07 November 2008

An exchange for Small and Medium Enterprises

SEBI has come out with a "Framework for recognition and supervision of stock exchanges/platforms of stock exchanges for small and medium enterprises". Though small and medium enterprise (SME) specific exchange platform has been talked about for years if not decades, for various reasons, the concept has never reached fruition.

Several of the then 'regional stock exchanges' were set up to cater to listing of the SME sector. Because of a geographical fiat, these exchanges survived for several years, till NSE and then BSE grew nationally and the geographical fiat was repealed, making them defunct (some are doing well, though not in their function as an exchange but as brokers of BSE/NSE). The next round of SME exchange came with the Indo-next platform, which was given as a concession to the BSE - while the history of Indo-next is somewhat complex, BSE never really wanted it to succeed as an SME platform. The Indo-next platform thus met with a still born transfer from BSE's own junk yard and a few companies from regional exchanges on transfer. To get a fuller history of these, please see the "Report of the Committee to Study The Future of Regional Stock Exchanges (RSEs) – Post Demutualisation" of which I was a part. The report, though focused on the Regional Stock Exchanges, examined various possibilities of one or more regional exchanges becoming SME oriented. But even then, it looked like a serious management challenge unlikely to succeed.

Now SEBI has put out a framework to take forward the incomplete task. While the framework ought to give relaxations to existing rules for the exchange and its companies to become viable, it doesn't give any indication of such relaxations e.g. half yearly disclosures instead of quarterly disclosures. The framework only repeats the requirements of the existing legal framework for recognising exchanges.

These are usual requirements for recognising any stock exchange. However, instead of granting relaxation, it provides for a minimum trading lot of Rs. 100,000. And it also provides that the exchange have a networth of Rs. 100 crores (Rs. 1,000,000,000). The first requirement is counter-intuitive, but appropriate. Small cap companies are extremely high risk i.e. most of them will naturally fail as most entrepreneurial ventures do. Thus investors in small cap companies must be large sophisticated investors. By putting a minimum trading lot limit of 100,000 rupees it will protect the smaller investors from burning their fingers.

The other requirement of a billion rupees of networth is inappropriate and anti-competitive. Even the current massive exchanges (BSE, NSE and MCX) are not obliged to have such numbers. The networth would depend on the size of trading and risk management requirements of the exchange. Further, if the clearance and settlement is outsourced (as is envisaged in the framework), the entire risk management no longer resides in the exchange and the exchange in fact does not rationally need a substantial networth. IOSCO principles clearly recognise this (IOSCO is a body comprising of all securities regulators). Besides being bad policy, this will also make such an exchange unviable - a capital of a billion rupees at a 20% expectation of returns just doesn't make economic sense unless it is being run as a cost centre by an existing exchange.

SEBI thus needs to drop the requirement of networth, which needs to be applied rationally according to size and risk management principles. Even clearing corporations cannot be mandated to have a one size fit all networth requirement which would only entrench the existing players and kill competition. Also the framework must flesh out the specific relaxations which are envisaged for the companies and the exchange. Without these, the concept is not likely to take off at all.

To see the full post please see my main blog here.

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