The report of the Bimal Jalan Committee, constituted by the Securities and Exchange Board of India (Sebi) in January 2010, on changes in ownership and governance of Market Infrastructure Institutions (MIIs), such as stock exchanges, clearing houses and depositories, has sparked an intense debate.
It is said that the first casualty of a fiercely contested public debate is “truth”! The more intense the debate and the more polarised the expressed views, the less likely one would get to an objective and neutral policy conclusion. Very often these extreme views tend to be well-funded but not well-founded in economic theory and reasoning.
Equally worrisome is the self-reinforcing nature of the polarisation of views: anyone with a view that is neutral and balanced is likely to get rejected by both sides, marginalising balanced views and giving prominence to extreme views. At the risk of being rejected by both sides, I would like to analyse the recommendations of the Jalan Committee from the neutral perspective of economic theory of market design and industrial organisation.
The Jalan Committee report contains recommendations on how many stock exchanges there should be in the country; on ownership structure of stock exchanges; on profits of stock exchanges; and on listing of stock exchanges. Many commentators have observed that the committee took an anti-competitive and protecting-the-status-quo stand that would favour the currently dominant stock exchange as against the other current and future stock exchanges. The first important question to ask in this context is whether a competitive market structure is necessarily and always socially optimal or desirable. The common-sense argument favouring competitive market structure stems from the ideas of classical welfare economics that related perfect competition to efficient allocation of resources.
But, as we know from the works of Professors Joseph Stiglitz, Bruce Greenwald and Sanford Grossman, in situations of informationally incomplete and imperfect financial markets, competitive mechanisms may not always ensure optimal resource allocation. Moreover, in demanding a competitive market structure, we must distinguish between competitive outcome and competitive process. A game-changing and substantial technological or financial innovation can generate a dominant firm, and such an outcome is socially desirable even if it looks non-competitive. Monopolistic outcome, however, raises two classes of problems: first, a monopolist can affect the terms and alternatives available for other market participants because of the power she possesses; and how would one ensure the “social responsibility” of a monopolist.
This is where the argument for competitive process comes into picture: if the overall process of market design is competitive, the current dominant position will always be contestable either by the existing or by the potential entrants. In other words, the opportunity to become a dominant exchange should always be available for every potential entrant to ensure that no permanent monopolies get established. In the current context, one could ask if one stock exchange is in a dominant position, how to ensure that it doesn’t limit the domain of financial innovation that should be available for other stock exchanges and the resultant benefits of financial innovations to investors.
It appears that the Jalan Committee, while correctly recognising the social benefits of a vertically integrated dominant stock exchange in terms of economies of scale and scope, seems to have underestimated the power of competitive process in disciplining the dominant stock exchanges. Instead, it chose to control the stock exchanges by regulating the entry, ownership structure and incentives of the management along the lines of a public utility.
Consider, for example, the issue of self-regulatory nature of stock exchanges. It is being argued how a for-profit/listed stock exchange operating to maximise its shareholder wealth may not always have incentives to enforce rules governing the behaviour of exchange members. In a competitive environment, this is not an issue as the process would ensure the migration of liquidity from a badly managed stock exchange to another stock exchange that protects the investor interest. Instead of recommending the creation of such a competitive environment, the committee takes a position that “entry of a large number of stock exchanges will fragment liquidity to such an extent that this might stifle growth and innovation in the process”. The committee recommends regulations that micro-manage the ownership structure, caps profitability and management incentives of stock exchanges to resolve the potential conflicts of interest in the three-way principal-agent problem of owners and management of stock exchanges, and the investors.
While there is no clear, established evidence showing how a particular form of stock exchange ownership adversely affects the incentives to enforce regulation, there is abundant evidence that profitability and incentives have significant impact on financial innovation. While stock exchanges are to be considered institutions of systemic importance, they are not like other public utilities because of their innovation-intensive nature. Caps on profitability and micro-management of incentives for stock exchanges can, therefore, create implicit entry barriers and damage the financial innovation process.
Despite the tremendous success that we have had in terms of creating securities markets infrastructure over the last 15 years or so, India still has a long way to go in terms of catching up with global peers in financial product, function and institution development. It is our ability to innovate on a continuous basis that ensures the development of financial markets and institutions in the long run. The sole purpose of any rules and regulations, therefore, on ownership structure, management of incentives and competitive process related to financial markets should always be the efficient financial innovation process.
It is easy to be tempted by the backdrop of the biggest financial crisis of this century and choose policies that focus on short-term stability at the cost of long-term development. But, the real art of financial policy is in ensuring stability in times of change and encouraging change in times of stability.
