Time for new generation stock exchanges

From trading under a banyan tree in the nineteenth century, the Indian stock market has come a long way, measuring up to its global peers in almost all aspects. The basic building blocks were put together by the British, by establishing regional stock exchanges in all the important cities, creating regional pools of investors trading stocks of companies in that region.

The 1990s was a watershed period, when the market ecosystem changed from ring-based trading controlled by a few influential brokers to a more democratic online screen-based, pan-India market. The market regulator, Securities and Exchange Board of India, and the National Stock Exchange came into existence, futures and options replaced the controversial badla trading, the BSE was demutualised and the regional stock exchanges bowed out, one by one.

Indian stock exchanges are once again at a momentous juncture. The pandemic is changing the investment landscape, introducing the world of stock market to the millennials, who were hitherto too busy enjoying their lives to realise that stock markets can provide equally adrenaline-pumping thrills. The number of demat accounts with depositories has almost doubled, exchanges are witnessing higher investor registrations and low-cost online brokerages are laughing all the way to the bank.

There is a difference in the way in which the new set of investors, mostly millennials, trade or invest. They are tech savvy, transacting with their smart phones on online brokerages. More important, the appetite for innovative tech-based products is higher among this bunch. SEBI’s discussion paper in January, seeking to help Indian stock exchanges move forward in adopting innovations could, therefore, be the game-changer, helping set up new stock exchanges that cater to this demand.

Doing away with the archaic caps on promoter holding in stock exchanges is the way forward in paving the way for the new generation exchanges. But it may not be possible for the new exchanges to make major inroads into existing product categories.

The future of exchanges

The SEBI discussion paper is right in pointing out that Indian exchanges too need to move towards adoption of the digital ledger technology and artificial intelligence in the exchange platforms. A few global exchanges such as the London Stock Exchange Group have experimented with this, building a blockchain-based platform to digitally issue shares of small and medium size enterprises for Borsa Italiana.

The progress is however likely to be slow and it needs to start with smaller exchange platforms that are newly set up. The existing exchange platforms and depositories are built on legacy platforms and it will be quite difficult to migrate the historical databases onto a new platform.

If SEBI is able to dilute the ownership norms (discussed below) and new exchanges are set up, these are some ideas for the future.

One, an exchange primarily for long-term investors. This idea was mooted in a paper by UNEP Finance Initiative, ‘Evolving Business Models and New Applications of Technology by Stock Exchanges’. This exchange, modelled on the Investors Exchange or the IEX, provides a solution to the threat posed to long-term investors by high-frequency trading by deliberately slowing down the order execution time through longer cables and keeping the orders hidden in a ‘dark pool’.

Conventional Dark Pool exchanges have not really been taken too seriously in India given the comparatively smaller investor base and lower quantum of trading, overall. But if algo trading, which already accounts for around 40 per cent of current turnover, continues to grow, the regulator could consider permitting new exchanges exclusively for long-term investors, where bulk deals are transacted, without the influence of HFT. Also, the impact cost of trading in Indian markets can move lower if the larger orders are moved to another exchange.

Two, exchanges can be set up exclusively for trading virtual currencies and other crypto assets such as non-fungible tokens and other digital collectibles. There is clearly a market for these and transactions are taking place in a dispersed manner on unregulated platforms. Exchanges can be set up, with less stringent regulations and transaction cost for trading these assets.

Three, social impact exchanges, sourcing funds for social impact could increase in numbers going forward. These exchanges can be built based on the blockchain technology, where the details of the beneficiaries are captured on the digital ledger so that the donors can have proof of impact. This model is being tried by South Africa’s ixo foundation.

Dilution of ownership

Relaxation of the current onerous norms on exchange ownership is however required before these new age exchanges make an entry into India.

The market regulator is doing right by proposing to increase the ownership cap for stock exchanges and depositories significantly from the current levels. Existing rules came into force due to the recommendation of the Bimal Jalan Committee in 2010. These rules lay down that not more than 5 per cent of the shareholding of these market infrastructure institutions should be held by domestic or foreign individuals. A higher cap of 15 per cent exists for institutions such as banks, other stocks exchanges, insurance companies, multilateral organisations, and so on.

These lower caps were imposed despite opposition from various stakeholders on the grounds that promoters will not come forward to set up stock exchanges if their stake was limited to 5 per cent. It was also suggested then that the promoter stake could be higher, in line with ownership limits in banks and insurance companies.

The discussion paper is trying to undo the harm by proposing that a domestic promoters can hold up to 100 per cent of the shares in a market infrastructure institution, which is to be brought down to either 51 per cent or 26 per cent over 10 years. In case of a foreign promoter, the initial cap is to be 49 per cent which is to be brought down to 26 per cent or 15 per cent over 10 years.

No threat to existing exchanges

These relaxed shareholding can usher in a new era for innovation in Indian stock exchanges.

These new platforms should however be encouraged to operate in niche areas that do not overlap with the product categories in the existing exchanges for stock and commodities. The experience with the numerous commodity exchanges and the failure of the Metropolitan Stock Exchange to make any inroads into stock trading shows that it is almost impossible to wean away traders and investors from the exchange platforms with higher liquidity.

It is also moot if more stock exchanges improve competition. Most countries have one or two principal stock exchanges with other platforms for alternative products. Batting for more stock exchanges, in existing products, can turn out to be an exercise in futility.

COMMENT NOW