The report of the Bimal Jalan committee on “Review of Ownership and Governance of Market Infrastructure Institutions” is now available on SEBI’s website for public comments (due on December 31, 2010). The report makes a number of key recommendations regarding the ownership structure and corporate governance norms pertaining to three key institutions providing securities market infrastructure, being the stock exchanges, clearing corporations and depositories. Of the three institutions, matters relating to stock exchanges have evoked the greatest amount of debate recently.
On the one hand, stock exchanges are crucial to a country economic infrastructure and they perform a public function by engaging in regulatory supervision over companies that are listed on it. On the other hand, stock exchanges need to evolve their businesses and practices through innovation and competition fuelled by private entrepreneurship and capital investments. The committee report essentially attempts to reconcile these somewhat conflicting objectives. This it does so by: (i) imposing restrictions on maximum ownership of market infrastructure institutions (MIIs), (ii) providing greater means of attracting long-term committed “anchor” financial investors rather than short-term investors or speculators, (iii) prohibiting listing of MIIs, (iv) prescribing stringent corporate governance norms for such institutions, including the appointment of public interest directors.
As we have previously discussed on this Blog, the crucial element of regulation of MIIs, and particularly stock exchanges, is the conflicts of interest they create: “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.” The committee report is helpful as it discusses (on pages 22 and 23) the various methods by which such conflicts have been addressed:
Strong Exchange SRO Model: A public authority is the primary regulator, it relies on Exchange(s) to perform extensive regulatory functions that extend beyond its market operations, including regulating member’s business conduct. Examples: US (CME), Australia (ASX), Japan (TSE, OSE), Malaysia (Bursa Malaysia).
India has adopted the strong exchange SRO model. It is premature to think of the ‘independent SRO model’ [where the exchange performs extensive regulatory functions] in the Indian context given its evolution over a period to is present state; the government model may not be entirely possible in the Indian context considering the size of the market. However, due to the potential conflict of interest in the strong exchange SRO model, the Committee is of the view that SEBI must take a more active role in setting a level playing field with regard to fees, entry, etc. of members of MIIs.
In order to address these conflicts in terms of process, the Committee has recommended that regulatory functions of the exchange (such as risk management, surveillance, listing, enforcement, etc.) should report directly to an independent committee of the board consisting of a majority of public interest directors and also to the CEO (through dual reporting).
While imposing high barriers to entry into the market infrastructure sector will ensure quality and integrity of players, there exist arguments to the contrary that such a regime will encourage monopolistic behavior and discourage the useful effects of competition.