In January 2010, Sebi set up a committee headed by Bimal Jalan, former RBI governor, to review the ownership and governance of Indian stock exchanges, depositories and clearing corporations, collectively called market infrastructure institutions (MIIs). The Jalan Committee report (JCR) was submitted in November 2010 and since then there have been several commentaries on the JCR’s proposals. This article examines the report’s principal recommendations and some of the negative comments.
The JCR’s suggestions for MIIs can be summarised along the following four lines: (a) Ownership — existing Sebi regulations should be amended such that only anchor institutional investors, defined as adequately capitalised public financial institutions and banks, are eligible to own up to 15-24 per cent of stock exchanges. Depositories and clearing corporations should not own other classes of MIIs; (b) Public listing — MIIs should not be listed; (c) Profits — should not exceed a risk-free benchmark plus appropriate risk premium; (d) Compensation — should be fixed and not include any variable component linked to “commercial” performance. We could quibble about the fine print in the JCR. For example, the recommendation that anchor institutional investors should bring down their holdings in MIIs to 15 per cent or less within 10 years. On balance, in broad terms this report’s suggestions are timely and, if implemented, would improve the regulatory environment in Indian capital markets.
MIIs are natural monopolies similar to public utilities. Therefore, it would not be commercially viable to set up dozens of stock exchanges, depositories and clearing corporations in any one national jurisdiction. Since the number of MIIs which can be set up is limited, it follows that efficiency engendered by competition would also be limited. Hence there is a strong case for MIIs to exercise self-restraint and self-regulation in the best interests of the clients they are expected to serve.
No statutory regulator can keep up fully with market innovations. MIIs are closer to markets and better placed to track the intricacies of trading as compared to regulators such as Sebi or SEC. For example, unusual trading in a stock in terms of timing of purchase or volume has to be detected by stock exchanges, in the first instance. There is no practical way in which these policing functions can be spun off to another organisation or allocated to a separate department with Chinese walls between it and the rest of the MII. Market knowledge involved in running MIIs gives them the required insight to carry out regulatory functions effectively. MIIs are, therefore, the first line of regulatory surveillance and defence, and should be viewed as front-line regulators.
The 2008 financial sector meltdown, which started in the US, had an adverse impact on markets around the world. Internationally significant MIIs should have been more proactive about adequacy of risk capital. For instance, stock exchanges should have lobbied SEC for fresh regulations to be framed to move credit default swaps (CDSs) to exchanges. If CDSs underwritten by AIG had to be registered with central clearing exchanges and subjected to margin payments, AIG would have been compelled to limit the volume of CDSs it underwrote.
The Financial Times, in an article dated December 29, 2010, categorised the JCR’s conclusions as “too prescriptive to encourage further development of the Indian economy”. This article also claimed that “the clear evidence of the past decade is that exchanges function much better as for-profit, publicly listed companies”. Others have commented that the JCR’s recommendations are equivalent to “regulatory sabotage” and “backdoor nationalisation” of Indian equity markets.
According to the Oxford dictionary, “prescriptive” means “concerned with” or “laying down rules of usage”. The JCR has been put in the pubic domain and the report suggests that if its recommendations are accepted, the revised norms for MIIs should be re-examined after five years. This does not sound prescriptive. More importantly, there is no evidence in the FT article to justify the sweeping statement that the JCR’s conclusions will not allow further development of the “Indian economy”.
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It is also not clear on what basis the FT article claims that there is “clear evidence” that exchanges function better when they are listed as for-profit companies. Obviously, it would be in the interest of MII owners and management for these institutions to be for-profit. However, focusing on profits occasionally leads firms to take on unsustainably high levels of leverage. Surely, we do not want MIIs, which have an important regulatory role, to ignore or cut corners on their oversight function in pursuing profits.
MIIs should not be listed for the same reason that they should not engage in profit maximisation. There are bound to be sharp conflicts of interests between MII owners/managements and their clients. For example, frequent purchase/sale of MII shares through holding and shell companies could obscure true ownership. Effectively, controlling ownership of MIIs could end up with the same firms that MIIs are expected to regulate.
The G20 had directed the Financial Stability Board (FSB) to suggest ways in which excessive risk-taking by market makers, such as banks, induced by prospects of overly generous compensation packages, can be curtailed. The FSB put together a “Thematic Review on Compensation” dated March 30, 2010 which suggests “Alignment of Compensation with Prudent Risk Taking”. It is logical, therefore, that compensation in MIIs which are front-line regulators should not be at market levels. Professionals make choices and working for MIIs or a regulator, such as Sebi, at lower compensation levels is a conscious choice. Looking back, when the NSE was set up, its senior management came from IDBI. From all accounts, the NSE has performed well beyond expectations, particularly during the crucial first ten years after it was set up, with compensation levels close to public sector bank salaries. Going by past experience, the listing and compensation policies at the NYSE and LSE are not necessarily “best international practices”.
A scare tactic which is being used by critics of the JCR is that trading on Indian stock exchanges will migrate to stock exchanges in Singapore, London and elsewhere if this report’s proposals are accepted. To sum up, this is a risk worth taking since the systemic risks associated with for-profit, listed MIIs, with compensation and dividends linked to trading volumes or profits, would be much higher.
The author is India’s ambassador to the European Union, Belgium and Luxembourg. Views expressed are personal