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Demutualisation of stock exchanges

The Government through an ordinance has amended the Securities and Contract (Regulations) Act to makecorporatisation and demutualisation of stock exchanges mandatory. In this context, two authors give their viewson the implications of the move for the future of the near dormant regional stock exchanges.

RECENTLY, THE Securities Contract (Regulations) Act (SCRA) was amended through the promulgation of an ordinance to make corporatisation and demutualisation of stock exchanges mandatory. The amendment not only requires separation of ownership and trading rights, it also requires that the majority ownership rests with the public and those without any trading rights. Also through these conditions, the Government has signalled a major shift in its earlier stand that stock exchanges should be self-regulating agencies of their members. It now desires that they should be externally regulated.

Though the social desirability of such external regulation and supervision in a liberalised environment is debatable, it may be assumed that there is a genuine reason for the Government to believe that such a move is socially desirable. However, there are several difficulties and practical issues when the exchanges are forced to comply with the provisions of the ordinance.

A review of the developments in the last one and half decades relating to stock exchanges will serve as a background to understand such difficulties and thereby also enable the current move to have the right perspective.

Recent reforms

Till the middle of the 1990s, the stock market in India was fragmented with several regional exchanges. The Bombay Stock Exchange, more than a century old, has been serving as a central exchange for the country. The need for multiple exchanges was felt at that time due to the poor telecommunication facilities. Many new exchanges were opened and were all doing well in terms of volume. With the development of telecommunication facilities over the years the basic constraint of having a single stock exchange for the whole country was removed.

Ideally, the Government could have allowed the BSE to emerge as the national exchange and facilitate the regional exchanges to integrate with it. The securities scam of the early Nineties and the involvement of a few members of stock exchanges gave a tainted picture of members controlling stock exchanges and the Government made a hasty and costly move in the process of reforming the stock market.

It sponsored the establishment of the National Stock Exchange through state controlled financial institutions and banks and allowed it to enter the equity segment in a big way though the original objective of NSE was to develop the debt market. Simultaneously, the Government started strengthening its monitoring and supervision of the regional exchanges through the Securities and Exchange Board of India. During this period, the relationship between the regulator and the stock exchanges became strained several times.

Inherent weaknesses

In addition to monitoring, the Government forced the exchanges to invest heavily in technology without much concern for their future. The spread of NSE with strict monitoring of its members was generally appreciated by investors of all types most of whom have almost moved into the new exchange.

The members of regional stock exchanges, instead of taking corrective action and coming out with an alternative strategy, took the easy route of becoming dealers for NSE either directly or indirectly through subsidiaries of the regional exchanges. The regional exchanges are virtually extinct today and several attempts to revive them have not taken off partly due to their inherent weaknesses and also due to an overcautious approach of the Government. The net result has been the futile modernisation of these exchanges costing crores of rupees.

Fate of exchanges

The present move of the Government like its earlier moves is directionless. It is difficult to guess where the regional stock exchanges would be in five years from now after complying with the provisions of the ordinance.

The first two requirements of the ordinance, namely, corporatisation and separation of ownership and trading rights, can be easily complied with by the exchanges. Many of them already function as companies registered under the Companies Act, 1956 and have issued shares against lawful consideration.

These exchanges have also conferred trading rights on members only after they became shareholders and after complying with the necessary rules, regulations and provisions of the Act in force at that point in time. Members have paid several lakhs above the value of share capital to obtain the trading rights though technically such payments have been called by different names. A formal separation of ownership and trading rights may require the issue of a separate certificate for trading rights to each member. These exchanges can also prepare new rules for the issue of trading rights to non-shareholders in the future.

The real problem lies in making a stock exchange a truly public company by reducing the existing members' stakes to 49 per cent or below either through sale of fresh equity to the public or requiring the members to divest their holdings.

While the objective behind this move is laudable and consistent with moving away from self-regulation, the question is who will buy the shares of the stock exchanges which are non-existent for all practical purposes and have no visible future. The only assets they have are some real estate and miscellaneous assets, which can be realised by the investors only when the exchanges are liquidated.

If the ordinance forces the existing members to sell the shares either directly to others or indirectly requiring the company to issue fresh shares, the only feasible way is to sell them at a deep discount to the fair value represented by the real estate value of the exchanges. Such a move is not only unfair to the members of the company but will also force the members to voluntarily opt for liquidation of the exchanges.

If liquidation of these exchanges is the desired outcome and the objective behind the whole exercise of corporatisation and demutualisation, then the Government can in turn directly inform the regional exchanges that they have completed their mission of providing a market when there were no communication facilities in the country and they are no longer required under the current dispensation. This way at least the time consuming and costly process of demutualisation and the cost associated with monitoring and supervising several exchanges without any trading can be avoided. On the other hand, if the Government still feels that there is a role for one more exchange other than NSE, it has to specify and outline the future course of action clearly instead of wasting its energy on the current move.

The primary objective of stock exchanges is to provide liquidity for stocks of public limited companies and thereby enable the promotion of public companies. Developed countries have used this mechanism extensively to build large corporations and even in India, companies like Reliance Industries and Infosys Technologies have come to their present stature through public participation.

Trading rights

If the Government feels that it is desirable to segment the stocks either on the basis of nature of industry or size and allow different exchanges to provide market facilities for different types of companies, then it can involve the regional exchanges in creating one more exchange similar to the NSE for this purpose.

It may not be optimal to have several small exchanges to discharge this function since the cost of regulation and monitoring will increase considerably without any benefit. Further, today the NSE controls the whole stock market though technically there are several exchanges to compete with it. This monopoly role and power may not be desirable in the long run and in that context a strong second exchange which incorporates all the good features of the NSE is desirable.

If the Government is serious about a second world-class exchange similar to the NSE, it should allow all the regional exchanges or their members to promote it with nominal investments along with financial institutions and banks which can have a stake of 90 per cent. In the latter case, the members of these exchanges should be allowed trading rights for a nominal fee but should comply with capital adequacy norms as applicable to the NSE. The employees of the regional exchanges can be hired by the new exchange.

The new exchange should also be allowed to grant new trading rights to anyone who is willing to pay the fee and comply with the capital adequacy norms.

These two exchanges should have a clear cut demarcation on the kind of securities listed in these exchanges with a facility of automatic dual listing of select shares having market capitalisation above a certain value (say Rs. 10,000 crores). This is to ensure that no single exchange has monopoly of highly liquid stocks.

Survival problem

These two exchanges can be encouraged to attract overseas securities (equity and debt), particularly from Asian countries, for listing and promote India as a second financial hub of the region. In this process, over a period, all regional stock exchanges can be allowed to be liquidated. Such a move will be fair to members of the stock exchanges who have not participated in any financial securities scam and depend on the capital market for their survival.

M. S. Narasimhan

Professor of Finance, Indian Institute of Management, Bangalore.

(The views expressed in this article are personal).

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