12 April 2012

The future of BSE

I have a piece in today's Financial Express on the future of BSE. I draw a rather bleak picture with the BSE in charge of only 3% of the equity (cash and derivatives) trades with the balance being traded on the NSE. I wish them well,  but it is a very tough road ahead. Here is the full piece:

Come to think of the Indian financial markets and the first image which is likely to come to mind is the Bombay Stock Exchange building in Fort. The photo of the building is variously used to represent the securities market, or the economy and not rarely the country itself. It is a joke amongst the BSE community, that the exchange would be much richer if it charged royalty for every use of the photo of the iconic building.

The exchange could do with the extra money as its operations are in steady decline for the past decade or more. While the cash segment (in market parlance, or the regular equity segment in common parlance) has increased, most of the increase has been because the size of the pie has increased since the year 2000. The three year record is more sobering, it fell every year to record turnover of 11 lakh crores versus its rival NSE’s 330 lakh crore according to SEBI statistics. With India becoming a flavour of the past decade the turnover of exchanges met with explosive growth. Hidden in the growth was the slow and steady relative decline of the BSE. Far more abrupt was the decline in the volumes of the derivatives segment. These volumes had nothing to hide behind. Launched in the year 2000, derivatives volumes surpassed the only other competitor NSE for a few months. Then they virtually fell off a cliff. Today they are virtually absent in the segment. Given the much larger size of the derivatives market, the BSE’s overall market share is 3% now. Of the many well wishers of the exchange, there has been steady support. Unfortunately that hasn't been enough.

While clearly, the initial few years after the NSE came into play, BSE was ill prepared for the efficiency, independent management and the clear technological lead provided by the NSE. Some was subsequently blamed by many on the bias of SEBI towards NSE. This was probably untrue. SEBI stood for much of what NSE stood for rather the NSE itself. There were some delays which are normal in any regulatory approval for instance granting BSE a nationwide terminal tag, which would have helped it spread quickly.

The second stage was the early 2000s which saw the launch of equity derivatives on both the leading exchanges. The lead which NSE had shown in trading in the cash segment led to a complete rout of its rival in the derivatives space described above.

The third phase was the attempt of the BSE board to get new management in place and give the institution a managmenet makeover. They appointed Madhu Kannan who had a senior role at the NYSE and a team of international experts around 3 years back. Just before the appointment was a phase of a disputes between the board members of the exchange and some board members and the CEO. This pre third phase did no favour to an already ailing exchange. With two drivers in the seat, the car didn't really rally anywhere in particular. In addition, the parliament's mandate to demutualise focused energy on that task which made the exchange to have distinct classes of shareholders, brokers and managers. Finally, in this phase SEBI wrongly imposed an ownership cap of 5% on any person to own shares of a stock exchange. This continues till today and is a huge problem as I will discuss below.

This phase was full of hope of reform. Brokers who received shares of the exchange in lieu of the fractured ownership and trading rights briefly traded shares of the BSE at huge premiums. International investors like Deutsche Boerse and others, despondent about the 5% cap, saw a ray of light. New investors like George Soros saw merit in investing in the exchange. Despite the best efforts of the A star team, BSE continued to struggle. It invested quixotically (15%) in a currency exchange, the United Stock Exchange thereby outsourcing its exchange function in currency derivatives for a 15% share in the returns. The problems in this phase were a) the 5% limit on ownership, which meant that anyone who wanted to invest in BSE and give it a competitive advantage was unable to take control of BSE and give it a makeover b) because the shareholders had been so emasculated, the managment felt directionless with a Board which drew no power from the shareholders. c) there was no competitive advantage the BSE had. There was nothing, nothing at all which BSE could do, which NSE couldn't replicate in 24 hours with more technology, more money and with a history of far deeper markets in an industry where liquidity breeds more liquidity. d) there existed a policy vacuum with respect to whether SEBI stood for listing of exchanges or not, further muddied by the Jalan Committee report which made recommendations without even reading the annexures attached by them to the Committee report. This cloud has thankfully lifted a few days back.

If you ask what is the future of the BSE, I only have a crystal ball which can see imprecisely. In addition, my crystal ball shows a dire future unless the stars align differently than they currently do. As we have seen, a good management team is a necessary but not sufficient condition for the positive future of BSE. The new team must be well grounded in the realities of the Indian market and leverage the still continuing goodwill of its members, negotiate with the sometimes tricky labour relations and work with the Board without allowing the Board to also sit in the drivers seat. Second, the 5% ownership cap must be removed by SEBI for the sake of a healthy competitive market - at least for a few years. This will enable BSE to tie up with an NYSE or equivalent who will own a chunkier stake in the exchange in return for a competitive advantage. Of course, competition has not historically been BSE’s strong suite. Third, the exchange must list immediately, irrespective of the valuation it would command today. This will give the exchange direction and accountability. Shareholders, where brokers have a limited say, would decide on the direction of the exchange. The management will come out with disclosures, explanations and accountibility to its shareholders, not to talk of performance measurement. Similarly, the board too would be elected largely by the shareholders with some public interest directors. These are somewhat naive and simplistic suggestions, as they don't answer the key question. What is BSE's competitive advantage? Can it do something which its rivals cannot duplicate immediately and more effectively. Here the answer is hard, very hard. And only a visionary can answer it. Fortunately, with the other three conditions met, this will be achievable, though with difficulty and a lot of luck.

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