This column of mine regarding stock exchange regulation and competition appeared in the Financial Express today. Coincidentally, yesterday evening, the Securities and Exchange Board of India released its order rejecting the application of MCX-SX to start trading equities in India. My column was written early this week well before SEBI passed its order. I am not yet masochistic enough to sit up all night to read a 68 page order and then write a column about it.
The ongoing dispute regarding the shareholding pattern of MCX-SX is an opportunity to rethink the current regulatory conception of the stock exchange as the extended regulatory arm of the state. Given this regulatory conception, the ownership structure (legal ownership, ownership of economic interests, and ownership of control rights) of the stock exchange becomes a matter of public policy. However, the requirement to have dispersed shareholding is likely to result in an unacceptably anti-competitive outcome.
There is a different way of looking at stock exchanges—not as frontline regulators, but as the equivalent of a shopping mall for securities. We do expect shopping malls to comply with the building safety code, but do not expect them to “regulate” the shop owners. If we treat stock exchanges the same way, we would expect them to comply with basic regulations regarding trading systems and infrastructure, but would not expect them to regulate either the listed companies or the stock brokers.
We could not have thought of stock exchanges like this a century ago because there were no securities regulators in those days and the central banks too did not bother to regulate the markets. For example, in the US a hundred years ago, it was left to the New York Stock Exchange to demand that companies publish their annual accounts (and delist even large companies like Proctor and Gamble for refusing to do so). Similarly, in those days, it was the London Stock Exchange that imposed free float requirements (67% free float!) because there was no other regulator to do so. Today, we expect the securities regulators, the company law departments and the accounting bodies to perform much of this regulatory role.
The time has come to ask whether the stock exchange should be a listing authority at all in an era of demutualised stock exchanges and alternate trading systems. There are stock exchanges elsewhere in the world that are listed on themselves; this appears to me to be as absurd as a snake swallowing its own tail. Of course, the alternative of a stock exchange listing on a rival exchange is only slightly less laughable. Some countries have shifted the listing function into an arm of the regulator itself and I think there is much to commend such a move.
Another problematic area is that of market surveillance. In an era of highly interconnected markets, the idea of each exchange performing surveillance on its own market is an anachronism. A stock exchange that sees only the trades happening on its own platform is no match for a market manipulator who trades in multiple cash and derivative exchanges (as well as the OTC markets) and shifts positions across these markets to avoid detection. The flash crash in the US markets on May 6, 2010, has highlighted the folly of relying on surveillance by the exchanges. Some of the best analyses of the events of that day have come not from the exchanges or the regulators but from data feed companies that specialise in processing high frequency data from multiple trading venues.
The final regulatory barrier to free competitive entry into the stock exchange industry comes from the extreme systemic importance of the clearing corporation of a major exchange. In the UK, the ability to outsource clearing to LCH.Clearnet has been very important in the emergence of alternate trading venues. Indian regulators should also explore such a solution.
Shorn of listing, surveillance and clearing, a stock exchange would be very much like a shopping mall and it would be possible to permit free entry without any significant regulatory barriers. The regulators should then be blithely unconcerned about who owns, controls or runs an exchange. By unleashing competition, this could help bring down costs and improve service levels.
In the interest of ensuring competitive outcomes, I think it would be useful to also dismantle the utterly dysfunctional “fit and proper” regime throughout the financial sector. The global financial crisis has shown that there is scarcely any bank or financial intermediary in the world that is “fit and proper” enough to be entrusted with any significant fiduciary responsibility without intrusive supervision and stringent regulation. The illusion of a “fit and proper” regime only serves to discourage private sector due diligence.
I believe that regulators worldwide should accept this reality and abandon the “fit and proper” requirement altogether. Resources devoted to screening applicants at the point of granting a licence are much better spent supervising those who are already licensed. Today, the position is the opposite. In India banks and stock exchanges have retained their licences long after they had deteriorated to the point where they would not get a licence if they were applying for it afresh. This is an intensely perverse anti-competitive situation.
In short, the problems relating to shareholding pattern of stock exchanges highlighted by the MCX-SX episode should be solved not through legal hair splitting but through more robust regulatory frameworks.