Contemporary Concerns Study

The battle between the Bombay Stock Exchange and the National Stock Exchange
presented to: Prof. Ashok Thampy and the Jury

On 19 November 2008 by: Daan Struyven with significant support of and inspiration provided by Estelle Cantillon

Indian Institute of Management (IIM)

Bangalore

Table of content
1. 2. 3. Need for the proposed work and objectives:............................................................... 3 Literature review ......................................................................................................... 3 Genesis of NSE ........................................................................................................... 3 a. What were BSEs weaknesses before NSEs establishment? .............................. 3 b. What was the mid-term context for NSEs establishment?.................................. 3 c. What was the short-term trigger for NSEs establishment? ................................. 4 d. Policy response to the scam ................................................................................. 4 e. Chronology of NSEs genesis .............................................................................. 5 4. Relevant aspects of competition ................................................................................. 5 a. Impact of technology on transaction costs and access ......................................... 5 b. Governance & Management................................................................................. 6 c. Product scope. ...................................................................................................... 6 d. Geographical reach ............................................................................................... 6 5. Overview of key facts and figures over time for both exchanges............................... 7 6. Hypothesis and analysis ............................................................................................ 14 7. Conclusion ................................................................................................................ 21 8. Sources ...................................................................................................................... 22 a. Websites ............................................................................................................. 22 b. Databases ............................................................................................................ 22 c. Scientific articles ................................................................................................ 22 d. Interviews ........................................................................................................... 22 e. Other sources ...................................................................................................... 22 9. Appendices ................................................................................................................ 24 a. Literature review ................................................................................................ 24 i. E. Cantillon & P. Yin: Competition between exchanges................................ 24 ii. Christensen: The Innovators Dilemma .......................................................... 27 b. Indian financial sector in the beginning of the nineties ..................................... 29 c. Mehta scam ........................................................................................................ 30 d. Relevant aspects of competition......................................................................... 32

1. Need for the proposed work and objectives: The National Stock Exchange was launched in 1994. The NSE surpassed BSE in one year although the natural monopoly-character of the liquid stock market. This study aims to identify the reasons for this shift. 2. Literature review This study is related to literature on competition between exchanges, the literature on technology adoption and the literature on competition between networks. I read 3 papers including the study of E. Cantillon and Pai-Ling Yin: Competition between exchanges, Lessons from the Battle of the Bunds. This paper studies the determinants of traders exchange choice in the DTB-LIFFE case. I tried to incorporate its following aspects: The methodological steps: related literature, qualitative and historical description of relevant aspects of competition, key charts, model and hypothesizes, testing of hypothesizes and conclusion. The role of vertical and horizontal differentiation, access and product scope. 3. Genesis of NSE a. What were BSEs weaknesses before NSEs establishment? Since its foundation in the 1850s, BSE had always functioned as a club like regional exchange run by powerful groups of Gujarati operating with high margins, low transparency, bureaucracy and unreliable clearing and settlement systems. b. What was the mid-term context for NSEs establishment?1 Until the late 1980s Indian state dominated the inefficient financial sector. This led to rents captured by insiders dominating the market.2 Towards the end of the 1980s, new economic forces, the economic growth and currency crisis emphasized the need for modernization of the financial system. Government created the Securities and Exchange Board of India (SEBI) in 1988 whose reforms were blocked by BSE.

1 2

Based on Susan THOMAS -How the financial sector in India was reformed R. RAJANR, L. ZINGALES(1995). What do we know about capital structure? Some evidence from international data. Journal of Finance, 50, 14211460.

c. What was the short-term trigger for NSEs establishment? As shown on chart 1,the Indian stock market crashed in April 1992. Investors like Harshad Mehta diverted 35 Bn INR3 from the bank system via Ready Forward Deals to the equity market which they manipulated. Chart 1: The performance of Indias main equity index Sensex in 1991-1992:

Source: http://www.bseindia.com/histdata/hindices.asp

d. Policy response to the scam Minister of Finance Singh stressed prima facie evidence of a nexus between brokers and bank officials4 and the need to create competition between exchanges. He tapped the Industrial Development Bank (IDB)to take the lead of the project of creating competition for BSE.

Samir BARUA and Jayant VARMA,Securities Scam: Genesis, Mechanics and Impact, Journal of the Indian Institute of Management,18, no.1 4 http://parliamentofindia.nic.in/lsdeb/ls10/ses4/2004089210.htm -last access on 23rt October 2008
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e. Chronology of NSEs genesis NSE has been incorporated in November 1992. It started with trading on the Wholesale Debt Market in June 1994 and it launched the Capital Market Segment in November 1994. Table 1: Timeline of NSEs genesis
Event First proposal idea Mehta scam induced crash NSE Incorporation Managerial team in place Regulatory recognition as exchange Market design and B-plan readied Trading Debt Market Trading Equity Market Date June 1991 April 1992 November 1992 January 1993 April 1993 May 1993 June 1994 November 1994 Time elapsed (years) 0 0,8 1,3 1,5 1,8 1,9 2 2,3

Sources: NSE facbook 2007 and www.nseindia.com

4. Relevant aspects of competition a. Impact of technology on transaction costs and access5 Trading system. NSEs trading system was cost-efficient, order driven, electronic and based on satellites which reached locations all over India which resulted in a conversion rate6 of 90% vs. 30% for BSE, 4 times lower membership costs and spreads narrowed by 75%. Table 2 : Trading system timeline
Event Start electronic trading NSE Debt Market Start electronic trading system BOLT Launch website NSE Launch website BSE Launch online trading Launch online trading system(BOLT) Exchange NSE BSE NSE BSE NSE BSE Date June 1994 1995 May 1998 2000 February 2000 2002

Sources: http://www.bseindia.com/about/st_key and http://www.nseindia.com/

Customer oriented clearing and settlement. NSE reduced effective delivery lags from 1 month to +- 7 working days and eliminated counterparty risk with the establishment of NSCCL.
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Figures based on Tarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and Yours, HBS press (Penguin Asia) and http://www.businessweek.com/archives/1996/b3490154.arc.htm -access on 22th October 2008 6 In this context, conversion rate is defined as the percentage of orders which result in transactions.

b. Governance & Management Governance NSE. NSE started as a limited liability tax-paying company owned by public sector financial institutions with a management separate from owners and brokers. Governance BSE. BSE had always functioned as a club like run by powerful groups of Gujarati and Marwari businessmen7 with entry barriers to membership and governance. In 2005 BSE has been corporatized and demutualised.

c. Product scope. Today, both stock exchanges trade equity, bonds, options & derivatives. NSE first entered the bond and equity market in June and November 1994. NSE & BSE introduced simultaneously options and derivatives between June 2000 and November 2002. The O&D segment was contested from June 2000 until July 2001 before NSEs quasi monopoly. During the period of shifting, options and derivatives were not traded yet. Hence, product scope cannot be the uttermost factor explaining NSEs victory. Table 3: product scope timeline
Event Launch of Bonds Launch of Equity Stock Launch of Derivatives trading (Index futures) Launch of Derivatives trading (Index futures) Launch of Index Options Launch of Index Options Launch of individ. securities Options Launch of individ. securities Options Launch of individ. securities Futures Launch of individ. securities Futures Exchange NSE NSE NSE BSE NSE BSE NSE BSE NSE BSE Date June 1994 November 1994 June 2000 June 2000 June 2001 June 2001 July 2001 July 2002 November 2001 November 2001

Sources: http://www.bseindia.com/about/st_key and http://www.nseindia.com/

d. Geographical reach Access of brokers to BSE was restricted to Bombay until 1995 with the introduction of the Bombay Online Trading System (BOLT) system.

Tarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and Yours, HBS press (Penguin Asia)

5. Overview of key facts and figures over time for both exchanges Chart 2: Equity market share measured as share in total Indian equity turnover NSE increases its markets share-defined as NSEs average daily equity turnover divided by the sum of NSEs and BSEs average daily equity turnovers- from 2% in November 1994 to 59% in November 1995.

Sources: http://www.bseindia.com/about/st_key and http://www.nseindia.com/

Chart 3: O&D market share measured as share in total Indian equity turnover

Source: Prowess database and NSE factbook 2007

Chart 4: Market capitalizations of traded companies

Rather than obtaining listings, NSE announced from the beginning a list of stocks in which trading was permitted-which was facilitated by Indian law8. Since this list contained almost all the most valuable companies, market capitalizations for traded companies at each exchange are almost equal from November 1994 until now.

Sources: Prowess database and NSE factbook 2007

Ayay SHAH and Susan THOMAS, David and Goliath: displacing a primary market: How the start-up NSE surpassed Indias largest stock market BSE in only one year , Global Financial Markets, 2000
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Chart 5: number of traded/listed companies

In the beginning NSE opted for the system of permitting companies to be traded rather than being listed. Thats why data for the number of listed companies at NSE are only available since April 1999.

Sources: http://www.bseindia.com/about/st_key and http://www.nseindia.com/

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Chart 6: distribution of listing places

Source: Prowess Database

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Chart 7: number of members

For NSE, we have the yearly number of members from March 1995 until March 2002 after which we have monthly data until March 2007.For BSE, we have monthly data for 1994 and 1995 from the Key Statistics from the Mumbai Exchange for the year 1995 and from January 1999 until now from BSEs website.

Sources: http://www.bseindia.com/about/st_key ,http://www.nseindia.com/ and Key Statistics from the Mumbai Exchange for the year 1995

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Chart 8: city distribution of trade volumes in March 1995

Sources: Annual Report NSE 1995 and www.nseindia.com

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6. Hypothesis and analysis Chicken & egg problem Our research question gives rise to the chicken & egg problem: to attract investors and brokers, an exchange should have a large base of traded companies, but these will be willing to be traded/listed only if they expect many investors or brokers to trade. Scheme 1: the 4 actors at the core of the multiple market

Hypothesizes We can breakdown the research question: Why did NSE surpass BSE in 11 months on the equity segment of the stock exchange market? into 3 mutually exclusive9 hypothesizes: 1. NSE surpassed BSE primarily because NSE was more successful than BSE in attracting traded companies; 2. NSE surpassed BSE primarily because NSE was more successful than BSE in attracting brokers(category of intermediates); 3. NSE surpassed BSE primarily because NSE was more successful than BSE in attracting investors and traders ( category of end-users).

Theoretically, we could imagine that attracting 2 or even 3 of those actors is equally critical.

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Suppose now the 2nd hypothesis10 is true. Since not all the brokers started trading at NSE at the same moment (chart 7),one could wonder: Which types of brokers started trading at NSE first and why did they do so? To answer this question we have to: analyze sources of heterogeneity among brokers (SOH); understand key exchange decision factors for brokers (KEDF); analyze which key exchange decision factors convinced brokers to trade at NSE rather than at BSE. Scheme 2: three hypothesizes

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Similar reasoning for hypothesizes 1 and 3 can be developed.

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Hypothesis elimination There is some evidence for eliminating the 1st hypothesis since almost all valuable companies were double traded from day 1 and since the system of permitted trading allowed exchanges to trade shares without having to convince the companies to list. 2nd and 3rd hypothesis cannot be directly eliminated since the attraction of critical masses of brokers, traders and investors was relatively slow and since NSE and BSE were heterogeneous with respect to several key exchange decision factors for brokers and brokers.

Five stories According to the 1st story (vertical differentiation 1- economic factor liquidity), traders and/or investors with low liquidity needs were predominantly attracted by the fee structure and customer oriented clearing-, settlement- and dematerialization processes of NSE. Investors with high liquidity needs - being involved in high volume trades with high market-impact costs are the domestic institutional investors (banks, mutual funds, insurance companies) and FIIs. According to the 2nd story (horizontal differentiation 2- non economic factor ethnicity), non-Gujarati brokers, traders and/or investors with low needs to be part of the Gujarati financial community were predominantly attracted by the fee structure and customer oriented clearing-, settlement- and dematerialization processes of NSE. According to the 3rd story (vertical differentiation 3- dynamic economic and political factors), traders, investors and public policy makers with a important long-run financial and/or political interest to transform the Indian equity market into a competitive and attractive market were predominantly attracted by the fee structure and customer oriented clearing-, settlement- and dematerialization processes of NSE. According to the 4rd story (geographical access) traders and/or investors -who originally used brokers -became member of NSE because of the possibility to trade electronically outside Bombay. According to the 5th story (vertical differentiation- economic factor- arbitrage needs) traders and/or investors with high needs to participate in risk-free arbitrage

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transactions -occurring because of price differences for equal securities between BSE and NSE- were among the 1st to execute a part of their orders at NSE.11

In table 5 the idea is to formalize how exchange features can create and/or destroy investor value generated by a transaction in which an investor buys a security. The core idea is to breakdown the net present value generated by a security transaction into costs and incomes cashed and discounted over time. For the monetary costs, we illustrate that liquidity
(see chart 2)

and pricing policies

(see 4.a and 9.d)

impact customer value. For the non-

monetary costs, opportunity costs of time arise from the transaction ,clearing, settlement and dispute resolution
(see 4.a and 9.d).

On the income side, we distinguish on the one hand

cash-flows linked to the ownership of the security- which exchanges cannot impact- and on the other hand future incomes which can be expected to rise from better market conditions such as lower margins, lower spreads, etc. By buying a security at an exchange which offers those transformational perspectives competition is fostered. The discount factor depends on the one hand on the risk-influenced by the degree of coverage of counterparty risk by the clearing house
(see 4.a and 9.d).

- and on the other hand on the

timing of cash-flows influenced by the clearing- and settlement policies.

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Construction arbitrage cannot explain tipping because an arbitrage transaction generates the same volume on both exchanges. But significant volumes created a new market on both exchanges.

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Table 5 : Linkages between transaction value creation and features exchanges

NPV st nd rd building Element 1 Element 2 Element 3 Value Driver block Break-Down Break-Down Break-Down Total Cost monetary costs margin broker Price for broker Midmarket rate =price for investor 1/2 spread market impact- cost Exchange fee Clearing margin Non monetary Opportunity cost costs time transaction t/ succesf. order time/order Conv. rate t (clearing) t(settlement) unit price time Op cost t. (disp.) Total Income Y(ownership security ) Y(transf. market) risk risk (Y(own security)) risk (trans.)

Exchange Feature Liquidity Pricing Pricing Trad. system Trad. tech Trad. tech Clear. policy Set. policy Disp. Res. P. Tranf pers. technology risk policy Transf persp Set. policy Set. policy Set. policy

DCF

risk (non deli.)

non deli. rate

discount period

risk(Y(transf M)) avg t(Y own secur) avg t(deliv) Theo. t (deliv) avg t(delay)

delay rate Avg. cond. delay

Table 6: Legend for Table 5:

Abreviation avg. clear. cond. conv. deli. Meaning average clearing conditional conversion delivery Abreviation disp. M p. res. sec. Meaning dispute market policy resolution security Abreviation set. succesf. trad. transf. Y Meaning settlement succcesful trading transforming income

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Evidence for 5 stories The 1st story would be supported by data showing that: a) Initial liquidity12 and fees13 are lower at NSE; b) Brokers/investors with low liquidity needs -with small transactions-start trading at NSE (rejected since Indias biggest financial institutions were at the basis of NSEs creation. Moreover, interviews show that FIIS, investment funds and insurance companies shifted early). Because of lack of support by b), the 1st story is not the most plausible story. The 2nd story would be supported by data showing that: a) Initial liquidity and fees are lower at NSE; b) Share of Gujarati traders/investors in transactions at NSE is much lower than at BSE14. The 2nd story is thus supported by a) and b). The 3rd story would be supported by data showing that: a) Initial liquidity and fees are lower at NSE; b) Historical evidence proving the dynamic motives of the actors having created NSE to transform the Indian equity market to be better off in the long run;15 c) A dynamic financial/political model proving the positive net present value for NSEs main investor and public shareholding banks/policy makers like Mr. Singh to execute/encourage NSE transactions which are more expensive today than similar ones at BSE- knowing that this would contribute to the creation of longrun liquid, efficient and competitive Indian equity market- which would result in long-run positive impacts on future transactions. This model should also take into

Supported by chart 2: Equity market share on p. 7 assuming that NSEs lower initial equity turnover is a good proxy for its lower initial liquidity and higher initial market-impact cost. 13 Supported by part 4.a) on p.5 (and Tarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and Yours, HBS press (Penguin Asia) 14 Supported by paper Ayay SHAH and Susan THOMAS, David and Goliath: displacing a primary market: How the start-up NSE surpassed Indias largest stock market BSE in only one year , Global Financial Markets, 2000 and by interviews with Finance Phd students with trading experience Vishwesh MEHTA and Lakshman MUDDU. 15 Khanna confirms that the finance Minister Singh and senior decision makers of public banks like Nandkari, the chairman of IDBI, committed themselves to support NSE by providing liquidity to NSE in a coordinated manner in Tarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and Yours, HBS press (Penguin Asia).
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account the free-rider and coordination-costs problems. Game theory, finance and strategic economics could be combined provided sufficient data; d) Historical evidence proving the tremendous progress of the efficiency of the Indian equity market- equivalent to the long-run pay-out of the initial market impact cost investment16- and evidence for the control of the coordination problem17. Overall support for the 3rd story seems relatively strong. The 4th story can be supported by a snapshot on the 1st March of 1995 of the geographical scope of both exchanges.18NSE allows trade in 5 cities through 233 VSATS with already more than 50% of trade outside of Mumbai whereas BSE is still a monocity exchange. The 5th story is supported by literature. In the mid 90s huge volumes were due to arbitrage across the exchanges19. The initially large price differences- running up to 10 INR on a Reliance base price of 300 INR- resulted in very high net returns in a week between 1 to 3 % and then dropped because the risk free arbitrage attracted more and more participants.

The paper Susan THOMAS -How the financial sector in India was reformed gives an impressive overview of how reforms of the financial market led to higher transparency, higher liquidity, higher rate of diffusion of innovations, etc. 17 Government intervention- described inTarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and Yours, HBS press (Penguin Asia) has been dynamic factor behind the solution of the coordination problem. 18 See also chart 8: city distribution of trade volumes in March 1995, p.13 19 A. JOGANI,K. FERNANDES, Arbitrage in India: past, present and future, October 11, 2002
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7. Conclusion NSE surpassed BSE on the equity segment in only 12 months because of 4 main raisons. First of all, non-Gujarati traders and/or investors with low needs to be part of the Gujarati financial community were predominantly attracted by the fee structure and customer oriented clearing-, settlement- and dematerialization processes of NSE. Secondly, traders, investors and public policy makers with a important long-run financial and/or political interest to transform the Indian equity market into a competitive and attractive market were attracted by this potential to reshape the market and by the fee structure and the customer oriented clearing-, settlement- and dematerialization processes of NSE. Thirdly, traders and/or investors -who originally used brokers -become member of NSE because of the possibility to trade electronically outside Bombay. Fourthly, price differences attracted arbitrage traders who supported liquidity at both exchanges. On the other hand, we could wonder why order flow did not completely drop to nearly zero-levels20 once spreads at NSE were much more narrow. The strength of the relationships build during the former decades between intermediaries and investors is probably part of the explanation.

The synthesis is that the governmental intervention in this inefficient market was successful because of BSEs weaknesses (unfavorable transaction costs, customer processes and narrow geographical scope) and because of visionary market design-, technology- and governance innovations implemented by a strong NSE management.

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Which happenend in the DTB-liffe Case

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8. Sources a. Websites
www.business-standard.com www.financialexpress.com www.sebi.gov.in
http://parliamentofindia.nic.in/lsdeb/ls10/ses4/2004089210.htm www.nseindia.com http://www.bseindia.com/about/st_key http://www.businessweek.com/archives/1996/b3490154.arc.htm http://news.oneindia.in/2007/04/12/bse-receives-overwhelming-interest-for-41-per-cent-stake-1176386869.html

b. Databases
CMIE Prowess Database

c. Scientific articles
Samir BARUA and Jayant VARMA,Securities Scam: Genesis, Mechanics and Impact, Journal of the Indian Institute of Management,18, no. E. CANTILLON, P. YIN: Competition between exchanges: Lessons from the battle of the Bund.February 2008 B. CAILLAUD, B. JULLIEN: Chicken & Egg: competition among service providers. Rand Journal of Economics, Vol.94, No.2,Summer 2003 p.900-928 C.M.CHRISTENSEN: The Innovators Dilemma :When New Technologies Cause Great Firms to Fail, Harvard Business Review Press, 1997 A. JOGANI,K. FERNANDES, Arbitrage in India: past, present and future, October 11, 2002 R. RAJANR, L. ZINGALES(1995). What do we know about capital structure? Some evidence from international data. Journal of Finance, 50, 14211460. Kaolo RAO, The Banker, Asia: India - Decade Of Reform - India's Securities Went From Third To First World In Record Time. But Is T+1 A Step Too Far,.(T+1, securities settlement system), 2004 Susan THOMAS -How the financial sector in India was reformed Ayay SHAH and Susan THOMAS, David and Goliath: displacing a primary market: How the start-up NSE surpassed Indias largest stock market BSE in only one year , Global Financial Markets, 2000

d. Interviews
Interviews with IIMB Finance Phd students with trading experience ;Vishwesh MEHTA and Lakshman MUDDU on 15th and 25th of September 2008.

e. Other sources
NSE facbook 2007 Key Statistics from the Mumbai Exchange for the year 1995 Annual Report NSE 1995 Indias Securities Markets- A brief history, ABN AMBRO Publications, 2007SRINIVISAN, From brokers club to world-class exchange... -- BSE's tale of transition ,Business line investment World, 14 May 2000 VAIDYANATHAN, The Coming of Dematerialization- Business Line Financial Daily- 6 February 2000

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9. Appendices a. Literature review i. E. Cantillon & P. Yin: Competition between exchanges Introduction This paper studies the determinants of traders exchange choice in a famous 8 year-lasting episode. In this case the market for future on the Bund moved entirely from LIFFE, the incumbent London-based derivatives exchange, to DTB, the entering Frankfurt-based exchange. The paper tries to understand why both exchangestrading the same products- could co-exist although LIFFEs liquidity advantage. The starting point is that trader heterogeneity must be part on any explained since dynamic market share charts show that some traders shifted earlier than others. The paper builds a model of exchange membership choice that clarifies the relationship between the decision of where to trade and the decision of joining an exchange as member when membership is not required for trading. Relevant aspects of competition Firstly, the paper presents relevant aspects of competition. LIFFE is portrayed as a member-owned exchange open outcry exchange who launched automated trading in 1989. DTB is portrayed as member-independent exchange where trading was conducted electronically from establishment in 1990 where clearing was provided by DKV, a German company. DTBs volumes were very low until mid-1991 where leading German banks with a stake in DTB signed a Gentlemens agreement to support liquidity on DTB by acting as market makers. DTB and LIFFE competed in the product space by launching options, futures and new services such as simultaneous trading. DTB realized early that access of trading firms was critical. By signing agreements with the French exchange MATIF(1993) and the Dutch regulatory authorities (1994) and thanks to the Investments Services Directive(1996), EU-based trading firms could have remote access to DTB. Contrarily, LIFFE members were forced to have staff in London because of the open outcry feature of LIFFE for most of 1990s. Finally, the electronic trading versus open outcry-debate , the macroeconomically driven growth of the bund future market and mergers were also relevant aspects of competition.

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Exchange choice model In the exchange choice model, traders decide to be members of DTB, LIFFE, both exchanges or neither of them. Members are assumed to take choice decisions function of the profits of those 4 options. Membership profits consist of a fixed component- that does not vary with traders trading in the Bund-, a variable component, and an admission cost to the exchange. Variable profits are the product of traded volumes and profits per contract. The profits per contract depend on the average revenue on each contract, the transaction fee paid to the exchange, the margin deposited at the clearing house (which has an opportunity cost) and the impact cost which is negatively correlated with liquidity- and a broker fee paid if hes not member. This model has two distinctive features: exchange membership is not necessary to trade on a market and traders can become members of both exchanges. Four hypothesizes According to the 1st story (vertical differentiation), traders with low liquidity needs were predominantly attracted by the fee structure and market organization of DTB. According to the 2nd story (access and adoption costs), traders who originally used brokers become member of DTB because of the geographically determined access costs who decreased because of access deregulation in the EU and because of electronic trading at DTB. According to the 3rd story (horizontal differentiation 1), DTB was more dynamic in broadening its product portfolio. According to the 4rd story (horizontal differentiation 2- non economic factors), political nationalistic factors pushed German banks to trade on DTB. Data The novel panel dataset contains individual trading firms membership status at each exchange together with other firm characteristics, and pricing, marketing and product portfolio strategies by each exchange. The authors check to what extent the increase in membership of DTB is due to newcomers or to traders switching from DTB to LIFFE. Since newcomers chose DTB at a ratio of 4 to 1 and since the size of the market for exchange members increased significantly, the battle of the Bund is a story of newcomers rather than switchers.

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Cumulative distribution functions of the time at which groups joined DTB proof that the country (driving degree of access deregulation)and business type of the groups matter: German, Dutch and French groups who can have early access- and investments banks switch earlier. The empirical model contains several sources of variation. Traders vary by geographical presence, headquarter locations and business models. There are also three sources of variation over exchanges and time: (1) access deregulation (time-and country specific) , (2)exchange fees, margins, liquidity and volatility (time- and exchange specific) and (3) product scope (time- and exchange specific). The empirical model estimates the variables in the traders profit functions with a multinomial logit model wherein trading reoptimize every period. Geographically-determined access costs are highly significant and explain most of the variation in the data. Linking the results to the four stories For 1st story (vertical differentiation-liquidity), regression results show that traders took liquidity into account. However, which traders variable signals value for liquidity? For the 2nd story (access and adoption costs), the figures- showing that its a newcomers rather than a switchers story- suggest that DTBs success was due to its ability to attract new members and that this ability was related to deregulation. For 3rd story (horizontal differentiation 1),econometric results are mixed. For the 4rd story (horizontal differentiation 2- non economic factors), there is no evidence that German headquartered traders were biased in favor of DTB. Conclusions Liquidity matters but national regulation, product portfolio and user convenience all provide scope for differentiation. The battle of the Bund is a story of newcomers rather than switchers. Geographical presence is a key determinant of adoption time, and it is clearly linked to the timing of access deregulation. Lessons for this case: I would like to incorporate the following aspects of this excellent paper in my study: The methodological algorithm: related literature-> qualitative and historical description relevant aspects of competition -> key charts -> model and hypothesizes -> testing hypothesizes -> conclusion.

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 The role of vertical differentiation The role of access costs: NSEs remote access and the relative densities of the exchanges office networks across India The role of product scope: NSE market domination in the O&D segment is overwhelming The role of service scope: NSE has always been 1st mover in IT-applications and user convenience Interview sessions with E. Cantillon, Lakshman Vijay Muddu21 and Vishwesh Mehta, highlight the following extra dimensions and/or differences: A multiple stock exchange is three-sided market linking not only traders and investors but also listed companies. The inefficiencies before NSEs entry which were the trigger for the governments intervention to open the market The role of official and unofficial membership requirements: the Gujarati- and club-based membership model of BSE vs. the open model of NSE The role of dematerialization, technology and the clearing- and settlement agencies as key drivers behind NSEs cheaper, faster and more efficient service a. Christensen: The Innovators Dilemma Objectives and introduction Christensen wants to solve the puzzle of why well managed companies that are competitive, listen to their customers and invest aggressively in new technologies- fail to stay atop their industries when they confront certain types of markets and technological changes. His research began with a study of the collapse at the end of the 80s of Digital Equipment, the leading manufacturer of minicomputers. The decisions to consider Unix as unimportant and to consider the personal computer as an architecture not to worry about led to the demise of this company and were made when everyone thought that is was one of the best run companies in the world. Threat, opportunity of disruptive technology The disruptive technologies model has three pieces. The first concept the performance that customers can absorb- suggests that there is a trajectory of improvement in the product or service that the customers can

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absorb over time. This line is a distribution of customers around a median that varies from demanding customers to undemanding customers. The second concept- the improvement trajectory- is a separate trajectory of improvements that innovators make available by introducing new and improved product generations generation after generation. This curve slopes upward faster than the ability of customers to absorb it: companies targeting demanding customers often overshoot their customers absorptive ability. The third concept relates to the difference between sustaining technological improvements and disruptive technology. Sustaining technologies make much better products for the best customers that could be sold for higher margins. Disruptive technologies bring to the market something that is worse, in terms of performance valued by the mainstream customers. Disruptive technologies are simple and missed by established companies because their customers dont use them. Management of sustainable and disruptive technologies The successful use of disruptive technologies begins in the low-end, low-profit market segments and then moves as quickly as possible into the mainstream markets by coming in at the bottom of the markets in terms of desirable niches of the mainstream market. Examples of disruptive technologies are minimills in the steel industry, self-administered distance education programs and internet telephony. When new, disruptive technologies are first on the horizon, there are two strategic tracks that can be taken in commercializing those technologies. The first track is to stretch the technology until it can be used in the existing market segment, with existing customers. The second track is to find or create a new market segment. Those companies know the technology is not good enough, but they create a market that will value the attributes of the technology as it exists today. Only companies who follow the 2nd track succeed. The ability of on organization to succeed using disruptive technologies depends on whether or not corporate resources, values and processes give the organization capabilities to properly frame the question of whether the disruptive technology is a marketing rather than a technological problem. The probability of a company surviving one of these transitions by trying to address it from within the main company, or somehow by trying to change the main company so it

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can be competitive in the next wave, is zero. However, successful cases such as the creation of a separate IBM pc organization and the shifts from Charles Schwab over Merrill Lynch to E-trade prove that setting up a new organization rather than trying to transform the old one can allow the established groups to stay at the top in their profoundly changed market.

Lessons for this case Electronic trading could be considered as a disruptive technology for which challenger NSE creates a new market for traders and investors outside Mumbai. The technological aspect in this case should not be neglected. Nevertheless, analogy is not complete since BSE in 1994 could not be considered as a well managed company for which Christensens theories explain failure. b. Indian financial sector in the beginning of the nineties Until the late 80s Indian state dominated the inefficient financial sector through22: Outdated state-owned banks; the enforced purchase of government bonds for banks, pension funds and insurers; the absence of a developed derivatives market; control of financial transactions by the RBI( setting interest rates on various products) and the Ministry of finance (price control at security issuing); entry-barriers in sectors of banks, mutual funds, brokerages firms, insurance company and securities exchanges; capital controls such that Indian households and companies had to limit their funding to the domestic market; This inefficient way of organizing markets in emerging economies-which are especially vulnerable to the risk of being captured by vested interests 23- led to rents captured by insiders dominating this market.

22 23

Susan THOMAS -How the financial sector in India was reformed R. RAJANR, L. ZINGALES(1995). What do we know about capital structure? Some evidence from international data. Journal of Finance, 50, 14211460.

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Towards the end of the 1980s, new economic forces emphasized the need for modernization of the financial system: 1. The higher economic growth and boom in IPOs underscored the limitations of the BSE club-based market practices; 2. The balance of payments crisis in 1990 pushed policy makers to attract FDI and portfolio flows by making market design more appealing to Western investors. Both financial institutions and policy were facing the dilemma of choosing between creating new institutions and reforming existing ones. When Mr. Manmohan Singh came to Government in June, 1991 he appointed within a few weeks the Narasimhan Committee to look into the financial aspect when he was introducing his macro-economic restructuring24. The problems in the secondary equity market liquidity led domestic financial institutions to create the Over the Counter Exchange of India,Ltd (OTCEI). OCTCEI was inspired by the NASDAY system of using multiple, competing market makers.25 This national market trading shares that had very low liquidity on BSE was unable to create a liquid market. This case showed that international market design cannot always be transplanted and raised the level of complacency among the incumbent exchanges and brokers.26 Government created the Securities and Exchange Board of India (SEBI) in 1988. The independence and the clear and sole focus on regulation of securities markets were the first modern elements in Indias financial architecture. SEBI imposed some focused reforms reducing freedom of existing exchanges (e.g.; unbundling the brokerage free from the price for a share when a broker issued a contract note to a customer). Those reforms were blocked by BSE which persuaded policy makers that incremental reform was not feasible and that a new exchange should be created c. Mehta scam The short-term trigger for the creation of NSE was the Harshad Mehta scam.in 1992. This scandal led to the crash of the Indian stock markets in April 1992. Harshad
24 25

http://parliamentofindia.nic.in/lsdeb/ls10/ses4/2004089210.htm -last access on 23rt October 2008 Susan THOMAS -How the financial sector in India was reformed 26 Susan THOMAS -How the financial sector in India was reformed

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Mehta poster boy of the new can-do attitude of the Indian investor27- and other brokers had manipulated the Indian banking system to siphon off the funds from the banking system and builded large stock positions. They diverted funds to the tune of over 35 billion INR28 from at least ten major Indian commercial banks, foreign banks like Citibank, Standard Chartered PLC and ANZ Grindlays and the National Housing Bank-which is a subsidiary of Reserve Bank of India- during the period April 1991 to May 1992. The used mechanism was the Ready Forward Deal (or repurchase agreement); in essence a secured short term inter bank loan done against government securities. Normally, the borrowing bank sells the securities to the lending bank and buys them back at the end of the loan period at a higher price-which represents the interest on the loan. During the scam the RF was transformed from a secured inter bank loan to a unsecured loan to a broker by three crucial steps: i) ii) iii) The intermediation of a broker in the settlement process; The crediting of the brokers account; The persuasion of the lending bank to dispense with security for the loan by the broker. The money would have gone to share purchases by Mehta and the equally powerful bear cartel, represented by Hiten Dalal,A.D. Narottam and others, to bribes and to foreign currency purchases. The immediate impact of the scam was a sharp fall of the share prices (Sensex decrease of 35% in 3 months between the peak on 1st of April and 1st July); a market capitalization loss of 1000 billion INR. Technically speaking, scam resulted in withdrawal of 35 billion INR, which is a relatively small amount with a little impact on prices. But the phenomenons of tainted shares and perceived slow down in reforms were the two main raisons for the fall. Policy response to the scam Government reacted by discovering and punishing the guilty, recovering the money and investigating more radical financial reforms. The task of discovering and punishing the guilty had been allocated to the Central Bureau of Investigation and the
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Tarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and Yours, HBS press (Penguin Asia) Samir BARUA and Jayant VARMA,Securities Scam: Genesis, Mechanics and Impact, Journal of the Indian Institute of Management,18, no.1

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Joint Parliamentary Committtee which affected people -holding key positions in the India's financial sector29. In parliament, Minister of Finance Singh stressed prima facie evidence of a nexus between brokers and bank officials and the need to create competition between exchanges as it is the case in China where the new stock exchange in Chenzen allowed computerized transactions and the state exercising a highly regimented control on the listing of companies.30 Government tapped the Industrial Development Bank to take the lead of the project of creating competition for BSE. The Industrial Development bank of India (IDBI) was a government-owned institution dedicated to providing long-term finance in India. Nandkari, the chairman of IDBI, asked Ravain Narain- now managing director and CEO of the NSE- and 4 other employees of IDBI to build this online exchange rapidly. Among those who drew up the blueprint for the National Stock Exchange (NSE), was-besides Narain- R H Patil, a development banker who later became the NSE's founder chairman. "Our mandate was to set up a nationwide securities exchange that would offer modern trading facilities across the breadth of the country," he says. A Hong Kong-based consultant was appointed and in eight months the plan was ready31. Intelligentsia and BSE brokers who called the new exchange the sarkari share bazaar (government stock exchange)were confident that NSE would put no challenge because exchanges are not about technology, they are about people32. d. Relevant aspects of competition Trading technology NSE has been systematically 1st mover in the technological field by introducing respectively: Satellite and terminal- based real-time trading outside Bombay from day 1; A website in May 1998; Online trading in February 2000. NSE received several awards rewarding its IT performances:
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Including K. M. Margabandhu, then CMD of the UCO Bank who was arrested and V. Mahadevan, one of the Managing Directors of Indias largest bank, the State bank of India who was had to quit his job. 30 http://parliamentofindia.nic.in/lsdeb/ls10/ses4/2004089210.htm -last access on 23rt October 2008 31 Kaolo RAO, The Banker, Asia: India - Decade Of Reform - India's Securities Went From Third To First World In Record Time. But Is T+1 A Step Too Far,.(T+1, securities settlement system), 2004- http://goliath.ecnext.com/coms2/summary_0199-95177_ITM -last access on 23rd October 2008 32 Tarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and Yours, HBS press (Penguin Asia)

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 Award for 'Best IT Usage' by Computer Society of India in 1996 & 1997 Dataquest Award for Top IT User in 1996; Cyber Corporate of the Year Award in 2008 CHIP Web Award by CHIP Magazine in 2009. Trading system The key characteristics of the trading system at the NSE were the following: Trading was order-driven and orders were placed in an electronic central limit order book Satellite technology was used to reach locations all over India from a central trading computer located in Bombay The tick size was uniformly set at INR 0.05 for all stocks. The decision to be order-driven was controversial because of 2 reasons. The 1st reason concerns both national (BSE, OTCEI) and international (NYSE, LSE, ) prevalence of quote-driven exchanges. Secondly, quote-driven markets reduce the risk of buyers and sellers not finding counterparts in a timely fashion in illiquid securities. But the symmetry among all agents and the elimination of market dealers and their complex monitoring were determining factors for NSE to go for a order-driven market in the aftermath of the scam. NSE chose very small aperture terminals (VSATs) for satellite-based communications as distribution channel. Reliability and flexibility in deployment were main drivers for this technological choice. NSEs current Managing Director explains the necessity to set up an own telecom company: There was no viable telecom infrastructure on the basis of which a state-of-the-art exchange could be launched. We obviously could not rely on terrestrial lines.33 Equipment and software from vendors in the U.S., Canada, France and Israel were put together in a consortium led by Tata Consulting Services. Investors had real-time access to a single screen through the VSAT network which as linked to the computers in brokers offices. Knowing the exact time and price of each transaction reduced uncertainty and transactions costs. This electronic trading resulted in

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Tarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and Yours, HBS press (Penguin Asia)

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a conversion rate of 90% in sharp contract with the 30% conversion rate for BSEs openoutcry 30% conversion rate. Since BSE had to react, BSE installed all the equipment needed by brokers offices, including the VSATs, antennas, Uninterrupted Power Systems and other internal connections.34. It started to operate the Bombay Online Trading System (BOLT) which was still restricted to Bombay, a far cry from NSEs national reach. The tick size on the BSE ranged from Rs.0.25 to Rs.1.00. BSE members lobbied for large ticks in order to maximize spreads. In order to favor the interests of NSE chose a uniform tick size of Bs.0.05 for all stocks. Clearing system Clearing consist of checking that both sides agrees with the exchange records and can consist of netting of trades. Futures-style settlement involves significant counterparty risk. On the BSE, counterparty risk was handled by appealing to the ethnicity that linked the BSE members. Delays were accepted and collective accommodating loans were granted to the member in distress. This practice was harmful to investors and new brokers. In NSEs first months, no alternative to this ethnical-club-like-solidarity-system was provided. But the National Securities Clearing Corporation (NSCC), a wholly owned subsidiary of the NSE, was created in April 1996. NSCC requires collateral in the form of initial margins and mark-to-market margins. As counterparty to the net settlement obligations of all brokers, it fulfills those obligations in the case of a brokers default. Today, trades are guaranteed both by NSCCL and the Bank of India Shareholding (BOISL) and each exchange assumes the counter-party risk of each member.35 Settlement system Settlement is the actual delivery of cash and securities. Before NSEs entry, BSE followed an account period system in which transactions made in a single account during each two week trading period were netted.

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Tarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and Yours, HBS press (Penguin Asia) Indias Securities Markets- A brief history, ABN AMBRO Publications, 2007

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In practice, trades were netted over a month because of the system of badla and administrative delays In addition, 6900 of the 7000 shares traded were not settled centrally through the Clearinghouse but bilaterally between BSE members, which increased the administrative complexity and settlement risk. It took from one to three months before share selling price amounts were obtained. In 1994 NSE opted for a netting period of one week, using physical share certificates, with a highly efficient implementation. The money- equivalent to the net open position at the end of the week- was obtained with a lag of 5 working days after netting and thus a total lag of 5 to 10 working days. Since April 1996, The National Securities Clearing Corporation (NSCCL) determines the funds/securities obligations of members and ensures that trading members meet their obligations. In 2002, SEBI obliged all listed securities- both at NSE and BSE- to be settled on a rolling T+5 basis and the Account Period settlement was discontinued . Initially BSE was opposed to the introduction of this rolling system and preferred a modified system of badla to suit the rolling settlement system. Managing Director Rathi favoured the introduction of the rolling settlement only with adequate supportive tools that would ensure liquidity in the market-place.36 Since 2003, all securities are settled in a T+2 rolling settlement. On the trade day, NSCCL (in the case of NSE)/the Clearing House (in the case of BSE) notifies the trade details to clearing members and custodians. The custodians affirm the trades to NSCCL/The Clearing house by day T+1 which nets the position of counterparties do determine their obligations. The transfer of securities/funds is done on day T+2. Dematerialization The introduction of dematerialized trading was the precursor to the next big changes- rolling settlements and paperless trading.37

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SRINIVISAN, From brokers club to world-class exchange... -- BSE's tale of transition ,Business line investment World, 14 May 2000
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VAIDYANATHAN, The Coming of Dematerialization- Business Line Financial Daily- 6 February 2000

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The holding and trading securities in paperless mode was an alien concept in India before 1995. As the FIIs complained about the paperwork as a major constraining factor, the government and SEBI passed the Depositories Act in 1996 was passed and the NSE launched the National Securities Depository Ltd (NSDL). NSE started dematerialized trading and settlement in December 1996.But the depository concept did not gain popularity because of the lack of liquidity. Therefore SEBI made demat trading in stock mandatory in phases. Governance Governance NSE The NSE started as the first public sector exchange in the world. The governance structure adopted at the NSE differs from the BSE model along 3 dimensions 1.Ownership: The exchange is a limited liability tax-paying company owned by public sector financial institutions, particularly the Industrial Development Bank of India (IDBI).38 The government-owned IDBI played a leading role in the establishment of the NSE. The chairman of IDBI - Nandkarni - served as the chairman of the NSE, and the task of building the NSE itself was handed to a team of five that left IDBI for this purpose. Nandnkarni gave full power to Narains team and he urged them to go do this, do it quickly and dont tell me what youre doing.Ravi Narain became Managing Director of NSE. As an MBA from Wharton, he was an unusual choice.39 2. Management: The shareholders appoint a board of directors and a management team. Brokerage firms do not own the exchange and are represented neither on the board of directors nor the management team. This means that while BSE elected one of the brokers to administer the exchange, the NSE was run professionally by a Managing Director.40 At NSE the principles of separation between management and ownership and value-maximization are reflected by this governance form. 3. Role brokers: Brokerage firms are franchisees of the exchange and express their views

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Tarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and Yours, HBS press (Penguin Asia) 40 Tarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and Yours, HBS press (Penguin Asia)

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through membership on a variety of Exchange-appointed committees working on such things as market design and dispute resolution. By opening barriers, brokers were no long assured of fat-cat profits, but where disciplinized by fair competition.

Governance BSE Before NSEs entry, BSE had always functioned as a club like run by powerful groups of Gujarati and Marwari businessmen41 with entry barriers to membership and governance. In 2005 BSE has been corporatized (from an Association of Persons) and demutualised under the provisions of the Companies Act, 1956, pursuant to the BSE (Corporatization and Demutualization) Scheme, 2005 notified by the Securities and Exchange Board of India (SEBI). Core points of this demutualization scheme are: Voting rights of trading shareholders are restricted to 5%; Trading members representation in Board may not exceed 25%42; The CEO has to be ex-officio director43; Rights trading shareholders should rank pari passu with trading rights other members44

In April 2006, the remaining 41% was sold to international and national institutional and individual investors with overwhelming interest.45

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Tarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and Yours, HBS press (Penguin Asia) 42 Nevertheless, from table 4 we imply that 3 out of 9 directors are trading member directors. 43 http://www.sebi.gov.in/stkexchange/BseCorpDMut.html - last access on 26th October 2008
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http://www.sebi.gov.in/stkexchange/BseCorpDMut.html - last access on 26th October 2008 http://news.oneindia.in/2007/04/12/bse-receives-overwhelming-interest-for-41-per-cent-stake-

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1176386869.html - last access on 26th October 2008

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Table 4: BSE Board of Directors

Non-Excecutive Chairman Mr. Jagdish Capoor Chairman, HDFC Bank Limited Public Interest Directors Mr. Jitesh Khosla Joint Secretary, Ministry of Corporate Affairs, Govt. of India Mr. S. N. Menon - IAS (Retd.) Chairman, Nicco Parks & Resorts Limited Shareholder Directors Mr. Ishaat Hussain Finance Director, Tata Sons Limited Mr. Vivek Kulkarni - IAS (Retd.) Chairman and CEO, Brickwork India Pvt. Ltd. Mr. Sudipto Sarkar Senior Advocate, Kolkata High Court Trading Member Directors Mr. Prakash R. Kacholia Designated Director Emkay Global Financial Services Limited Mr. Balkishan Mohta Mr. Siddharth J. Shah Designated Director J.G.A. Shah Share Brokers Private Limited

Product scope Today, both stock exchanges trade equity, bonds, options & derivatives. NSE first entered the bonds market in June 1994. Then NSE wanted to compete with BSE in equities trading-which it launched in November 1994. Rather than obtaining listings-which involved delays and the risk of non-persuasion- of the firms- the NSE chose to permit trading in the 1200 most liquid stocks. Gradually, NSE obtained significant income-generating listings. For the options & derivatives, NSE & BSE introduced simultaneously index futures, index options and options and futures on individual securities between June 2000 and November 2002. The O&D segment was heavily contested with capricious market share jumps from June 2000 until July 2001. Since July 2001, NSE has always dominated the O&D market with market shares above 90%.

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Service scope BSE has been the first exchange in selling information products and providing financial trading. More recently, NSE innovated by launching a NSE research unit and 18 media channels in joint venture with CNBC.

Table 5: service scope timeline

Event Launch selling information products Launch selling information products Launch Training Institute Launch Training in Financial Markets Launch of NSE Research Launch of NSE-CNBC TV 18 Media Centre Exchange BSE NSE BSE NSE NSE NSE Date Since 80s 1994 1989 July 1998 February 2000 January 2007

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