The Hindu Business Line : The power of demutualisation

The tilt towards demutualisation is a good bet. Upsetting tradition and triggering competition through demutualisation are good ideas; they produce desirable results. SEBI has reaped the benefits of the establishment of the NSE. The demutualisation of the BSE could spur the NSE to reinvent itself and more benefits could emerge.

REGULATORY institutions such as the Securities and Exchange Board of India (SEBI) and the Forward Markets Commission (FMC) have taken a normative position that exchange-traded markets should be demutualised. Their stipulation sounds absolute, and seems founded on an exact science that endorses the superiority of demutualised exchanges.

But the FMC and SEBI are betting on demutualisation and professional management because they think that these would be good for the economy. The question is if the bets are justified and if their policy on demutualisation would yield the desired results. The question is important since policymaking is not an exact science.

Economics is not an exact science, and it is inconceivable that economic policy-making can ever be an exact science. For example, there are times when policy-makers think a domestic currency should be strong to avert one crisis and should be weak to avert another crisis.

Though an exact exchange rate can remain elusive forever, errors in policy can be reversed rather quickly. However, decisions based on the mandated demutualisation of exchanges may not be amenable to quick and whimsical flip-flops. The voluntary demutualisation of a stock exchange is particularly not amenable to a quick and tidy reversal.

Asia's oldest stock exchange, The Stock Exchange, Mumbai, known around the world as the Bombay Stock Exchange or BSE, is planning to demutualise (Business Line, May 21). Its plan is driven in part by the corporate structure of its rival, the National Stock Exchange of India (NSE). The proposed change is driven in part by the influential views of SEBI, the stock market regulator. If demutualisation were a bad economic idea, the BSE, NSE and SEBI would be embarrassed. They could be trapped in an irreversible mess.

Empirical endorsement

Demutualisation is not a bad idea. It is a very good economic idea. Recent empirical research by Professors Chandrasekhar Krishnamurti (Nanyang Technological University), John M. Sequeira (National University of Singapore) and Fu Fangjian (University of Rochester) shows that the organisation structure of a stock exchange matters.

Their research paper (Stock exchange governance and market quality, 2003) utilises the unique setting that prevails in India. The BSE and NSE have similar trading systems, trade identical stocks and follow the same trading hours. Their structures of governance are, however, different. The BSE and NSE offer a very rich experimental setting.

In such a setting, the research examines the impact of their governance on transaction costs and price efficiency of 40 equity stocks that are simultaneously traded on the BSE and NSE. It uses a reliable measure of market quality to determine if the differences in governance matter. The examination shows that the NSE provides a better quality market than the BSE.

This result is consistent with the work of Domowitz and Steil, two financial economists, who first proposed in 1999 — five years after NSE began operations — that demutualised exchanges are superior to mutualised exchanges in governance.

Upsetting tradition

Not many in the world would have expected the NSE to blaze a trail and to lead the emerging and developed economies in setting up a demutualised stock exchange. But that is what the NSE has accomplished. It was founded as a for-profit, shareholder-owned securities exchange. Each share has a vote.

It has been in the business of providing an electronic marketplace since June 30, 1994. It first offered a nationwide marketplace for trading debt. Equities were added in November 1994. By contrast, the Stockholm Stock Exchange — the first stock exchange to effect a change in its ownership structure — was demutualised in 1993. It was a mutually-owned exchange prior to the change. The NSE is owned by nearly two dozen banks and financial institutions. The NSE's ownership, management and control are separated.

The separation of ownership, management and control has produced extraordinarily instructive results. It is not surprising that the Domowitz and Steil proposition came five years after NSE's bold move.

The BSE has been a member-owned, mutualised exchange since its inception 128 years ago. Each member has a vote. Ownership, management and control are not separated in a member-owned, mutualised exchange. It is remarkable that such a structure has remained relevant for so long.

The longevity of the BSE model reinforces the view that exchanges are not amenable to quick and tidy changes in their structure of ownership and governance. But competition from the NSE has upset tradition. The BSE is now keen to embrace demutualisation and, thereby, pursue quality, innovation and efficiency.

Member-owned exchanges are a characteristic of India's commodity markets. It is the plan of the FMC — India's commodity futures regulator — to introduce competition and encourage new structures of governance in the commodity futures marketplace. The promotion of market quality, efficiency and innovation is its strategic intent.

The FMC has made a set of decisions aimed at upsetting tradition. It has given mandates for the establishment of new demutualised commodity exchanges, and has given wide latitude to member-owned exchanges to respond to competition. Upsetting tradition and triggering competition through demutualisation are good ideas; they produce desirable results.

In the main, the stain of orthodoxy and the stigma of heterodoxy are avoided when regulators smartly and diligently side-step the problem of endorsing one structure of ownership and governance ahead of another. The FMC and SEBI have allowed the market to resolve its problems even while actively encouraging innovation and competition among rivals.

Well-founded bet

The tilt towards demutualisation is a good bet. SEBI has reaped the benefits of the establishment of the NSE. The demutualisation of the BSE could spur the NSE to reinvent itself. More benefits could emerge. The FMC is on course to reap similar benefits. From bets to benefits, it is a great leap. Such a leap has been made possible by a body of knowledge that has been known as financial economics over the last 35 years. Explaining empirically observable phenomena and modelling outcomes as responses to stimuli are its principal activities. There is little that is normative in financial economics. It merely describes empirical phenomena as verifiable results of hypothesised models. When SEBI and FMC stipulate that exchanges should be demutualised, they rely on financial economics.

They do not rely on normative models because there are no normative models of governance. When they stipulate that exchanges should have professional management that is separate from ownership and control, they rely on the hypothesis that good governance is the result of an apt structure of incentives and disincentives. It is their bet that demutualised exchanges and professional management provide powerful and desirable sets of incentives and disincentives.

Clear determination

The NSE was established as the underdog, but it faced a powerful set of incentives. The BSE was the top dog, and it had the choice to change rapidly or remain steadfastly wedded to its tradition.

The underdog assiduously re-engineered every sub-system of the trading, clearing and settlement system. While the NSE's order-matching engine and communications technology have been widely and favourably reviewed, its unprecedented success at establishing a reliable clearing protocol through its subsidiary, the National Securities Clearing Corporation Limited (NSCCL), has not received wide attention.

The NSCCL has clearly altered the incentives that exchange users face while fulfilling obligations. It has also clearly altered the disincentives that users face in choosing to default on obligations.

The BSE's settlement guarantee fund is inferior to the process of novation and guarantee that the NSCCL offers users of NSE. The BSE's settlement guarantee fund does not deter selective defaults. By contrast, the NSE is solid as a rock because of NSCCL and the resulting reliability of the clearing and settlement sub-systems.

Professors Krishnamurti, Sequeira and Fu have no comment on the decisive impact of NSCCL on NSE's market quality and price efficiency. The NSE has quite clearly been a pioneer in establishing the NSCCL, a fact that some global analysts fail to acknowledge while reviewing the literature and empirical evidence pertinent to demutualisation.

The Domowitz and Steil proposition of 1999 does not reckon with the structure and reliability of clearing and settlement processes. But the NSCCL was established in 1995 and began clearing trades in 1996. India's accomplishments seem stuck in a permanent penumbra!

The Asian Development Bank (ADB) does not include the NSE in its list of Asia's demutualised stock exchanges. Mr Shamshad Akhtar, ADB's director for governance, finance and trade, has discussed the factors driving demutualisation, and the benefits and viability of demutualised stock exchanges (Demutualisation of Asian Stock Exchanges — Critical Issues and Challenges, 2003).

Though the ADB's discussion of demutualisation is very recent, the NSE is mentioned once and because it is one of several exchanges with which the Singapore Exchange (SGX) has an alliance.

The ADB does not regard the NSE as a demutualised stock exchange because it regards demutualisation as the change in legal status of an exchange from a mutual association with one vote per member, into a company limited by shares, with one vote per share. It has little to comment on how exchanges without a history boldly upset tradition. New institutions have to upset tradition to win, and there is much that India could learn from its NSE.

(The author is a financial analyst. Feedback may be sent to markets@prosyslab.com or indiagrow@sify.com)

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