The Report on the Ownership and Governance of Market Infrastructure Institutions submitted by the Committee headed by Bimal Jalan, the former Reserve Bank of India governor, is an important document. In a quiet way it has suggested a blueprint for the future regulatory architecture of the securities market. Whether one agrees with all or some of the recommendations is a different matter and the extent to which the recommendations are implemented by the securities market regulator remains to be seen.
Central to the recommendations of the Report, and the one on which the cognoscenti have spent less time, is the regulatory framework for these infrastructure institutions. The Report correctly identifies three institutions – the stock exchange, the clearing corporation and the depository – as being critical to securities market infrastructure. These three institutions are responsible for the entire process beginning with the buying and selling securities and ending with the transfer of ownership of assets bought or sold. But classifying the three institutions under the same head makes the institutions similar but not the same. The institutions are different not only functionally, but also fundamentally. The stock exchange, for example, provides not only the trading infrastructure, but is also the market itself, while the other two institutions are pure service providers and retain the characteristics of utilities. This is a distinction, the importance of which should not be lost.
The Report recognises that these three Market Infrastructure Institutions (MIIs) as “suppliers of an indispensable public good for modern society” and then reaches the conclusion that “to ensure dependability of the process to the fullest extent possible, [a] certain degree of regulatory powers have to necessarily reside in each of the MIIs, albeit in varying degrees”.
Of the MIIs the stock exchange has been called the “first level regulator” because it performs multiple regulatory functions such as issuer regulation, member regulation, trading regulation and investor regulation. Indeed, from the time informal trading alliances came to be set up for trading in securities in Antwerp, Bruges, and in the coffee houses of Amsterdam and London or under the buttonwood trees and banyan trees in New York and Mumbai, this was the traditional and accepted view. The securities market regulators were not to be born till a couple of centuries later and it was the stock exchanges that had to lay down the rules for admitting members and conditions for trading. In fact, as Joel Seligman recounts in his Transformation of Wall Street, when the United States Securities and Exchange Commission was born, its first attempts to bring the New York Stock Exchange under its oversight met with stiff resistance. This was the case in India too and it was not easy for the Securities and Exchange Board of India (Sebi) to regulate the Bombay Stock Exchange.
But that was then. The present times are different and what got us here won’t get us there and for that matter any further. Technology has altered the way trading is done. The trading pits have long been replaced by trading platforms and CPUs, and it is the location of the CPUs that matter, not the building or the address of the stock exchange. Integration and connectivity are the buzzwords. Indeed with all these changes, when the demands for funds increased and the traditional stock exchanges faced competition from the more agile private trading platforms set up by large brokerage houses, there was pressure for them to change their nature and constitution. From mutual organisations they became demutualised and the trading rights that were once an integral part of membership of an exchange became separated from the ownership rights. One could be a shareholder of the company that owns the stock exchange, with or without becoming a trading member. But once demutualised, the stock exchanges were no longer not-for-profit entities. Profit became one of the business objectives and rightly so. A demutualised stock exchange with shareholders should have a profit maximisation motive; it is a commercial enterprise. Profit is not a bad word, but it becomes a bad word when “public good” is involved. The Jalan Committee Report recognises this when it observes that “the goals of profit maximisation for an MII and that of welfare maximisation for the public may not always run parallel and the MII may be tempted to charge prices well in excess of the costs from its users”.
This is only one facet of the conflict between the twin objectives. Others such as market share and predatory practices, as we have seen in recent times, arise from competition. Even these come into direct conflict with the public good objective and are far too important to be ignored. It then becomes difficult both theoretically and more so practically to imagine a profit maximising regulator. Reasonableness of profit can never be incontestably established. The moot question is whether under the changed conditions the regulatory powers should continue to reside in the stock exchange as has been argued in the report and whether that would be effective. Indeed, this is an issue that many countries are being confronted with and a common satisfactory solution is not yet in sight.
Looking for a solution through a mechanism to ensure regulatory autonomy through the separation of personnel who are carrying out regulatory functions, placing a cap on remuneration and the introduction of the concept of “Chinese Walls” are non-solutions. In financial markets when human behaviour is involved and one has to constantly deal with greed and the need to cut corners to grab market share, “Chinese Wall” becomes a euphemism for the most porous walls through which information flows freely without the need for osmotic pressure to drive the flow. The most desirable way of addressing the conflict is to segregate the functions of operating an infrastructure or providing an efficient service efficiently and economically, and regulating it. The stock exchanges could continue to provide the trading system and trading platform and may even continue to implement the risk management system, while their regulatory roles are bundled into another body created specifically for the purpose under the Sebi Act or the Securities Contract (Regulations) Act and given statutory status while making it function under Sebi oversight. This is necessary, given the complexities of the Indian market, which are very different from other markets, but not easy. But once this is done, it would be easy to implement some of the recommendations of the Jalan Committee. In fact, some of the recommendations may not even be necessary.
Views expressed are personal The author is a former executive director of Sebi and is currently associated with International Finance Corporation’s Global Corporate Governance Forum and the World Bank.pratipkar21@gmail.com
