Opinion

Don't over-regulate stock exchanges

Ashima Goyal | Updated on January 21, 2011

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The Jalan committee on stock exchanges has expressed concern over ownership patterns and excessive profits. The best response to such market imperfections is to promote competition and tone up systems with better governance and technology.

The Jalan committee on Market Microstructure Institutions (MIIs) starts from basic principles, moderated by context. This is the best way to go about regulatory redesign. It discusses the evolution of Indian markets, the essential characteristics of market infrastructure institutions, and their responsibilities. The positions of interested parties contribute to domain knowledge, but only arguments based on principles can help reach an objective social- welfare maximising decision. What then are the committee's arguments?

TECHNOLOGY AND GOVERNANCE

It starts with the basic principles, but has not drawn the correct conclusions from them. As the committee points out, in the days of floor trading stock exchanges were set up as associations of persons. Exchanges were no-profit clubs of intermediaries distributing the rent among heterogeneous members. It was advantageous to have a geographical clustering of financial intermediaries.

But with new technologies, geographically dispersed intermediaries can provide liquidity as well. The governance structure of exchanges changes to a for-profit corporation. Profits help in improving technology, which is now the main avenue of competition. Better technology and processes attract more customers.

Fear of broker or insider dominance leads the committee to try and restrict types of ownership, and to make entry difficult. But such dominance follows from the first structure. Professional managements and good systems are sufficient to prevent it in any modern exchange, since structure follows technology. Therefore, in focusing on ownership, the committee is fighting the wrong battle. It is not that Indians are corrupt; it is systems that generate certain types of behaviour. The regulator should rather ensure better systems though correct governance principles.



NOT BY PROTECTIONISM



A corporation's rationale is to make profits. But in protected markets this new organisational form generates excessive profits. So its stance in favour of protection forces the committee to suggest restrictions on profits. But these are difficult to administer, involving too much regulatory intervention and interface, which creates incentives for corruption and regulatory capture, just as the earlier control regime did. Regulators are also fallible, so another basic principle of regulatory design is to minimise regulatory discretion. In a market-based system, the best way to reduce profits is to encourage competition; today's battle must be fought with modern weapons.

APPREHENSIVE OF INSTABILITY

But another principle, that of network externalities, suggests a potential risk from competition. Electronic markets work like a network, costs fall for the one that is able to attract more customers, so others also find it in their interest to migrate and the equilibrium tips over.

Having defined an exchange as an “essential facility” and a “public good”, the committee becomes over- protective since it is wary of any instability in this space. Lessons from international experience suggest, however, instability may not be a problem. First, strong risk management systems make exchanges robust. Although many banks were in trouble during the global crisis, not a single exchange failed. Post-crisis, most countries are encouraging transparent, exchange-traded financial products.

Exchanges were stable despite the pro-competitive stance of regulators, who knew that managements, aware of the possibilities of tipping in networks, try to lock in customers in various ways.

For example, competition alone was inadequate, given the possibility of tying software, so the judiciary intervened in the famous Microsoft case. America's Securities and Exchange Commission has a “best-price” stock-handling rule to maintain competition across exchanges. Even if liquidity tips over in one product, an exchange can be competitive in other products.

Markets remain liquid if the transaction is conducted at the exchange offering the best deal. Customer service improves and transaction costs reduce. Exchanges are pushed to remain at the fast moving frontier of technology.

CONFLICTS OF INTEREST

Since an exchange is itself a regulator, there is a possible conflict of interest. The committee fears that competition will lower standards in a regulatory race to the bottom.

An essential facility cannot be allowed to deteriorate like that. But the power of electronic systems in recording and making available all kinds of information enables the design of preventive, yet non-invasive, surveillance.

Exchanges may be individual entities, but there is a regulator above them to enforce standards. Designing random checks and reporting norms is not resource intensive.

Therefore, regulatory change must be such as to ensure competition, using the safeguards of better governance and better technology-enabled systems. India's past experience shows that overprotecting an industry is a good way to ensure it never grows up.

Dr Jalan himself wrote, in his 2005 book on Indian governance, that replacing “old and cumbersome administrative procedures” based on multiple discretionary approvals “by a rule-based system largely based on self-certification” was very successful in the regulation of the capital account. This lesson needs to be applied to MIIs also. That means the regulated use of markets with the minimum of arbitrary restrictions.

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Published on January 12, 2011
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