No separation

The Budget speech this year had the enigmatic sentence "We shall now take steps to create a single, unified exchange-traded market for corporate bonds". There are two ways to interpret this sentence which make sense.

The first is a separation between equities and corporate bond trading. There was a threat that RBI would regulate corporate bonds while SEBI regulates equities. This unification makes sense because the same news and speculation drives both shares and corporate bonds. Bad news for Reliance drives down its share price and drives up the interest rates of bonds on Reliance. The measurement of credit risk in modern finance is done using information contained in stock prices and stock options. Hence, trading in all financial products based on Reliance "" equity, bonds, stock options/futures "" should be unified. A speculator should be able to place coordinated trades across all these intimately linked products on a single screen.

The second separation is between the archaic phone market and the electronic exchange. The government bond market has been bedevilled by RBI's efforts at keeping a phone market "" which is its own preserve "" distinct from electronic trading at stock exchanges. The elimination of telephone market trading for corporate bonds, and the consequent unification of all order flow at electronic exchanges, would improve transparency, reduce malpractice, reduce entry barriers in either intermediation or speculation, and deliver superior liquidity.

While both these notions of 'unification' make sense, there is one interpretation of the word 'unified' which makes no sense. A recent SEBI report takes a big leap, away from the issue of unified trading in corporate bonds, to the issue of competition between exchanges. SEBI feels that because BSE is smaller than NSE, it needs to be supported. Hence, it is proposed that corporate bond trading should be the monopoly of BSE.

In the late 1990s, D. R. Mehta's SEBI repeatedly strayed into supporting BSE in competing against NSE. The resumption of this stance, in the unlikely context of a committee report on corporate bonds, is highly surprising and deplorable. The core dharma of a regulator has to be competition. The regulator must not be a caring mother drawn from a socialist utopia, giving a helping hand to firms which are doing badly. The regulator must simply enforce competition. Whether MTNL is doing well or badly, the job of TRAI is to foster maximal competition in the telecom market. The SEBI committee has displayed a lack of understanding of regulation and competition. A SEBI order which prohibits NSE from trading in corporate bonds could be anti-competitive and should be challenged by the Competition Commission.

At first blush, it looks like NSE and BSE are separate stock exchanges. However, what lies beneath the surface is a fascinating combination of competition and unified price formation. Both exchanges are in the field every day, trying to offer better services and lower prices, to woo customers. We need more of such competition, not less. And yet, price formation is unified through arbitrage. Thousands of eyeballs and hundreds of computer programs are constantly scanning both exchanges, looking for the smallest divergence in prices, to grab a profit through arbitrage. Equities trading on NSE and BSE is an ideal situation combining unified price discovery in a competitive framework. Corporate bonds must be simply merged into this framework for equities trading.