Creative destruction in India’s stock markets will yield better results

Regulators of the Indian financial system are looking to infuse competition in their respective financial market segments. The Reserve Bank of India (RBI), the banking regulator, had constituted an internal working group (IWG) to review the “extant ownership guidelines and corporate structure for Indian private sector banks”. The IWG has recommended allowing corporates to become promoters of banks, and large Non-Banking Financial Companies (NBFCs) to be converted to banks.

Similarly, the Securities and Exchange Board of India (SEBI) had also instituted an IWG to review the “extant regulatory framework with respect to ownership and governance norms for Stock Exchanges and Depositories”. Based on its recommendations, SEBI has issued a discussion paper which recommends opening the stock exchanges and depositories to outside competition.

The discussion paper terms the two institutions as Market Infrastructure Institutions (MIIs). The need for such a proposal is that the MII space has become highly concentrated. The stock market space resembles a monopoly with the National Stock Exchange (NSE) cornering nearly 93 percent of settlement turnover. The depository space is also a monopoly with NSE promoted National Securities Depository Limited (NSDL) towering over the BSE-promoted Central Depository Services (India) Limited (CDSL). This is ironical as these MIIs are promoted to build markets and competition, but, in turn, are more like a monopoly.

Such concentration of economic activity leads to inefficiencies and lack of innovation. SEBI’s paper also points to this concern. Globally, the MIIs such as the London Stock Exchange Group in the United Kingdom and NASDAQ in the United States are looking at new-age technologies such as distributed ledger technology, artificial intelligence, machine learning, etc. The blockchain technology in particular is designed on principles of decentralisation and could disrupt the centralisation model followed by current stock exchanges and depositories. The fintechs and techfins are also providing competition in this space by deploying these new technologies.

Taking cognisant of these developments, SEBI proposes to open the MII space for further competition. However, the current ownership norms are highly restrictive for open competition. The individual promoters and institutions can own maximum 5 percent of MIIs and special institutions are allowed up to 15 percent (LIC owns 12.5 percent of the NSE).

The paper thus recommends that regulations regarding ownership of the MIIs be changed. The new regulations shall allow individuals/institutions to own higher stake of their promoted MIIs and then gradually diluting the ownership. Accordingly, the IWG has proposed that resident promoters could start with 100 percent stake and then dilute it to 26 percent or 51 percent over 10 years. Foreign promoters could start with 49 percent ownership and dilute it to 15 percent or 26 percent over 10 years. For existing MIIs, resident individuals/institutions may acquire 100 percent stake, and the limit for foreign residents/institutions is kept at 49 percent. These acquisitions will be based on approvals from SEBI. There are other norms such as new promoters should have minimum experience of five years in areas of capital markets or technology-related to financial services.

There are suggestions to improve and strengthen governance of MIIs so that they serve their “role as public utilities and first level regulators”. Currently MIIs have two types of committee categories: functional and oversight. These two are further divided into sub-committees. Functional includes four sub-committees: grievances and appointment/remuneration and oversight includes technology, regulatory and risk management. These four comprise mainly public interest directors (PIDs) and independent experts. The new norms specify the presence of PIDs and MD/CEO in most committees to infuse confidence among investors as PIDs will act in investors’ interest. Likewise, in the technology committee one should include MD/CEO to make the position aware of the technological developments and a Chief Technology Officer (CTO) to increase professionalism.

One of the basic lessons of economics is that increase in competition leads to better market outcomes. Incumbents initially complain, but those who adopt the changes and fight new competition eventually grow as a firm. SEBI is trying to do the same in the MII sector. In many ways, life has also come a full circle for stock exchange business in India. The NSE was introduced in 1994 to break the monopoly of BSE. After 25 years, measures have to be taken to break the monopoly of the NSE.

Blockchain technology has the potential to disrupt the depository business. Hopefully the two depository players will learn from these competitive forces. Joseph Schumpeter famously wrote that “creative destruction is the essential fact of capitalism”. MIIs are often seen as face of capitalism and they should be part of this creative destruction process as well.