By: Subhajit Chattopadhyay
Future Roles of Stock Exchanges in India
Indian Stock exchanges commenced their operations way back in 1875, when Bombay Stock Exchange started functioning. This was followed by the formation of Calcutta and Madras stock exchanges in the year 1908. As business expanded, capital requirement and need for investment increased. So several exchanges were formed as of now there are 23 stock exchanges functioning in India. Apart from stock exchanges, there are several dedicated commodity exchanges, too.
Harvey (2007) identified two broad factors which impacted the operation of stock exchange operation, first changes in the business scenario and changes in the regulatory environment. Increased technological capabilities of Alternative Trading System have put pressure on traditional role of stock exchanges as order matching intermediary. Further, innovation financial instruments and its derivatives have caused exchanges to look for ways to enter into these markets. Regulatory interventions like Regulation on ATS (adopted 1998) and regulation on National Market System (adopted in 1975) in US impacted the operation of exchanges.
Further in UK, MFID’s intent to stimulate competition and European Commission’s aim to consolidate the market to reduce cost of raising fund impacted the functioning of exchanges. Moreover, gap between standards between Europe and U.S. regulatory environment made the EU a more favoured destination for raising capital.
To manage the difference across countries three pronged approach were taken –
Indian Stock Exchanges – Two decades of existence
The performance of the stock exchanges if analysed till last year since inception of liberalisation policies during ‘90s till, a distinctive phenomena can be noticed. Following table captures the performance of the stock exchanges in a nutshell –
Table 1: Performance of Stock Exchanges – 1992 – 2001
|Names of the Stock Exchanges||Average Volume*||Rank – Volume||Average Growth rate||Rank – growth rate|
(* measure in crores)
The first decade marked strong performance of stock exchange as turnover in the cash segment registered 9 times (approx) growth compared to same in 1992-93. Out of the 23 stock exchanges, 18 recorded a positive growth. ISE recorded highest growth whose turnover increased by 180 times within a period of 3 years from 1999. But in terms of annual average volume of transaction NSE ranked at the top within 7 years of inception. The next table summarises the performance in the second till 2012.
Table 2: Performance of Stock Exchanges – 2002 – 2012
|Stock Exchanges||Average Volume (2002 -12)||Deviation from first decades’ average|
From the table above, it can be noted that out of 23 exchanges, 21 recorded a negative growth. Only exceptions are NSE and BSE, which recorded consistent growth. It can be observed that during this decade, there were only 4 exchanges which functioned though volumes of transactions that were decreasing steadily. The regional stock exchanges became redundant and failed to encourage the investors to invest through them.
Evolving Roles of Stock Exchange & Related Concerns
Traditional roles of stock exchange are providing a platform where corporate can raise capital in an efficient manner and at the same time protecting interest of the investors is also paramount. Over the years, the traditional roles have evolved, where stock exchanges actively participate in creating new asset classes for investment, promoting investors’ awareness, maintaining transparency in operation, creating an effective mechanism for grievance redressal of investors at the same time to create new products for investment, new technology and devising more techniques to manage risk.
But as the stock exchanges themselves evolved as a profit making companies and their stocks were registered in their respective stock exchanges then issues of conflict of interest, concern on comprise on quality of surveillance & implementation of regulations emerged. According to the report published by OICU – ISCO (2006), following concerns came up from different countries –
- A) Balancing commercial and public functions – Concerns were raised as the exchanges become for-profit organisation, which may compel the stock exchanges to look after the members’ interest by compromising interest of the broader market. Further, in order to boost profit such exchanges may reduce spending on regulatory standards and on implementation of other compliance related issues.
- B) Misuse of regulatory power – Most of the exchanges are entrusted with some amount of regulatory power to make the market. Concerns were raised as profit makers where such regulatory roles are susceptible to misuse of power for commercial benefit. This may happen particularly where such exchange is subject to little completion. This may happen in two ways, first initiating regulatory actions which are disadvantageous to competition and second using its power to finance operation through regulatory income.
- C) Conflicts due to self-listing – Demutualisation of an exchange has its benefit as exchanges get access to more capital and the promoters/ member realise the value that has been created. In such scenarios doubts have been raised as whether they can works as their own regulator.
- D) Financial Risk & Exchange viability – The report also raises question whether for-profit exchanges may take more risk than other type of exchanges.
The OICU-IOSCO report (2006) enlists the following approaches to contain various concerns that were voices in the report –
- Governance arrangement – The essence of remedies discussed under this section primary deals with composition and power of the governing body of the exchange e.g. appointment of independent or public directors in governing bodies.
- Separation of functions within an exchange – Issues discussed under this section basically underlines that regulatory functions should be insulated from commercial compulsions of the exchange. And there should be specific provisions for appointment or removal of head of regulations, regulatory oversight or audit by independent or public directors
iii. Restriction on ownerships – Ownership related issues revolve around 3 categories of actions. First, placing specific eligibility (fit/ proper) requirement on controlling/ substantial shareholders; secondly, public disclosure once threshold limit is exceeded and third placing restriction on permitted size of shareholding with/ without discretion to approve higher levels.
- Oversight arrangement – This section suggests increasing oversight by regulators, special oversight to deal with self-listing and specific terms included to exchanges authority.
- Transfer or removal of functions
In this era of global economy and free movement of capital, the role of a stock exchange is inextricably linked with the continuous development taking place around the world. Development in terms of innovation in financial products & technology, functioning of market intermediaries, harmonisation of international standards and operation procedures keeps changing the role of stock exchanges and style of functioning. In Indian context concentration of trades in two stock exchanges viz. NSE & BSE while other regional stock exchanges are steadily decaying. Thus we shall look into the following issues –
- Infusing or attracting liquidity into stock exchanges – this may be of relevance to the regional exchanges
- Exploring market structure and its determinants – this could include different types of trading strategies, order routing services as emerging in various developed markets
- Auxiliary roles of stock exchanges like promoting investor awareness / education which play a direct role in protecting investor’s interest and also an indirect role in increase the depth of the market.
Research methodologies are designed based on the issues that are being explored or investigated and the objective of the research. Given the research topic which dwells with anticipating future roles or operational style of stock exchange can only be analysed by studying the new developments taking place in Indian stock market. To understand the Indian picture, tracing global changes is required to serve as a context. Thus, approach here is to review concerned literatures and unveil the trends in stock market operation.
Some researchers have defined various terms like approaches or paradigm. Chalmers (1982) has underlined that paradigm has the following dimensions –
- Explicitly stated laws and/ or assumptions
- Standard ways of applying the fundamental laws to a variety of situations.
- Instrumentation and instrumental techniques that bring the laws of the paradigm to bear on the real world.
- General metaphysical principles that guide work within the paradigm.
- General methodological prescriptions about how to conduct work within the paradigm.
Various authors have identified three basic paradigms – a. post-positivism b. critical theory c. interpretivism. Apparently the approach to research is segregated as qualitative and quantitative. But both these approaches depend upon two terms like Ontology and Epistemology. Epistemology is connected to exploration for the proof/ characteristics of existence and identifying the method which will help in establishment of existence whereas Ontology is concerned with the reality of existence. The entire approach of quantitative methods of research is a derivative post-positivism approach whereas qualitative research has been classified by Creswell (1997) as ethnographic, interpretive and critical research. The difference between these two approaches are characterised by the difference in approach toward exploring or examining realities and how to understand what we know. It is observed qualitative methods are adopted to describe and explain phenomena, current experience with an objective to develop a new theory where as quantitative methods are used to confirm the validity of a theory which is different in different sisituations and also to modify it increase the depth of understanding.
In qualitative research issues or phenomena are studied to make a sense of the phenomena and also to interpret the same. To carry out information/ data in various forms e.g. personal experiences, life stories, introspective, interviews, observational & historical interaction are studied.
In the present context it is basically a comparative study wherein an attempt has been made to examine the actions taken in India with respect to the various emerging phenomena (which is continuously emerging and has the potential of impacting the operations of stock exchanges). Such phenomena could range from liquidity, product innovation, innovation taking place in terms trading strategies (including market integration, efficiency and transparency), technological issues impacting trades, maintaining transparency, protection of investors’ interest etc.
In order to capture data pertaining to capture recent changes taking place in global stock market various research reports especially conducted by IOSCO have been referred to. Simultaneously, various reports, concepts papers and reports of various committees have been reviewed to understand the future style of operation of stock exchanges in India.
Operation of an Indian stock exchange is strictly regulated by SEBI (Security Exchange Board of India). Thus, the spirit of the research method is to explore and capture the recent changes taking place around the world as evident in various publications of the recognised bodies. The attempt is to underline the new changes as revealed by the various public reports, consultation and working papers.
Liquidity is critical for sustenance of stock exchange. A report published on liquidity in emerging markets (OICU-IOSCO, 2007) underlines following factors to boost liquidity –
- Reducing concentration of ownership and thereby increasing free-float level in publicly listed companies. Also more active participation of pension funds is sought to ensure infusion of capital.
- Liberalising intermediary sector and opening foreign participation. Reduction of transaction cost by lowering commission and taxes. Encouraging cross-listing & dual listing will increase liquidity.
- Availability of more investment products viz. structured and call warrants hedge funds etc.
- Capital Raising Process
Indian perspective – modernising capital raising process
In terms of boosting liquidity and making stock market a lucrative source of finance SEBI pondering upon modernising capital raising process. A group consisting of representatives of stock exchanges, depositaries, merchant banks etc has been formed to ponder upon reduction of post-issuance cost, participation of retail investors in IPO, and reduction of post issues settlement period from 12 days. In this context a concept paper has been released on January, 2015. Following the though process investors are allowed to submit their application to SEBI registered stock broker, depository participant, self certified bank. Simultaneously investors could also apply online through the web-portals of the above mentioned entities. This process ensured that post-issue timelines reduced from 12days to 6 days. To encourage use stock market as a source of capital fast track issuance was initiated (available to enlisted entities). This obviated the necessity of filing of draft offer document with SEBI and can open the issue with Red Herring prospectus. Further, SEBI is currently examining the relevance of the conditions of having Rs3000 crore of public shareholding requirement and relevance of public float criteria.
Attracting Foreign Investment in Stock Market
Role and impact of foreign capital is significant. In order to encourage such investment SEBI has attempted to minimise regulatory hurdles of foreign investors. SEBI formed a committee to study the existing provisions and came out with a report (June, 2013) on Rationalisation of Investment Routes and Monitoring of Foreign Portfolio Investments. The salient features of the recommendation of committee is as follows –
- To create one single route by merging FII, sub-account and QFI. The relaxations given to PIO/ NRI should be retained where more sector should be permitted to access foreign venture capital.
- It also suggested that foreign portfolio investors (FPI) need not directly register with SEBI. Eligible entities can directly approach designated depositary participant (DDP) which will register them on behalf of SEBI. It is DDP which will carry out due diligence, maintain investment, disseminate information of investment made an FPI.
- FPI should be a resident of a country which either a signatory of IOSCO’s MOU or have bilateral MOU with SEBI.
- FPI and DDP shall ensure that total shareholding should always be less than 10% of the paid-up equity capital of a investee company. Aggregate shareholding of all FPIs shall not exceed the lower of 24% of the paid-up equity or sect oral cap.
Crowd funding – a challenge to existing stock exchanges
Crowd funding is a financing methods which has surfaced very recently. The method is currently in a very nascent stage in which people fund a creative venture (perhaps in small amounts). Such capital could be sought from various online platforms including social media. IOSCO (2014) has come out with a working paper which indicates four types of funding mechanism like social lending, reward, peer-to-peer lending and equity crowd funding. Similarly SEBI also came out with one consultation paper in June, 2014.It offers various benefits ability to raise capital at a lower cost, compliance cost and cost concerning due diligence. Emergence of crowd funding made its space in the domain dominated venture capital funds and private equity. Along with its advantages it came out with its own risk, especially for the investors there is hardly any protection in case default, fraud, information asymmetry (given its dependence on internet) and absence of regulatory framework. However, the consultation paper on crowd funding mentions the ambit of SEBIs role in monitoring as follows –
- Recognition of crowd funding portals and period inspection of the same
- Oversight and regulation of crowd funding market
- No role in vetting of private placement offer of the issuing companies
- Issuing guidelines pertaining to information disclosure needed while making such offer.
To protect the interest of retail investors the consultation paper proposes that participation of retail investors are limited to following categories –
- Who receive advice from investment advisor/ uses services of portfolio manager/ having relevant qualification.
- And having a minimum gross income of Rs10 lacs, having income tax return for last 3 years,
- And will not invest more than Rs.60,000 in crowd funding and not more than 10% of their net worth.
The paper proposes that three categories of entities can create trading platform. Existing stock exchanges and SEBI registered depositaries which constitutes category-I. Category – II is comprised of technology business incubator promoted by central or state government or non-profit making societies having 5 years of experience with minimum of Rs. 10 crores. Also association or networks of private equity or angel investors having a paid-up share capital of 2 crores, registered under companies act 2013 with a minimum of 100 active members.
Further, following information have been sought in the consultation paper in the private placement offer letter –
- Name and address of the company
- Description of the exiting venture
- Issue size, target offering, intended usage of funds and valuation of securities.
- Past history of funding
Co-location / proximity server hosting:
Executing trade fast provides an advantage to the investors in exploiting the favourable conditions. Keeping the global trend in mind SEBI has permitted collocation and stock exchanges like NSE, BSE and MCX-SX provide this facility to enhance speed in carrying out transaction. This has also led to faster adoption high frequency trading practices. As of February, 2013, in NSE 94.16% of equity derivative order, 73.88% of cash market comes from collocated servers. For BSE is 7.06% and 17.96% respectively. Further, SEBI has proposed to offer the service in a manner which is fare, equitable and transparent. The stock exchanges should maintain infrastructure adequate to accommodate the vast segment of investors and at the same time non-collocated investors have also fair access to stock exchanges’ trading system.
Different types of orders & its execution
Keeping the diverse motives of the investors various types of ordering options has been devised. For example reserve order (where only a part of the order is visible while entire order is placed for execution), discretionary order (which has a visible price and a non-displayed discretionary price), hidden order, various kinds of PEG orders, inter-market sweep order, post only order.
In most of the cases best execution of order is defined as the most favourable price for the investor, given the circumstances.
But as competition increases and new trading platforms become available, other factors like cost of transaction, speed of execution, order size etc. has to be considered as indicated MiFID (OICU-IOSCO, 2013). Countries like Canada & USA have adopted Order Protection Rule which requires that better priced order to trader prior to inferior orders. Malayasia, Singapore, Mexico requires clients order to be traded ahead of the proprietary orders.
The same report indicates that in presence of multiple trading platforms, firms have to make information pertaining to venue of execution of order (order routing principles).
Different types of trading platforms & trading mechanism
The recent changes taking places in modus operandi of stock exchanges impacts the market structure. According to the report on Market Structure (OICU-IOSCO, 2013) entire European Union is experiencing increase in number of multilateral trading facilities. Italy and Germany particularly witnessed growth to the tune of 250%, whereas UK had a growth of 21% (though higher in terms of absolute numbers) during the period 2008 to 2012. Glaring contrast emerged as the number of regulated markets decreased for Italy, UK & Netherlands. In USA, involvement of undisplayed trading centres came to prominence as these exchanges account for 25.4% of share volume (SEC, 2010). Further offering of collocation services, role of dark pools i.e. alternative trading centres (which is catering to institutional investors) executing large orders without impacting affecting the price and reduced trading cost also presented a different paradigm of trading. The report has also pointed out that another type of trading arrangement which called broker-dealer internalisation (which is treated as underplayed liquidity) where trades are carried out internally.
In case of India, it can be seen that innovation with respect to various types of trade order are limited. Whereas in terms of embracing technological advances it is at par with the global practice. Indian stock exchanges are found to be promoting wireless/ mobile trading, internet trading, algorithmic trading, smart order routing facilities.
Protection of Investors’ Interest:
Given the poor financial literacy amongst Indian investors two pronged strategy has been adopted – one is to prevent spread of biased or misleading information, penalise insider trading and second one is to promote awareness and increase financial literacy.
SEBI Research Analyst Regulation:
SEBI sensed that there is a need to ensure impartial report to protect investors’ interest. Accordingly SEBI came out with Research Analysts Regulation in 2013. Following entities comes under the ambit of the regulation –
- Independent research analyst
- Intermediaries that employ research analyst and issues research reports
- Research analysts giving recommendation in the public media.
However, entities providing research reports to their unit holders shall not be required to be registered under these regulations. But incase their views are publicised through the public media then they need to comply with the regulation. This regulation imposes following conditions-
- To devise comprehensive, objective and written internal control system to avoid any conflict of interest. Further research analyst or the intermediary shall not trade within 30 days before or 5 days after publication of a research report.
- No report can be published or recommendation can be made in the research analyst/ intermediaries traded in the last 30 days.
- They cannot trade in any securities before the issuers’ initial public offering which is being tracked by the research analyst.
- Further, compensation of a research analyst cannot be linked with the brokerage of any merchant/ investment bank. Compensation of research analyst is to be documented and approved by the board of directors. And such compensation won’t be subjected to monitoring of any employee of investment/ merchant bank.
- Analysts cannot make public appearances for a company where he was involved. Similarly they are prohibited from road shows/ sales and marketing activities.
- Incase analyst predicts a price target for a security within a time period in its report then the report should indicate the past closing prices of similar duration or last three year whichever is shorter.
- Analysts making their comments in the public media should disclose their registration details and financial interest, if any.
High level committee of SEBI reviewed the SEBI (prohibition of insider trading) Regulations 1992 and came out with a new proposal on December 7, 2013. In the following section salient points of proposed regulation is underlined –
- Not only sharing or disclosing of unpublished price sensitive information (UPSI) is made unlawful but even the act of procuring UPSI has also been made unlawful.
- Persons having UPSI are prohibited from trading and in case of trade it shall be on the person to prove that no undue advantage has been taken. Further it allows the persons perpetually having UPSI to trade in securities provided their trading plan is approved by the compliance officer. And once this is approved the persons having UPSI can not deviate from the plan.
- Specific provisions have been created to inform the company while buying the shares and its impact on shareholding status. Further codes of fair disclosure to be stipulated and intimation of trading undertaken by the insider have to be published.
ISOCO (October, 2014) released a strategic framework for investor education. It emphasises on investment knowledge and understanding, financial skills and competence and programme design & delivery management. The report summarises the current practices of members participating in the study including India.
Members are found to be increasing awareness about availability of different investable products and its suitability. They are also engaged in developing short, medium and long term education plan to serve the investors’ need. A number of members found that they structure their website according to life events and stages and other focuses behavioural issues.
The report pointed out that it is important to identify various investor segment and then develop content for that segment. Segments can be created with the help of demographic variables.
Stock exchanges in India (only BSE and NSE) have developed short term programmes, certification exams and long-term professional programmes in connection to the regulatory bodies to facilitate promotion of financial literacy. But regional stock exchanges are not actively pursuing such initiatives.
O’Hara (2004) in his article has attempted to underline the direction of evolution of securities regulation. Advancement in IT which has significantly impacted the information searching cost (a component of transaction cost) significantly and also helped various exchanges to share/ integrate information. This changes the market dynamics where stock exchanges face competition as transaction cost reduced significantly and number of competitors increased. Consequently, the securities trading started to fragment into multiple venues instead of concentrating. This also impacted the style of functioning and changes exchanged structure. The competition facilitated the exchanges migration from a membership driven structure to a corporate structure (demutualised) – this enables the exchanges outside capital formation and aligns incentive and risk associated with an exchange. This paper envisages that such exchanges should be allowed to be self-regulated as investors will prefer those exchanges which protect investors’ interest the best.
Social Stock Exchanges
Social financing refers to financing companies working as social business. Yunus (2009) defined social business as “once whose purpose is to address and solve social problems, not to make money for its investors. It’s a non-loss, non-dividend paying company … these profits remain with the company and are used to expand its outreach to increase the quality of the product or service it provides and to design methods to bring down the cost of the product or service.” In social finance framework, social stock exchanges are functioning in South Africa as an advance stage of formation in UK. In this context South Africa has taken pioneering initiative as it has established worlds’ first social stock exchange (SASIX) that offers an opportunity to buy shares in various social projects (which is exactly not same as social business entity) as follows –
- Food security
- Small business development
- Vulnerable people
- Animal protection
- Environment and conservation
There is a listing framework which uses following criteria for enlistment –
- A primary social objective
- Financially sustainable business model
- Accountability and transparency mechanism
- Specific development interventions addressing an identified need in a community
- Clear and measurable deliverables
- Past track record in similar projects
- Conformity with SASIX good practice guidance
In UK the concept of SSE emerged from the report of Social Investment Task Force (SITF). SITF identified following challenges which needs to be addressed to encourage investments in social business –
- Consistent performance tracking
- Market definition of social business and structure
- Inadequate standards for measuring social impact against performance benchmarks.
Moreover issues related to accreditation process, rating agencies and remuneration for key personnel also needs attention for effective and efficient functioning of social stock exchanges.
Indian stock exchanges also have initiated following actions on the following issues to ensure transparency and accountability –
|1. Rationalisation of Investment Routes and Monitoring of Foreign Portfolio Investments|
|2. Public Issues by Insurance Companies|
|3. Public Issues by General Insurance Companies|
|4. Comprehensive Regulation for Credit Rating Agencies|
|5. Assessment of Long Term Performance of Credit Rating Agencies|
|6. Report of the RBI-SEBI Standing Technical Committee on Interest Rate Futures|
|7. Report on Unified Exchange Traded Corporate Bond Market|
|8. Short Selling and Securities Lending and Borrowing|
|9. Corporate Bonds and Securitization|
As illustrated in the previous sections the recent changes taking place in Indian stock market are geared towards speed, ease of trade and transparency. In the recent future we might see our exchanges moving towards following direction –
- Stock exchanges would be adopting more mechanism to encourage investor to participate. Like usage of wireless technologies in trade execution would broaden the investor base similarly use of smart order routing, algorithmic trading also attract sophisticated and intensive investor to trade,
- System complying more transparent practices about providing unbiased information (monitoring credit rating agencies/analysts’ recommendation/ kind of information disseminated in IPO prospectus etc), initiatives to provide quick clarifications and cost-effective dissemination of information of trading activities would also be adopted by the stock exchange.
- Given scanty participation of retail investors and lack of financial knowledge would not encourage our regulators to allow Alternative Trading System, formation of alternative trading system (with lesser regulation) or allowing Dark Pools/ Dark Liquidity. Similarly Broker-Dealer internalisation which can be considered as undisplayed liquidity may not be allowed till Indian stock market allows more maturity.
- Since trades are concentrated in two stock exchanges so the scope of coming out with different routing techniques are also limited. But since stock exchanges has the leeway in designing different types of order it can be anticipated that stock market will witness some witness some innovation in that respect.
- The stock exchanges may provide structured retail products for various categories of retail investor after assessing its suitability.
- SEBI, Report on Rationalisation of Investment Routes and Monitoring of Foreign Portfolio Investments, June 2014
- SEBI, Discussion Paper on Revisiting the Capital Raising Process, January 2015
- SEBI, Discussion paper on Co-location / Proximity Hosting Facility Offered by the Stock Exchanges, May , 2013
- SEBI, Consultation Paper On Proposed Regulation Of Research Analysts, November 2013
- SEBI, Report of High Level Committee to Review SEBI (Prohibition of Insider Trading Regulation, 1992), December 2013
- SEBI, Consultation Paper on Crowdfunding in India , June 2014
- SEBI, The Annual Report, 2013
- SEBI, The Annual Report, 2010
- SEBI, The Annual Report, 2009
- SEBI, The Annual Report, 2008
- OICU-IOSCO, Strategic Framework for Investor Education (Final Report), October 2014
- OICU-IOSCO, Factors Influencing Liquidity in Emerging Markets , December 2007
- OICU-IOSCO, Regulatory Issues Raised by Change in Market Structure, March 2013
- OICU-IOSCO, Report on IOSCO Social Media & Automation of Advice Tools Surveys, July 2014
- OICU-IOSCO, Regulatory Issues in Emerging Markets, June 2012
- OICU-IOSCO, Issues Raised by Dark Liquidity, June 2010
- Securities & Exchange Commission, Concept Release Securty Market Structure, April 2010
- OICU-IOSCO, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency, October 2011
- M K Maheswari, H L Verma, B S Bhatia, Future Regional Stock Exchange: A Case for Revival, Indian Management Studies Journal, 2009 (13).
APPENDIX – I
|Sr. No||Stock Exchange||2002-03||2003-04||2004-05||2005-06||2006-07||2007-08||2008-09||2009-10||2010-11||Apr’11 – Dec’11||Apr’12 -Dec’12|