We show that organization structure of a stock exchange matters by utilizing the unique setting prevailing in India. India has two major stock markets, the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). These two exchanges adopt similar trading systems, trade essentially identical stocks, and follow the same trading hours. However, these exchanges have different organizational structures: BSE is mutualized whereas NSE is demutualized. Using the Hasbrouck [Review of Financial Studies 6 (1993) 191] measure of market quality we show that NSE provides a better quality market than BSE. This result is consistent with the work of Domowitz and Steil [Brookings–Wharton Papers on Financial Services, 1999], who proposed that demutualized exchanges are superior to mutualized in governance.
In sharp contrast to the plethora of studies that examined the impact of corporate governance provisions adopted by manufacturing and service firms,1 there has been little research attention devoted to governance of stock exchanges. A notable exception is recent work by Domowitz and Steil (1999), who examine interrelationships between stock exchange automation, governance, and quality of markets.2 Traditionally, stock exchanges have been organized as non-profit, mutual/membership associations. A recent trend has been conversion of mutualized exchanges into publicly owned corporations, which are themselves listed and traded on a stock exchange. Domowitz and Steil (1999) list several benefits of demutualized as compared to mutualized stock exchanges. The primary driver for such benefits is the favorable governance structure associated with demutualized exchanges. Domowitz and Steil (1999) argue that members of mutualized stock exchanges have incentives to oppose innovations even if they increase the exchange’s value. Since traditional stock exchanges are mostly regional monopolies, they could, in the extreme case, even oppose enhancements to quality of services they provide if such improvements are thought to diminish the welfare of the respective exchange members.
One important implication of the Domowitz and Steil (1999) argument is that demutualized stock exchanges should provide a better quality market than mutualized ones. For expositional convenience, we refer to this implication as the “Domowitz and Steil Proposition”. Our paper’s primary focus is to examine the Domowitz and Steil Proposition using data from two competing stock exchanges in India, which differ in their governance structure – namely, the Bombay Stock Exchange and the National Stock Exchange. Direct comparisons of market quality in the two stock exchanges are facilitated by the simultaneous trading of at least 40 major stocks on both exchanges, with both utilizing similar trading systems. While prior studies have compared the quality of stock markets with different trading systems, reliable comparisons are, in fact, difficult to achieve.3 There exist two counterexamples to the proposition that good governance results in market dominance. Instinet and Tradepoint, despite being organized as for-profit firms, failed to capture significant market share from the floor-based NYSE and London Stock Exchange, respectively. 4 Given evidence suggesting that incumbency places entry barriers to potential entrants, the importance of stock exchange governance is an empirical issue.
Our study makes unique contributions to the literature. First, unlike previous studies to date, using transaction cost as the proxy for market quality, we compare the quality of two stock exchanges, which are similar in most respects except for their governance structure. Second, since our study is conducted in an emerging market setting, it has policy implications for other emerging markets.5 Third, our paper describes how advances in trading technology have implications for competition in the stock market trading industry. In particular, we show the importance of information technology in breaking down barriers to entry. It is extremely rare for an entrant to upset an incumbent exchange which makes it worthwhile to study the case of Indian stock exchanges. Finally, we draw policy implications for regulators who supervise “natural monopolies” such as stock exchanges.
The paper is organized as follows. Section 2 provides background information on Indian stock markets outlining the principal differences between the two stock markets analysed. Section 3 discusses the methodology used in this paper to compute transaction costs – our proxy for market quality. Section 4 describes the data; empirical results are presented in Section 5. The final section contains our conclusions.
The primary role of a stock exchange is to provide trading services to its ultimate
clients. Prior studies have concentrated on comparing the quality of markets with
different trading systems. Little attention has been paid to the critical issue of the
quality of markets and stock exchange governance. A recent trend has been in the
demutualization of stock exchanges, ostensibly, to better deal with emerging competition
from electronic trading networks. In a recent paper, Domowitz and Steil
(1999) provide convincing arguments in favor of demutualized exchanges. They reason
that members of a mutualized exchange have incentives to oppose innovation
that increase the quality of its services, and hence the value of the exchange, while
stakeholders of a demutualized exchange, are likely to favor any measure that enhances
the value of the firm.
We examine the Domowitz and Steil proposition using data from a large emerging
market, namely, India, which has two major exchanges with distinguishably different
organizational structures. The National Stock Exchange uses a demutualized form
of organization unlike the Bombay Stock Exchange, which continues to pursue
the mutual structure. Consistent with the Domowitz and Steil proposition, we find
that National Stock Exchange has a better quality market as compared to Bombay
Stock Exchange based on the market quality measure derived by Hasbrouck (1993).
Multivariate regression results indicate that superior governance of NSE is at least
partially responsible for its better market quality. Better governance, incorporation
of the latest technology, and governmental support, are major factors that jointly
contributed to NSEs superior market quality as compared to BSE.
This study has implications for emerging markets where regulators do not have
sufficient experience or influence in dealing with recalcitrant monopolists. Competition
has been shown to be more effective than regulatory dictates in transforming behaviour
of members on the Bombay Stock Exchange. Economic incentives are likely
to be more potent in transforming rent seeking behavior than directives from policy
regulators.
The role played by technology in transforming Indian stock markets is particularly
evident. Applying the latest technology, the National Stock Exchange was able to
penetrate barriers to entry in the stock-broking industry, which had the consequent
benefit of reducing the cost of providing these services. Being able to pass on lower
trading costs to investors, the National Stock Exchange posed a serious threat to the
existence of the oldest exchange in India, namely the Bombay Stock Exchange. That
technology is responsible for breaking barriers to entry and for dramatically improving
quality of markets in Indian stock exchanges is unequivocal.
