Regulation of Stock Exchanges

The proposed establishment of a new stock exchange in India has caused a revival of the debate pertaining to regulation of stock exchanges. There are unique issues: stock exchanges are not only profit-making institutions that are companies in form and substance, but they also carry out a regulatory role in respect of companies that are listed on them. This creates an inherent conflict of interest in their operations. As Mobis Philipose notes in The Mint:

“MCX Stock Exchange (MCX-SX) has applied to the Securities and Exchange Board of India, or Sebi, the capital market regulator, to offer trading in equities. If it wins approval, it would be the first greenfield equities exchange in India since the National Stock Exchange (NSE) started about 15 years ago.
The proposed new stock exchange would compete with NSE and the Bombay Stock Exchange (BSE). It would also be the first stock exchange with a common ownership and management in the post-demutualization era.
Globally, when stock markets moved from being broker-owned mutual associations to shareholder-owned entities—a process known as demutualization—concerns arose over the governance of for-profit equity exchanges. In most cases, the regulatory function has been spun off to a different entity to remove any conflict of interest.
A stock exchange’s responsibilities include surveillance of market participants and ensuring that a robust risk management mechanism is in place. It does this by monitoring position limits and collecting adequate margins on time. When the owners of the exchange oversee such regulatory functions, there could be a conflict of interest, some analysts say.”
Although the establishment of this new stock exchange will promote competition in the field and thereby encouraging innovation and better service to clients, there is a genuine concern (expressed by experts in the above Mint article) that this may lead to laxity in regulation of listed companies by stock exchanges (so as to promote listing and trading on them) thereby leading to an overall decline in regulatory standards, this trend being generally known as “the race to the bottom”.
This has been a serious governance issue world over. For example, Professor Allen Ferrell of Harvard Law School lays out the crux of the problem:
“The global movement of traditional stock exchanges to for-profit businesses has put pressure on the self-regulatory function of exchanges. A for-profit stock exchange, burdened with expensive regulatory duties (as a result of being a self-regulatory organization (SRO) under the Exchange Act), and competing with trading platforms that have lower regulatory burdens or no regulatory duties must grow its business to be successful. As with any business, profit growth may come from increased revenues or reduced costs. For a stock exchange, revenue growth must come from increased trading volume, by adding new listings or by acquiring other exchanges or trading platforms. Cost reduction may come from a reduction in regulatory burdens or through economies of scale, such as the consolidation of separate market surveillance units and operating acquired trading platforms on existing surplus IT capacity. This emerging business dynamic may be driving a variety of fundamental changes in global regulation.
There are concerns that this has placed undue strains on the regulatory structure. These issues have included the concern that trading might move to markets with lower regulatory requirements, the existence of inconsistent rules across markets, and that exchanges may reduce the rigor of their regulatory oversight in order to gain market share. There is also the concern that exchanges may be “too soft in regulating themselves and too severe in regulating competitors.” For example, the SEC in its concept release, and in an earlier concept release, discussed the possibility of regulatory arbitrage, whereby, for example, an exchange might reduce its market surveillance function to attract trading volume, or lower listing requirements to attract companies.”
There are a number of methods used in various jurisdictions by which this conflict of interest can be mitigated. These may be employed individually or through a combination of more than one method:
Separate the ownership and management of the exchanges. This can be achieved by imposing a cap on share ownership by a single entity or grouop. This is the model that NSE has been following.
House the regulatory functions in a separate subsidiary company that has a separate board (in other words, create “Chinese walls”). Ferrell notes that the NYSE and NASDAQ followed this approach.
Create a strong independent board that pays adequate attention to the regulatory functions of the stock exchange.
Provide for enhanced governmental supervision of the regulatory function of the exchange rather than by the exchange itself. Ferrell notes that some exchanges follow this: Australian Stock Exchange, the Hong Kong Stock Exchange, the Singapore Exchange and the Stockholm Stock Exchange.
Constitute a separate Regulatory Conflicts Committee of the board to deal with the conflicts between the commercial and regulatory sides of the exchange. The Singapore Stock Exchange follows this model.

At this stage, from the information available, it appears that the new exchange will largely follow the first approach of separation of ownership and management. Although many of these models will dilute the possibility of conflicts, such conflicts cannot be obliterated altogether given the basic feature of a stock exchange that is run on a for-profit basis.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.


  • The Exchanges business needs a serious relook. Even if there is a semblance of competition within the sector, in reality there is hardly any. Basically since the major source of competition, i.e. Product Development is still tightly controlled by the regulator, the exchanges have very little to innovate.

    Secondly if MCX comes as a Stock Exchange, it will be the largest conflict of interest , because FT the parent of MCX, already holds a majority share(around 80%) in the trading terminals in the market and can always manipulate that for its own benefit.

    Moreover since there is a trend of “Everyone doing Everything” i.e. all the exchanges have their hand in all types of businesses and are competing for the same set of brokers in each business.

    Moreover while most of the earlier broker owned became demutualised and reduced their broker ownership, NSE went the other way and got a broker on board(Goldman Sachs). BSE eventhough a demutualised exchange now, is still struggling to break-off from its past.

    Ideally a separate regulatory organisation to take care of listing and surveillance needs to be established independent of the exchanges to prevent regulatory arbitrage. Preferably this could be housed within the SEBI itself.

  • One should be careful referring to the NSE model. NSE was a creature of its times, backed by strong government support all the way up the food-chain. New entrants to the business will obviously not have access to such support.

    Moreover, NSE achieved commercial success over a badly bruised competitor, BSE. New entrants will have to deal with a strong, and well entrenched player. So achieving commercial success will take a lot of smarts, of the both the good and bad type.

    The regulator should obviously be focused on minimizing the incentives for mischief of the bad type. But separating ownership from management will run counter to everything we know about successful entrepreneurship.

    So while we continue to debate to improve our understanding of the regulatory conflicts in the exchange business, let us also devote some energy to ownership structure issues. Here is a suggestion that runs counter to conventional wisdom and current policy:

    There is a requirement that ownership structure be brought down to 5% or 15% (as applicable) within a year, maybe we should enforce a long-term lock-in, say, 5 to 7 years. Hard to manipulate the market for that long, and impossible to play the valuation game.

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