Listed exchanges pose unique problems
Business Standard, 17 May 2006
The question of listed exchanges is now a live one in India. MCX seeks to do an IPO. A recent SEBI report says that regional stock exchanges should do IPOs and list on themselves. BSE could get listed, possibly on BSE. But exchanges are not ordinary firms, where we applaud when the firm graduates from startup to IPO. Listed exchanges pose daunting policy questions. SEBI and MoF need to do deep thinking about whether India's interests are best served by a three-way separation between owners, managers and brokers.
In the bad old days, an exchange was a club of brokers. It was run by brokers, in the best interests of brokers. This led to malpractice. Today, we know that what works best is a three-way separation between owners, managers and trading members. The pioneers in this new "demutualised" framework were the Stockholm Exchange (1993) and India's NSE (1994). Over the years, most major global exchanges have moved towards this structure to some extent or the other.
Why does this work better? The managers have their reputations to protect, they only earn a salary, and have no financial interest in profits of either exchange or members. This helps them be impartial. The owners are institutions such as UTI, who are also the biggest consumers of the services of the exchange. A higher dividend from the exchange is small change to an owner like ICICI Bank, when compared with the benefits from a better run exchange. Hence, the interests of the owners are aligned with those of users of the exchange and the country at large.
The governance problems of a demutualised exchange are qualitatively altered by going IPO. This brings in a set of owners (the shareholders) who demand dividends. Post-IPO, the management team owns shares, has stock options, and gets bonuses linked to profits. The management team then gets a direct financial incentive to increase turnover and thus the profit of the exchange. The quest for turnover is incompatible with the regulatory and supervisory functions of an exchange.
Example: Suppose a big broker indulges in malpractice. If the exchange tries to take action against him, the broker can threaten to move his business to another exchange. A CEO who is powered by stock ownership or options would flinch from taking strong action.
Example: Suppose there is a rumour which ignites a frenzy of trading. The exchange staff would quietly applaud the fun, because they know that more turnover means their stock options make money. The job of an exchange is to quickly track down correct information, send it out into the market, and put an end to the frenzy. But the employees of the exchange will take their time in doing this.
Example: Suppose there are problems with market integrity on a well traded product. If the CEO has a financial stake in turnover, he will be averse to imposing limits or closing down trading.
Example: Many exchanges have a certain monopoly status. This can be used to extract monopoly profits. If this is not done through higher transaction charges, there are less obvious ways, like charges for data feeds or software hookups. An exchange can herd members into buying software from a sister concern which can pickup the monopoly rent.
Example: In the quest for turnover, an exchange can threaten to inflict punishment on a member who sends business to a rival exchange.
The worst problem is that of self-listing. The exchange is supposed to exercise regulatory power over a listed firm, demanding that it comply with listing rules. It is hard to get good enforcement by BSE of listing rules upon BSE.
As Robert Glauber of the US NASD said last month:
"Absent complete separation of a for-profit exchange and regulation of member conduct, there is the unavoidable inherent conflict that regulation of member conduct may be influenced by the commercial, financial and stock price impact of such regulation on the exchange doing the regulating."When an exchange goes IPO, and modern HR practices are used, it is inevitable that managers will endup thinking like owners. This leads to a breakdown of the separation between owners and managers. The listed exchange does not have a three-way separation: it only has a two-way separation, between the owner/manager and the trading member.
Internationally, IPOs by exchanges have been preceded by much cogitation and public debate about these conflicts of interest. As an example, the US SEC had an elaborate consultation-and-committee process leading up to a policy position on listed exchanges. Policy responses include placing regulatory functions of a listed exchange in a separate non-profit organisation, with a wholly separate management team and board, and a separate funding stream. A limit of 5% ownership by a single shareholder has been placed in Singapore, Hong Kong, Philippines and Tokyo. A variety of strictures have been placed to address the dangers of self-listing.
While top exchanges internationally have indeed gone IPO, they operate in a very different environment of competent regulation and effective justice system. If an exchange CEO in the UK instigates the malpractices described above, he stands a good chance of going to prison. In contrast, the Indian exchange CEO knows that just punishment is unlikely. With high returns and a low risk of punishment, even good people can do bad things.
These arguments suggest that the core institutions of the securities industry are not ordinary firms which should progress from startup to IPO. With an ordinary firm, the corporate governance puzzle is that of making managers act asif they are shareholders. But with exchanges, the governance puzzle is that of getting managers to not think like shareholders. When the management team of an exchange thinks like an owner, it seeks to maximise turnover, and incentives are created for malpractice. In the Indian environment of weak regulators, weak judiciary, mistakes in drafting of law, and politically well-connected exchanges, even good people can do bad things.
Hence, when it comes to the core securities infrastructure, we need to stay on course with the quest for three-way separation between owners, managers and trading members. What we have seen of the successful functioning of demutualised exchanges in India reflects a genuine three-way separation, with managers who are not owners, and owners who think more like users of the exchange and less like recipients of dividends.
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