Stock Exchange Markets
STOCK EXCHANGE MARKETS
STOCK EXCHANGE MARKETS India established the first stock exchange in Asia in Bombay in 1875. Given the large geographical size of the country and the typical floor-based trading system prevalent until 1994, a total of twenty-two stock exchanges were eventually created to cater to the needs of investors in every part of India. Three basic models were adopted: associations of individuals, limited liability companies (without profit sharing), and companies limited by guarantees. Regardless of the form of organization, all were recognized by the tax authorities as nonprofit entities, or entities in which their members had no claim to operating surpluses. Although the generated surpluses were not explicitly distributed, exchanges provided various services to their members invariably below cost, with the subsidy element varying from exchange to exchange.
Exchanges enjoyed subsidies in many forms. The respective state governments allotted land for constructing the buildings for exchange operations and brokers' offices on nominal terms. Until recently, the government of India had adopted the concept of regional stock exchanges (RSEs) defining the operating area of each exchange. A public company was required to list its stock on the RSE nearest its registered office.
A listed company has to pay listing fees, both initial and annual and such fees were linked to the size of its issued capital. For most RSEs listing fees were the main source of income. Each exchange enjoyed monopoly rights in securities trading in the city of its location. Investors had no mechanism to protect themselves from collusive behavior by the stock brokers. This monopoly also led to the creation of fragmented markets that were shallow, inefficient, and cost ineffective. Brokers generally dealt with investors through a multilayered chain of intermediaries increasing cost of transaction.
Since exchanges prohibited corporate membership, all brokerage entities were either proprietary or partnership concerns. Although the liability of a brokerage firm was unlimited, this did not mean much to investors, as almost all the brokerage firms were poorly capitalized. Brokerage firms distributed most of the profits at the end of each accounting year, transferring them to their family members. Thus, in the event of a firm's insolvency, investors were the main losers.
Reforms since 1991
Capital market reforms process launched in 1992 was in response to a major financial scam that shook the banking system and the capital markets. Some prominent stock brokers defrauded several Indian banks (both government-owned and private) as well as prominent foreign banks. They diverted bank funds to their personal accounts for artificially increasing the prices of their favorite stocks. This became possible due to severe deficiencies in trading and settlement systems for sovereign bonds and bonds issued by public sector units. The resultant boom in equity markets attracted thousands of gullible investors who hoped to make quick gains. The bubble burst after some investigative journalists exposed the frauds perpetrated by unscrupulous stockbrokers. When the banks demanded funds back from the brokers, the market collapsed. The banks lost an estimated U.S.$2 billion in this scam. For the Indian government, which had just launched a series of reforms in the securities markets, the crisis was a major embarrassment.
The government promptly introduced a number of measures with far reaching consequences in the securities markets. A significant component of this reform package was the need for setting up a new Indian stock exchange, which would be operated in accord with globally accepted best practices, both in trading and settlement systems. The National Stock Exchange (NSE) was thus born. It was initially conceived to be a model exchange to exert pressure on the other twenty-two stock exchanges, inducing them to improve their functioning styles. Within six years, its impact on Indian capital markets was so overwhelming that all the other exchanges, except for Bombay Stock Exchange (BSE), became virtually defunct. As a survival strategy, ten regional exchanges set up subsidiary companies that became members of NSE and BSE. The systems and procedures introduced by the NSE have been accepted by the market regulator, the Securities Exchange Board of India (SEBI), and were made applicable to the other exchanges, all of which look to the NSE for further initiatives in market reforms.
The Design of the National Stock Exchange
The NSE was set up as a limited liability pro-profit company by twenty-one leading financial institutions in 1993. Its executive board includes senior bankers, lawyers, and financial executives. To avoid any possible conflict of interests, the day-to-day management of the exchange is handled by professionals, who do not have proprietary trading positions in the stock market.
India's NSE is patterned on the U.S. Nasdaq model, extending its trading facilities to all parts of the country, and providing trading facilities only in large stocks, like the New York Stock Exchange. It has adopted an anonymous order-driven trading system, with orders originating from all its members being matched automatically by the computer as per the price time priority trading algorithm. Thus there is no human intervention in the deal-matching process. India's NSE is the first exchange in the world to set up a captive satellite communications network, connecting its members spread across a vast geographical area in the country to its centralized trading and settlement hub. All members enjoy a response time of less than 1.5 seconds; orders originating from any part of the country are matched, and trade confirmed on the respective trading terminals, in this short time span. This highly transparent system gives investors instant information about traded prices and quantities as well as unmatched bids and offers in all stocks on a real time basis. To start with, NSE enforced on its trading members (stock brokers) certain minimum stringent disclosure norms that provided a clean audit trail of a trade at the investor level. The trading members were forced to provide automatically generated trade and order confirmation notes to all investors. This unique system of disclosure became the standard regulatory requirement subsequently.
India's NSE also started guaranteeing the settlement of members' net obligations, at a time when guaranteed settlement was unheard of in India, by establishing a subsidiary National Securities Clearing Corporation Limited, which developed unique software to monitor each member's net exposure in each stock as well as members' aggregate exposure in all stocks. Each member was required to trade within the overall exposure limits, based on the concept of initial margin adopted globally by the futures exchanges. The moment a member exceeds the exposure level, all its trading terminals are automatically disconnected from the trading system. The trading terminals are reactivated only when additional funds are brought in. If a member fails to honor its settlement obligations, member margins are usually adequate to close out positions. The BSE took more than a year to adopt its own settlement guarantee program, but later developed its own exposure monitoring mechanism based on the national model.
Impact on Other Exchanges
The impact of the major investor-friendly trading and settlement systems was so decisive that the NSE emerged as India's largest exchange before it completed its first year in November 1995. Business losses then forced the BSE to launch computerized trading as well. Later, all RSEs computerized their operations. But since their response was slow and halting, they lost much of their business to the large exchanges.
Options and Futures
In June 2000, India's two major exchanges, the NSE and the BSE, offered futures and options products on their main indexes, with one-, two-, and three-month expiration contracts. Options on indexes on these exchanges began in June 2001, options on select stocks in July 2001, and futures on select stocks in November 2001. As of December 2004, stock options and futures were available on fifty-three highly liquid stocks. Based on certain objective criteria, the regulator approves inclusion of stocks in the list of equities eligible for futures and options trading. Stock futures and options have proved to be very popular among investors.
As of December 2004, average trading turnover in futures and options (both in stocks and the indices) was twice the turnover in the cash market for equities. The Indian futures and options market has become vibrant; from April to December 2004, the daily average of contracts traded on the NSE was 288,616. The average contract size was, however, small. India is among the few countries to have introduced stock futures, as they are feared to be highly risky. Unless stringent regulations and tight surveillance are in place, stock futures may be misused to manipulate individual stock prices. In India, stock futures account for over 60 percent of trading in the entire futures segment. The daily turnover in stock futures in December 2004 was about 155 percent of the NSE's turnover in the cash market for all traded equities. The Indian experience proves that even relatively backward capital markets can quickly and successfully absorb globally accepted trading and settlement systems.
India's new trading system has encouraged price competition and has helped in the significant decline in bid/offer spreads. As a result, transaction costs are estimated to have declined by a factor of eight to ten after the NSE came to dominate the Indian market.
R. H. Patil
There are three web sites that provide useful information on the Indian securities markets, including the functioning of the Indian stock exchanges: the Securities Exchange Board of India at <http://www.sebi.gov.in/> the National Stock Exchange at <http://www.nseindia.com/> and the Bombay Stock Exchange at <http://www.bseindia.com>. The following reports and publications are particularly useful: Securities Exchange Board of India, Annual Report, 1996–1997 to 2002–2003; National Stock Exchange of India's annual publication Indian Securities Market: A Review, 1999 to 2004; National Stock Exchange of India's annual publication Fact Book, 1998 to 2004; Reserve Bank of India, Report on Currency and Finance, 1999–2000.