For obtaining fairplay in the working of the market economy, one basic concept is the distinction between players and playing fields. We want many players to compete in an open and fair marketplace, but we need to be cautious about the behaviour of people who own, run or control playing fields.
Financial exchanges and the traders who compete on these
Consider a stock exchange. The exchange runs the playing field. It has power over every player.
The exchange has levers, rooted in financial regulation, such as rules about collateral (who is required to place how much collateral) and enforcement against market manipulation (who is restricted in his actions and who is not). The exchange also has levers rooted in computer technology as the orders of all traders are sent to the exchange. If the exchange throttles orders coming in from one trader, this can exert a dramatic and adverse impact upon his profitability.
These are not hypothetical concerns. In the past, on numerous occasions, we have seen players try to obtain help from the exchange either in terms of special privileges for themselves or special harm upon their rivals. Many great scandals of Indian finance have their origin in malfeasance by the exchange.
Hence, players become extremely uncomfortable when the exchange gets involved in the game. When the exchange is open for business, where it can be co-opted to support some traders in exchange for certain kinds of gratification, this introduces a whole new complexity of strategic gaming where all major players try to woo the exchange to support their cause, and keep track of who the exchange is supporting.
The introduction of this game theory into financial trading is a waste of time and energy for society: traders should be looking at securities and their prices, and they should not care about the smooth functioning of the playing field.
From the viewpoint of the trader, when the exchange is open for business on collaborating with certain traders, this increase the risk of doing business on the exchange.
How this is addressed in advanced economies
These problems are sorted out in advanced economies through two tools. The first is to separate out regulatory functions from the normal for-profit activities of the exchange. As an example, when the New York Stock Exchange wanted to become a for-profit organisation, it separated out its regulatory arm into a non-profit organisation named NYSE Regulation.
The second key factor at work in advanced economies is the maturity of commercial law and the legal system. Advanced economies have well developed concepts of `tort law’ which covers the harm done by person 1 against person 2. This gives grounds for person 2 to ask for damages in court. The courts of advanced economies work efficiently and deliver punitive damages. This legal system helps keep the exchange honest. If trader 1 felt that the exchange was giving an unfair advantage to trader 2, he would sue and get punitive damages.
How we address this with exchanges in India
In India, tort law works poorly. While there are mature reform proposals for better functioning courts, at present, the practical fact is that trader 1 would not sue and would not win punitive damages on the scale of the harm that was caused to him by the exchange.
Hence, in India, the main strategy in the exchange industry has been a `three-way separation’ between the owners of an exchange, the managers of the exchange and the securities firms who are members of the exchange (and the entities regulated by the exchange). As an example, the owners of NSE or BSE are certain large financial firms and financial investors but not securities firms; the management of NSE and BSE is a distinct group of individuals (who have no ownership stake in NSE or BSE or in any of the securities firms) and the securities firms who are members of NSE and BSE have no role in either ownership or management of NSE and BSE. The managers of the playing field have no interest in the profit objectives of any of the traders that they have powers over.
The three-way separation appears like a harsh restriction, but it has worked surprisingly well. If exchanges were conflicted, and the regulator constantly engaged in intrusive interference, there would be all kinds of problems including ignorance and corruption at the regulator.
Three-way separation is a simple restriction, that’s easy to verify, and one that goes to the root cause of the problem by changing the very objectives of the managers of exchanges. It has has given fairplay in the working of securities exchanges in India.
This separation has been vigorously debated. Under the previous ownership, MCX used to claim that for-profit exchanges were a good thing, and pursued business strategies which blurred ownership, management and membership. After the NSEL crisis, the wisdom of three-way separation was widely accepted.
The draft Indian Financial Code (version 1.1) (also called IFC v1.1) has additional concepts that are relevant for this debate. Exchanges have powers akin to those of the State in their dealings with securities firms. Hence, IFC v1.1 insists that exchanges must operate through the rule of law. They must not restrict any player through arbitrary actions under the shroud of opacity: all their restrictions must be written down as bye laws, approved by the financial regulator, published on the exchange website, and applied equally to all players. No coercive action by exchanges against traders is permissible, under IFC 1.1, other than that authorised by these bye-laws.
Players and playing fields in the Internet age
When a telecom service provider (TSP) can throttle the traffic, or change the pricing for traffic, associated with a protocol or website, the TSP can be a king-maker in the Internet age. This is the power of a playing field. A lot of the above logic then applies.
Implication 1: Playing fields that do side contracts with players can have have an adverse impact upon the working of firms. Players become extremely uncomfortable when the TSP is conflicted. If the TSP can be co-opted to support some players, this would introduce a whole new complexity of strategic gaming where all major players would try to woo the TSP to support their cause. This would dramatically increase the risk of doing business in the Internet age.
Implication 2: At the minimum, there is a case for the government to impose rule of law requirements. If the playing field was going to use such arbitrary powers in king-making, then we would require laws which force transparency and rule of law upon TSPs. As with exchanges in IFC v1.1, TSPs should only operate through rules which are approved by TRAI, are published on the TSP website, and applied equally upon all players. Before a TSP can adversely impact upon the business of a startup, it should have to undertake due process; this cannot just be deal making in smoke filled rooms.
Implication 3: Net neutrality as fairplay. Net neutrality is the assertion that the business of running data pipes should be held separate from all activities that use the data pipes. Under net neutrality, TSPs would be free to compete with each other in dimensions of bandwidth, latency, and other characteristics of the service level agreement for data communications. But they would not be able to inspect the contents of data packets.
Implication 4: Let’s think beyond restricting TSPs to changing their objectives. At a conceptual level, it would be desirable if TSPs had no stake in content businesses. This would ensure that they have no conflicts of interest. Such restrictions are analogous to the three-way separation that is found with financial exchanges. If TSPs did, indeed, have an interest in certain kinds of content getting superior data communications, TRAI would need to have an extremely intrusive level of regulation, to observe all actions of the TSP and ensure that there is a true level playing field. A simple rule that holds the data comm business and the content business apart is preferable when compared with highly intrusive regulation.
Ajay Shah studied at IIT, Bombay and USC, Los Angeles. He has held positions at the Centre for Monitoring Indian Economy, Indira Gandhi Institute for Development Research and the Ministry of Finance. He now co-leads the Macro/Finance Group at NIPFP in New Delhi. He does academic and policy-oriented research on India, at the intersection of economics, law and public administration. His work can be accessed on his home page (http://www.mayin.org/ajayshah) and on the blog
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