Jalan Report a damp squib - I
Deena Mehta 20 December 2010

The shareholding proposals of the Bimal Jalan committee on market infrastructure institutions are biased and not justified. The report also sidetracks corporate governance issues and the developmental role of stock exchanges  

The Bimal Jalan Committee report on the ownership and governance of market infrastructure was submitted to the Securities and Exchange Board of India (SEBI) a month ago and, unfortunately, what should have been a path-breaking review of the market infrastructure system has turned out to be a damp squib. The report sidetracks the main issues such as corporate governance, the absence of a development role the exchanges must play, and the important role they have in channeling savings into investments towards achieving a higher double-digit growth on a sustained basis. The report also addresses the issue of stock exchanges as service utilities in a roundabout manner.

Ownership of stock exchanges
Currently, the ownership of the stock exchanges is restricted to 5% of the shares being held by a single entity. Stock exchanges, the depository and clearing corporations are allowed to hold 15% collectively and the holding of existing trading members is restricted to 49%. Persons residing outside India, investing through the foreign direct investment (FDI) and foreign institutional investor (FII) routes are allowed to hold 49% cumulatively, which is further sub-divided into 26% through FDI and 23% through FII routes.

The regulations envisage listing of shares of MIIs (market infrastructure institutions) on the Designated Stock Exchange. The report introduces the concept of Anchor Institutional Investors, which includes public financial institutions and banking companies having a net worth exceeding Rs1,000 crore. This class of investors is permitted to hold an additional 9% of shares which need to be reduced after a period of three years.

Currently, depositories and clearing corporations are permitted to hold shares in another MII, but the committee has recommended that such holdings should not be permitted, since clearing corporations and depositories should function as public utilities and focus on improving the safety of markets and a reduction of costs. There is no mention of stock exchanges also functioning as public utilities.

The report offers no guidance as to how the 49% of shares held by trading members would be treated in the future scheme of things. There is no place for trading members holding shares in the model proposed for restrictions in share holding and there is no transition plan available for migrating to the model holding proposed by the committee.

The report also talks about the desirability of encouraging widespread ownership, encompassing both institutional and retail investors. The committee is of the opinion that dispersed ownership is to be favoured for the better functioning of stock exchanges. In the absence of listing, it is difficult to comprehend how the retail investors will purchase shares and whether the price integrity will be ensured, not to mention liquidity problems.

The entire stock market infrastructure has been created from broker funds. The Bombay Stock Exchange (BSE) had funds on its balance sheet from broker membership money and margin money collected by the exchange and non- payment of interest thereon. In the case of the National Stock Exchange (NSE) also capital was just Rs25 crore. The entire infrastructure of NSE was created from broker deposits and today also the exchanges earn from treasury income of the margins given by brokers. So, ignoring the interest of brokers to own shares of the stock exchange is misplaced.

Clearing corporations
The committee has recommended that 51% of the paid-up capital of the clearing corporation should be held by one or more recognised stock exchanges. In the ownership section, the committee talks about the clearing corporations and depositories being public utilities which would ensure that the costs are very low and hence serve the commercial objectives of the users of the system and not the shareholders.

It would be more apt to have banks and public financial institutions promote these clearing corporations, since these are essentially development organisations and managing money is their business. In fact, in the past, there have been discussions on the clearing corporation being permitted to have a limited banking license to move money efficiently. There should be one clearing corporation for the entire market (across exchanges) which would ensure optimum utilisation of collaterals through cross-margin.

The Jalan Committee has recommended that the holding of stock exchanges in a depository may be restricted to 24%. The report talks about vertical silos wherein the entire settlement and post-trade services are clubbed together under post-trade services. The depository service is part of clearing and settlement only. But this is not true as depositories also hold on to the securities unlike clearing corporations. But the risks are different.

The clearing corporation moves the money and the depository settles the securities. If the nature of both the entities is post-trade service and keeping the cost low is in the interest of general trade, why should depository ownership be different?

Another reason given in the report is that both the stock exchanges as well as depository perform surveillance functions and one surveillance mechanism is not desirable to be in control of another surveillance mechanism. The clearing corporation also performs the surveillance function. This report appears to be discriminatory on this issue of depository share holding.

The committee has recommended that all exposures need to be counted while calculating the shareholding limits. The committee felt that the participation of a shareholder through other means like creditor or holder of other instruments issued by MII, should be considered for the purpose of limits. The committee's objective is laudable but it again appears to be biased. It is a well known fact that a large number of QIP (qualified institutional placement), FCCB (foreign currency convertible bonds) and such other placements in companies are done with buyback arrangements, and if SEBI really wants to apply this principle then a huge aberration and turmoil in the market will happen, like it did in the case of pledging of shares. Nevertheless, the principle is correct that there should be no backdoor entry as a creditor, and so on.

Governance norms
The committee believes that trading members on the board of directors are privy to confidential information. The bye-laws and rules prior to demutualisation gave the entire management powers to the president and the governing board of the exchange, since the exchanges were trade bodies and mass participation of the public in exchanges was not visualised.

Post-demutualisation, the exchange has two broad functions, that of running it as a commercial entity and that of a regulatory body. These two functions are clearly distinguished and the matters that come before the board essentially concern the business aspects of the exchange. Hence, there being a conflict of interest between the regulator and a regulatee is totally misplaced.

Also, if any action is taken by the exchange on a member, then such a member is not permitted to be on the board on the exchange. There is, therefore, no case to state that no trading or clearing member should be permitted to be a member of the board of the exchange. It is outrageous to put the professional ethics of independent directors and exchange management above that of trading members. Integrity is a personal trait. In fact, the independent directors and stock exchange management are privy to a lot of insider information such as surveillance reports which can be personally used by them for their personal trading purposes.

Brokers are the channel which is used by the exchanges to market and deliver its services. They are closest to investors and serve as the eyes and ears of the exchanges .The committee feels that trading members with their rich experience should be utilised by the exchange and an advisory committee should be set up to take the guidance of these members.

It is my personal experience that the professional management hardly brings anything before the advisory committees and decisions are taken in the most ad-hoc manner. Advisory committees are only used as a rubber stamp when it suits the management of the exchange.

This brings us to the subject of corporate governance which has not been at all addressed by the committee report. The entire decision of changing the market timings was taken in an ad hoc manner and the entire power of the exchange has been concentrated only in the hands of the chief executive officer and a handful of top managers.

The report says that the powers of top management of exchanges are unfettered and more often than not, the board is expected to endorse every thing that is put before it. The report is silent on such issues. It would be advisable to study the minutes of the stock exchanges before such a recommendation is made.

Favouring large brokers is another danger that the capital markets face post demutualisation. The US is battling with black pools, where select trade-related information is made available to a handful of commercially important members. The report could have looked into these dangers of commercial interest that could compromise the integrity of the system.

(Deena Mehta is managing director of Asit C Mehta Investment Intermediates Ltd. Mrs Mehta is one of the three trading member directors on the board of the Bombay Stock Exchange. The second part of the article will be published tomorrow.)

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