12 May 2010

Governance & ownership in exchanges

I have a piece in today's Economic Times on governance and ownership restriction in equity and currency exchanges.

I argue:

Sebi regulations today restrict ownership of exchanges to 5% (15% in some cases) for any person along with persons acting in concert. Imagine a person who has the expertise, the money and the willingness to set up a new exchange. Such an entity, must find up to 19 investors who are willing to also invest in the new exchange and they must not be acting in concert. Each would thus have a financial stake which is substantial, but with virtually no voice in the management of the exchange. There would not be many takers for such a proposition. Witness the lethargic investments in the Bombay Stock Exchange despite liberalising the 5% limit to 15% for several entities. Add to that the unnecessary requirement of having a capital of Rs 100 crore (Rs. 1 billion), and the answer is clear why new exchanges have not entered the business.
The Rs 100-crore (Rs. 1 billion) capital requirement ignores how exchanges are run. Exchanges are essentially bundles of IT and surveillance systems. They don't need much capital. Requiring a large capital could have two rationales. To exclude small players or a lack of understanding of risk management based on the historical fact of exchanges being bundled with the clearing function. In an exchange transaction, everyone knows that the exchange guarantees the trade or in market lingo, acts as the counterparty, acting as buyer to every seller and seller to every buyer.

Thus, if any person defaults, the other party faces no risk. This perception is not accurate in reality. Actually, it is not the exchange which acts as the counterparty but the clearing corporation or house which guarantees each trade and which does the risk management. It is the clearing body which requires capital adequacy and closer risk management supervision. Even at BSE, where the clearing is done in-house, the rules and byelaws actually try to ring fence the exchange from default at the clearing house level.


True, small, fly-by-night operators should not run exchanges. But if size is the eligibility criterion, a drug lord would be welcome while the door would be shut on an entrepreneur who can design a cheaper and better exchange system, with an outsourced capital intensive clearing function. Combined with the requirement of finding 19 other people with money but no brains, this would indeed be tough.

While exchanges are a liquidity-inviting-more-liquidity business, the supranormal profits of even the second exchange points to a malaise in the competitive environment of exchanges. Compare this position to the wafer thin, or rather negative margins in the currency derivatives market where there are three, instead of two players competing for business.

The way forward is quite clear. Lower entry barriers and, simultaneously, enhance regulatory scrutiny. Do away with the pointless Rs 100 crore (Rs. 1 billion) capital requirement and focus scrutiny on clearing entities. The clearing entities need to move away from inhouse functions or a subsidiary function to professional clearing entities. Decidedly, these professional entities will provide more issues to resolve and possibility of a race to the bottom and thus require superior regulatory supervision. On the other hand, the lazy regulatory philosophy of banning knives will need to give way to better patrolling, surveillance and enforcement.

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