Why are stock exchanges different, Dr Jalan? 25th November 2010 Financial Express

The Jalan Committee Report is well-timed as it comes when there is a lot happening in this space and there is need for clarity on the structures of MIIs (market infrastructure institutions). This is important as the structure that is decided for the stock exchanges would also set benchmarks for commodity exchanges too. Also, there has been an addition to the number of players in both the stock and commodity markets. The introduction of forex derivatives exchanges will logically lead the way to their trading in stocks, while the commodity space, though apparently saturated, has seen progressive interest in setting up new exchanges. There is apprehension that there could be a game being played wherein promoters may leverage their valuation and make a profitable exit.

In brief, the report talks of three things: profits being earned, ownership patterns involving an anchor investor and listing options for them. Logically, if they are not to be super-normal profit making, then it follows that there should be a regulated ownership structure to retain interest and as a corollary, public listing is out of place. Is this the best combination?

To begin with, is there a consensus on whether stock exchanges are MIIs that address social infrastructure? All financial intermediaries perform the function of transferring and allocating funds and stock exchanges are no different. They are not established by the government but by private firms and hence strictly cannot be compared with say a road, which serves the public at large. In fact, stock exchanges are more private as all participants are there to trade and make money, unlike a typical social infrastructure project. This is the starting point because the entire edifice is built on the underlying concept. Banks and insurance companies also do social good and facilitate transfer of funds and provide services to customers. But they are not guided by non-capitalist objectives. Why should stock exchanges be different?

This is important because the Committee is talking of MIIs not making supernormal profits. All financial institutions make lumpy investments and hence resemble infrastructure. But they operate for profit and we are past the nationalisation phase when such a thought could be justified. If this is so, can we really decide on whether they should earn x or y profits? Further, the nature of the business is such that once the costs are incurred, essentially technology, then there is really little incremental capital to be ploughed in and profits can be exponential, depending on the transactions. While the transaction cost can be regulated to prevent the buildup of monopoly power, the resulting profits cannot really be decided by any extraneous principle in a market economy. In fact, the report talks of surpluses going into an IPF or SGF. But, then we do not have such rules being imposed on banks and insurance companies. So why should it be so for exchanges where provisions are anyway made for these funds.

The need for an anchor investor is important and valid, given the investment being made and the number of players operating; it needs to offer strength and stability. This can be done if there is identification of an anchor investor. Banking is mature and hence the same may not hold. But for insurance, the public needs to be convinced about the credentials of people running the show to put in their funds. Therefore, having an anchor investor makes sense, especially if it is not an institution. The term of 10 years is again debatable and a longer term may be prescribed. But again, drawing an analogy from banks, insisting on an institution to be an anchor investor is hard as this would drive away private entrepreneurs. Therefore, while the lock-in period is justified, the nature of the promoter should be flexible to include any long term investor. Lastly, the listing or rather non-listing of exchanges is an interesting thought. Globally exchanges like the LSE or NASDAQ or NYSE are listed on themselves. The Committee has spoken of how a fall in their value can create turmoil at the exchange, which is fair enough. However, once we accept the concept of anchor investor—which ensures that fly-by-night operators seeking valuation are out of the ambit, then listing should be permitted as a diversified pattern helps the industry to grow. We have not seen any negative repercussions for banks on account of listing and, therefore, can translate the same logic to an exchange.

In a free market economy, enterprise should be allowed to flourish within the regulatory framework. Once the enterprise is non-government, one cannot lay down standards for profitability. The listing of any company should be permitted provided the rules are obeyed. The fact that we have anchor investors will ensure that enterprises are here to stay, which will provide comfort. The same should hold even for stock exchanges.