterisation can be applied to various other financial or even non-financial institutions, which are not subject to the same recommendations as the Jalan Committee ones.

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For example, traditionally, electricity and telecom are considered public utilities, and even natural monopolies. But we have long given up the notion that they should be purely publicly owned, or that they should not be listed.

We allow unlimited free entry, even when some people despair of the overcrowding that competition entails.

Besides, technological change constantly challenges what is considered a natural monopoly or not.

SEs perform the role of price discovery and capital allocation. A stable, well-governed and trustworthy SE attracts companies as well as investors, traders and speculators.

This provides greater liquidity and lower impact of individual trades on prices. This is the natural monopoly feature, since more the participants, better the liquidity and price discovery.

But a single SE can never be expected to be the fount of all innovations for all time to come. Otherwise Nasdaq or the NSE would never have been born. Hence, without competition from other SEs or would-be entrants, the SE may become complacent, or prone to abusing its monopoly status.

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Electronics, telecommunication and interconnectedness remove the possibility of price arbitrage between multiple exchanges. This means that efficient price discovery no longer requires a single giant SE.

To be fair, on competition, the Jalan Committee has been open about the exact number. It has left to Sebi to decide what should be the appropriate number of SEs to license. That number is surely greater than two, but probably far less than two dozen.

But as illustrated by telecom, we need to be sceptical about conventional wisdom. In the era of electronic exchanges with ever-tightening oversight of the regulator, a new entrant can only compete on technology and costs.

So, free entry, or the fear of free entry, is essential to keep the stock market deepening and expanding.

Surprisingly, the Jalan Committee did not keep its openness regarding the number of competitors, as regards the listing option.

Prohibiting listing means that newer exchanges have to entice investors with alternative paths for value-creation. Given that newer exchanges will have to invest heavily in technology, or invest considerably in reaching out to "tier two and three" level investors and geographies, they will need risk capital.

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Smaller exchanges catering to niche segments like SME risk capital may need to come up. This capital will want to see a path to value creation, and not just via a dividend flow.

Prohibiting the listing option is cutting off flow of potential risk capital into stock exchanges.

Finally, on governance and ownership, the committee takes a stand that no one entity can own more than 5 per cent of the exchange from day one.

The exceptions to this are institutional investors like banks. But a diffused ownership from the beginning might lead to "management hijack", or investor disinterest, or both.

Lack of a passionate entrepreneur in the initial years might seal an SE's fate. In fact, Dr Jalan could have borrowed from guidelines on new entrants into banking, who are typically given a seven-to-ten year road map for dilution.

"Governance" is a word which does not have a suitable translation into Hindi, or any other Indian language. But just because we do not have the right word, it does not mean that Indians don't recognise good governance when they see it.

Granted that the Jalan Committee was not supposed to produce a magnum opus that would address all issues like financial inclusion, SME access to capital and funds or capital market deepening. But nevertheless, the road map that it has given to ensure sound governance and healthy competition is too rigid, and likely to scare off new entrants or new developments.

The author is chief economist, Aditya Birla Group. The views expressed are personal.