Asian Perspectives on Financial Sector Reforms and Regulation

10. Indian Financial Market Development and Regulation: What Worked and Why?

253 In this chapter I look at the regulation and development of financial markets in India over the last two decades and attempt to identify the strategies and approaches that have worked, contrasting them to those strategies and approaches that have not worked. I hope that the lessons from the Indian experience will be of relevance to other emerging markets, particularly in Asia. Technology, Competition, and Regulatory Reform The success stories in Indian financial market development are characterized by regulatory reform, which unleashed competition and actively pushed rapid adoption of new technology. This description shares some similarities with Edward Kane’s model of how technology, regulation, and competition interact in determining the evolution of the financial sector.1 At one level it is possible to argue that the true benefits flowed from the adoption of disruptive technology rather than from the farsightedness of the regulator. Regulators who claim exclusive credit for themselves are a little like the traffic policeman who claims credit for the dramatic improvement in the quality of the cars that drive past him. Having said that, I think regulators do deserve part of the credit. First, they deserve credit for not allowing antiquated rules and regulations to stand in the way of new technology. Second, they deserve credit for creating a Indian Financial Market Development and Regulation: What Worked and Why? jayanth r. varma 10 1. Kane (1984). 12689-11_CH10-rev.qxd 10/5/11 12:32 PM Page 253 254 jayanth r. varma competitive landscape in which new technology is adopted even by firms that otherwise might not but are aware of the risk of being left behind by more nimble competitors. Third, they can legitimately claim some credit for providing a regulatory push toward the adoption of the new technology. Technology as the Enabler of Change Finance, more than most other industries, has benefited from information and communications technology. The raw material of finance consists less of tangible goods and more of money and information, which are readily digitized. Information technology is particularly powerful in fast-growing, emerging markets because it converts variable costs into fixed costs and therefore produces large-scale economies. Paper processing usually has low fixed costs and high variable costs, while electronic processing typically has high fixed costs (for the computing and communications infrastructure) but near-zero variable costs. Many of the success stories in Indian equity markets are associated with major shifts toward electronic processing. electronic exchanges. Electronic trading based on an electronic limit order book was introduced by the newly set up National Stock Exchange (NSE) in 1994 and was quickly copied by the other Indian exchanges. The capital market was previously confined to Mumbai (where the largest incumbent stock exchange, the Bombay Stock Exchange [BSE], was located) and to a few other centers , where smaller exchanges provided only low-quality execution. Within a few years, this situation gave way to a national market based on satellite communications , which abolished geographical barriers. Among the benefits were superior liquidity, greater transparency, and lower costs. Several aspects of this transformation are interesting from a reformer’s point of view. First, while the incumbent stock exchange, the BSE, had been discussing computerization for a long time, it had made no progress at all until the NSE commenced operations and started taking market share away from the BSE. The BSE very quickly adopted the electronic limit order book, halting the loss of market share. This highlights the importance of competition in the adoption of technology . Automated trading itself was nothing new: the Toronto Stock Exchange had introduced an automated system called CATS (computer-assisted trading system) way back in 1977. Fifteen years after that, the incumbent exchange in India had not made any steps to even experiment with this. NSE’s use of satellite-based communications to create a national market was a major innovation in the context of the underdeveloped telecommunications infrastructure in the country at the time, but the speed with which the BSE copied this shows that this too was not technologically overly complex. The major obstacles in the adoption of electronic trading were not technological but were embedded in regulation and in the industrial organization of incumbent exchanges. First, from a private-ordering perspective, it is important to note 12689-11_CH10-rev.qxd 10/5/11 12:32 PM Page 254 market development and regulation 255 that the NSE was created by a government institution, with strong...