Right market for exchanges

The regulatory embarrassment suffered by the United Stock Exchange (USE) brings to the fore the question of the optimum size of the market for stock exchanges in the country. The Securities and Exchange Board of India (SEBI) has recently hauled up USE for artificially boosting trading volumes. It did so through a member, who put in trades from multiple locations and accounted for over 70 per cent of the exchange's volumes. That the USE was either unaware of, or remained a mute spectator to the phenomenon of a trading member simultaneously acting as buyer and seller of securities, is an astonishing example of failure of oversight. The exchange compounded its problems with SEBI by additional actions, such as amending of articles of association without the latter's approval, not installing a proper surveillance system, trying to undercut competition by not charging a transaction fee, and so on.

The above episode demonstrates that it is not easy for a new stock exchange to make inroads into the incumbents' market share. Investors and traders may converge on exchanges with higher volumes, since trades on such platforms would be done at lower bid-ask spreads and price discovery, too, will be more efficient. But luring investors to the new platform will not be possible unless the exchange facilitates trading in unique products: Take, for example, the NASDAQ, which mainly trades technology stocks. Multiple exchanges, if all of them are successful, would only fragment the volumes, creating many shallow trading pools.

The USE fiasco also highlights the risk of unscrupulous promoters starting an exchange with the sole intention of converting it in to a money-spinning venture. USE's management resorted to unfair practices to give a distorted picture of the exchange's activity to prospective buyers and investors. This is unacceptable, given that stock exchanges are institutions with systemic importance. At the same time, both investors, who trade on the exchange, and companies, whose shares are listed on it, stand to lose if the operations were halted. SEBI was unable to suspend USE's operation only due to the negative externalities involved, despite the exchange currently recording daily turnover of less than Rs 100 crore.

The equity exchange market in India is primarily a duopoly. SEBI, though, appears inclined towards giving permission to other players to enter this segment. Even if the regulator ventures into experimenting with an oligopolistic environment in equity platforms, it should exercise due diligence to filter out unprincipled promoters. Only serious players with a definite game-plan on developing the market and the products they would launch, or those willing to invest in technology and strong surveillance systems, should be given the go-ahead. The USE imbroglio also points to the fact that the existing regulations are so ambiguously worded that stock exchanges cannot be brought to book for their wrong-doings. The laws need to be scrutinised and amendments made to plug such loop-holes.

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