Capital market reforms in India have far outstripped the process of liberalisation in every other sector of the economy. In fact, barring issues such as the residual problems of paper-based trades, the lag in bank automation and the absence of derivatives trading the Indian securities trading infrastructure compares with the best in the world --- and in some respects is even better.

A careful study of stock market reforms indicates that in India, it was not the capital market regulator or the government, which drove the change towards automated trading systems and modernisation of stock exchanges. The National Stock Exchange (NSE), a mere market intermediary, through example, demonstration and sheer success forced a swift and relentless pace of change in the markets.

A new watch-dog:

The pace of reforms has been so dramatic, that it is almost difficult to recall that less than five years ago, the picture of stock trading in India was one of sweaty, raucous jobbers jostling to conduct trades in the crowded trading ring of Indias oldest stock exchange. As the NSE completes five years of operation, it is interesting to examine the process of change that ended the saga of broker defaults, counter party risk, low liquidity, delayed settlements and frequent closures, which were the hallmark of Indian bourses and their antiquated trading systems.

The creation of an independent capital market regulator was the starting point. It laid the grounds for experimenting with a professionally managed stock exchange. When the Securities and Exchange Board of India (SEBI), under chairman G.V.Ramakrishna, began to draw attention to malpractice on the bourses and demanded better regulation, discipline and accountability it led to a tremendous storm of protest from the brokers and only underlined the need for a professionally run alternative.

Around that time a committee headed by M.J.Pherwani, until then the darling of the brokers, recommended, among other things, the creation of a second stock exchange in Mumbai called the `National Stock Exchange. Once again, this let off howls of protest from the trading community, but over time, the continued recalcitrance of brokers and their intemperate protests against SEBI led to the establishment of the NSE.

Whatever the public posture of support with regard to the NSE, neither government nor the regulator expected it to be more than a threat to the Bombay Stock Exchange (BSE) forcing it into accepting regulatory supervision and modernise its systems. Nobody certainly expected the NSE to emerge as a clean and efficient nation-wide trading system providing investors in 280 cities direct access to a single, safe and transparent system.

A stymied start:

The BSE those days was dominated by a broker coterie whose power lay in its ability to dominate trading across bourses in Calcutta, Ahmedabad and elsewhere. The BSE had begun the process of automation in the early eighties, under the leadership of Executive director M.R.Mayya and President Mahendra Kampani. In fact, the duo had gone so far as to decide on the specific computer system that the BSE would buy. But, the broker coterie simply forced it to drop the move, fearing that automation and transparency would end their dominance. The process was revived only after the NSEs turnover crossed that of the BSE and continued to rise relentlessly.

NSEs biggest break was probably the fact that nobody expected it to succeed. The broker community had successfully perpetrated the myth, that "technology does not build markets, it is brokers who build markets". They claimed, and even believed that only brokers understood the complicated mechanics of stock trading and they alone could run bourses. This complacency had two positive consequences: the BSE, by refusing to change, allowed the NSE to set the agenda for change in the capital market without pressure, threat or interference. Since nobody gave the exchange more than a fighting chance of survival, no one coveted the top jobs and this set the stage for six honest and dedicated professionals to take on the challenge of creating a new exchange.

The team first discarded the concept of a National stock exchange as proposed by the Pherwani committee report except for its name. It chose instead a truly national exchange which provided simultaneous investors across the country access to a single screen through a VSAT* network. A system which documented the exact time and price of each transaction ensuring vastly improved transparency.

Ravi Narain, Deputy Managing Director of the NSE says that low expectations from the bourse allowed the team to take "humongous risks". S.S.Nadkarni, then chairman of the Industrial Development Bank of India (IDBI) and the NSE, allowed the team complete freedom to decide on the systems and structure. All he did was to "check every now and then if everything was going well".

Trading on the NSE took off on November 4, 1994 amidst predictions that it would soon fail. The faceless automated trades of its system had none of the drama and excitement of an open outcry system. The VSAT based system will never work, one was told. Wait until the first settlement has to be completed, said brokers. A bunch of 'sarkari' development bankers will never be able to conduct a weekly settlement, leave alone one at multiple locations, they said.

When the exchange refused to oblige by collapsing, the dire predictions were postponed to the time when turnover would increase. At the newspaper that I worked for, not a single day passed without calls from brokers announcing perceived and potential failures of the NSE. Some savvy investment analysts even said that NSE's very transparency and efficiency would be its undoing. Nobody in India wants a clean and transparent market-- it will have to provide an avenue for investing ill-gotten money, they argued.

New Brokers and small investors:

Institutional investors, including those who helped promote the exchange had as little confidence in its future as the rest of broker community. The NSE had assumed that at least a portion of institutional business would be directed towards it - this did not happen. Even foreign investors, who had never lost and opportunity to ridicule and speak disparagingly about our primitive trading systems took a real long time to shift their trades to the new exchange. Some explained that it was because they only had BSE brokers on their approved panels.

NSEs main support base came from new brokers who couldn't get on to the BSEs limited membership and from small town investors who had no direct access to the market. The latter group was tired of waiting for nearly three days to get a trade confirmation, usually at the worst price of the day. Another volume booster was the opening up of arbitrage opportunities between the NSE and other exchanges; these alone accounted for a big chunk of trading.

Predictably, trading picked up very slowly. After six months of existence, NSE chairman S.S.Nadkarni asked the team --"Are you ever going to cross into double digits?" The BSE turnover was then a grand Rs 100 crore per day. It slowly became clear that the NSE was not going to go bust and that weekly settlement on a nation-wide basis was possible. Turnover then began to grow at a spanking pace. From single digit turnover for six months, the NSE turnover crossed that of the BSE on November 5, 1995 exactly a year and a day after it began operations. One significant reason for NSE's growing turnover was the rate of order conversion. In the open outcry system conducted for barely two hours in a trading ring, just about 30 per cent of the orders were actually converted into trades. The automated system raised this to a whopping 90 per cent.

The NSE clearing corporation proved for the first time that not only were weekly settlements possible but could be conducted with clockwork efficiency out of four clearing houses across the country. The settlement procedure was followed by ruthless auctions to ensure that delivery and payment schedules were not messed around with. This has to be seen in the context of the BSE insisting to the then SEBI chairman G.V.Ramakrishna that weekly settlements were impossible for any exchange to handle. The BSE those days had a fortnightly settlement cycle and even these were always so off schedule that it was fairly routine for two or three settlements to be clubbed together.

This was the turning point. As NSEs turnover continued to grow, the BSE launched a blitzkrieg of criticism, cried unfairness at NSEs national operations and continued to predict potential defaults and collapse of the NSE at every new trading milestone. But nobody missed the writing on the wall. With the BSE's own member acquiring NSE memberships, its leadership realised that it either had to shape up, or wither away. It took the smart option and began to implement its own automation programme in a big hurry and spruce up its administration to conduct its own weekly settlements without anymore clubbing, delays or glitches. The NSE continued to find ways to make the market fail-safe.

Writing in the safety factor:

As NSEs turnover began to shoot up, the larger trades and order conversion also increased market risk. The next agenda was to introduce fool-proof risk containment measures. Unlike international bourses, the NSE had to rely as little as possible on the slow and stodgy legal system for redressal of issues related to broker default or fraud. The choice was to go for multiple risk containment measures borrowed from different types of markets. It forced members to be adequately capitalised by imposing high net worth requirements. This attracted corporate members and allowed it to get away from the dominance of the "fourth generation family broker model". Next, it introduced a centralised insurance cover for all trading members, in June 1995. An online risk monitoring system, which was introduced in January 1997, was a big innovation. Over a period of time it began to track open positions in real time, not merely at the end of the day. Brokers who crossed their exposure limits are immediately and automatically logged out of the system without any scope for bias or favour. They are re-connected as soon as they permit the exchange to close out their excess positions or bring in additional margins. When trading volumes began to approach the Rs 1000 crore a day level, NSE decided to tighten up security even further, by borrowing the concept of settlement guarantees from the options and futures exchanges, of Chicago. The settlement guarantee was provided through the National Securities Clearing Corporation Ltd., which is the NSEs subsidiary specifically set up to handle all clearing operations. The high level of automation could not wish away the dangers of fake and forged trades being dumped on the system, particularly since NSEs guarantee initially covered these risks as well. After being hit by deliberately introduced fake and forged certificates on several occasions, they put in place a strong surveillance system, headed by a former police commissioner. In January 1998 it began a 100 per cent pre-verification of securities introduced, to detect fake, forged and stolen shares.

Paper less trades:

While the NSE modernised the trading system, it was helpless against paper related problems, fake and forged shares and signature mismatches. Its reaction was to promote a Depository to push the move towards paper less trading. The Stock Holding Corporation of India, set up in the early eighties had not made much headway in transiting to a depository and continued to operate as a custodian, for the investments of financial institutions. Initially, the NSE tried to work with the SHCIL, but in 1996 it decided to pitch for setting up the depository on its own. In less than two years, the National Share Depository Ltd. has made rapid strides and the value of shares dematerialised has crossed Rs one trillion. The introduction of compulsory dematerialization in select scrips by SEBI has enabled it to move towards a rolling settlement in a few of these stocks.

One of its significant achievements was to prove that the separation of ownership and management of the exchange from trading rights can create a better, more efficient and transparent trading system. The NSE is owned by financial institutions and managed by professionals, without representation to brokers on its board of directors.

The question is what next? At the end of five successful years, the NSE is no longer the unfancied underdog - and that is when the troubles begin. Its growth now seems choked by bureaucratic and legislative roadblocks, almost as though the authorities want to give other exchanges a chance to catch up with the NSE. This has already begun to impact the NSE. The growth in turnover has not only stopped, but it has also conceded its number one position with regard to volumes to the BSE in the last week of August. Part of the reason may be SEBIs refusal to allow it to increase trading exposure in line with the imposition of higher margins mandated by SEBI.

The NSEs attempts to introduce Futures and Options trading has also been blocked for over two years for want of legislative and regulatory approvals. It had opted for the internationally accepted derivatives trading, instead of the primitive and outdated badla system. However, vague fears about the danger of derivatives trading and the uncertain political situation have kept this business from taking off. From September 6, the NSE kicked off a second three days settlement cycle, which will run parallel to the regular weekly one. According to brokers, this settlement will offer arbitrage opportunities between the two settlements within the exchange, and could help boost volumes again. Only time will tell whether this turns into yet another significant innovation or just a damp squib.

Its attempts to introduce stock lending through the Automated Lending Borrowing Mechanism have also received a luke warm response. Stock lending volumes average barely Rs 50 lakhs per settlement. The lack of enthusiasm is attributed to high lending/borrowing charges and the non-participation of financial institutions.

The NSEs debt market is also a sore issue with several of its members who coughed up big fees for the debt segment membership. The exchange, which planned to develop the debt market, has failed to make much headway for several reasons beyond its control. The silver lining is that following Yeshwant Sinhas 1999 budget, debt trading has slowly begun to pick up and daily volumes have touched Rs 1000 crores.

But the future is clearly uncertain. The NSE is now a big and formidable player which will be watched and blocked at every opportunity. Ironically, while stockbrokers are fond of dubbing it a sarkari exchange, it receives very little support or encouragement. For instance, if the mandarins at the finance ministry had devoted to the introduction of derivatives trading, even a fraction of the time they did to the reintroduction of badla trading, or the expansion of the BSE trading system, India would have been able to boast a full menu of international trading instruments including derivatives. In fact, the NSEs role in revolutionising Indian capital markets in so short a time is scarcely recognised.

It would be short-sighted to believe that the process of development and modernisation of Indian capital markets can now come to a halt. International money flows and our constant progress towards currency convertibility will put the Indian bourses in direct competition with aggressive and innovative exchanges in the West and the far east. Only constant innovation and aggressive marketing will ensure that trading in Indian shares remains in India. If the government recognises this, it will ensure that the young and innovative NSE is not stymied and killed -- after all an exchange is only as good as its best professionals.

* India was the first country to use a VSAT based trading system in the capital market. The NSE's VSAT network remains the largest such facility in the financial markets linking over 4000 terminals across 280 cities.

Sucheta Dalal, 1999