TRANSFORMATION OF THE INDIAN CAPITAL MARKET  

December 13, 2005

This is a recent public lecture delivered by Dr.R.H.Patil. Dr.Patil was the first Managing Director of the National Stock Exchange and the man behind its success. He is now Chairman of the Clearing Corporation of India Ltd.  

TRANSFORMATION OF THE INDIAN CAPITAL MARKET

By Dr.R.H.Patil

Page 1

Indian capital markets have witnessed radical transformation during the short period of a decade. There is hardly any country in the world which has witnessed such massive changes in its capital market during such a short period. If you permit me to use a phrase from anthropology I would say that the state of the Indian capital market around the early 1990s was akin to the Stone Age, a phrase used merely to indicate its primitive stage. During the early part of the 1990s, ranking of the Indian capital market with reference to the standard global indices relating to efficiency, safety, market integrity, etc was not at all flattering. With reference to the risk indices in particular, the Indian capital market was regarded as one of the worst as it figured almost at the bottom of the league. The same was the case in regard to its efficiency levels in trading and settlement systems. Strangely, not many people appeared to be bothered about the dismal state of our capital markets. As we are all accustomed to find India figuring in the bottom league in regard to so many other indicators of development such as per capita income, nutritional standards, health amenities to citizens, literacy levels, etc we did not feel sorry to note that Indian capital market was also ranked at the bottom of the global ranking sheet.

Interestingly, however, the same cannot be said about the current state of the Indian capital markets. From the viewpoint of both adoption of sophisticated information technology tools in trading and settlement mechanisms as also efficiency of capital markets, not only is India ranked in the top league but that it is also considered to be way ahead of many developed country capital markets. Even at the risk of being dubbed as personally biased I would affirm that National Stock Exchange (NSE) has been largely responsible for significantly upgrading the Indian capital markets to the best global standards. I would be the last person not to agree with the proposition that Government and SEBI have also played very crucial role in this transformation process. But there is a limit to what can be achieved merely through official interventions or directives. It may be recalled that Government did seriously try to bring about several desirable reforms in the capital markets in response to the recommendations of the 1985 G S Patel Committee Report. But it was not possible to make much progress in the desired direction as the stock exchange community was not receptive even to the marginal set of reforms. What is even stranger, the powerful broker community started talking about their own fundamental rights to do business as they thought fit although it may not always be in the interests of the markets and the investor community.

But after the NSE was set up the entire atmosphere changed. The broker owned and managed exchanges started worrying more about the competitive threat that NSE posed to their business and how they should meet investors’ minimum demands so that they did not lose out completely to NSE. All these exchanges became more receptive to what the Government and SEBI were telling about adopting clean business practices. NSE, in that sense, strengthened the hands of the authorities in making the other exchanges conscious of their social responsibilities.

How is it that the Indian capital market which was considered to be one of the most inefficient and risky got transformed into one of the best and the safest in such a short period of time? There appear to no parallels to this in any part of the world. In several countries capital markets have improved in terms of quality and efficiency continually over several decades before they could be bracketed with the top league of the best capital markets of the world. To the best of my knowledge no other country….even in the developed part of the world……has been able to witness quantum jump in the quality and efficiency of its capital markets in a short period viz., a decade. Hence, a detailed study of transformation of the Indian capital markets during the last decade will certainly prove to be a fascinating story. In my talk today I do not have the ambition of presenting a very detailed study before you. All that I am planning to do is to give a bird’s eye view of the developments in the Indian capital markets as I have seen them from close quarters as I was fully involved with the setting up of NSE right from day one and was also its MD and CEO for the first seven formative years. It is my humble claim that NSE has been the most important catalyser of the radical transformation of the Indian capital market during the last decade. Hence I consider myself to be one of those few most fortunate people who could witness/participate in the unfolding of this fascinating story from the central place where most of the catalytic activity took place. Before I turn to that story let me, with all sincerity and utmost humility, seek your forgiveness if I am forced to become autobiographical on too many occasions during my presentation since I participated actively in this major experiment which has….fortunately….become so successful.   

Let me begin my story by drawing your attention to the major disaster that struck the Indian financial system during 1991-92. It shook the stock market to its very foundations. During this scam several banks----both small and big, foreign and Indian, and public sector as well as private sector-----lost huge amount of money. Very strangely many stock brokers prefer to refer to this disaster as a banking scam, as if the broker community did not have any role in perpetrating this scam. The real truth was that money was siphoned off from the banking system by the stock brokers through many devious ways. The equity prices were hugely manipulated by several prominent brokers with the help of the money diverted form the banking system. Although brokers used to issue their contract notes, their concerned stock exchanges did not bother to have regulatory surveillance on these transactions. There is hardly any doubt or dispute about the proposition that the stock brokers were the kingpins of the major fraud that shook the financial system and the capital markets.  It was in this context that urgency was felt to bring about necessary reforms in the area of capital markets so that such serious mishaps do not recur. This prompted GoI to delegate powers to SEBI under the Securities Contracts (Regulations) Act, 1956 and later to enact a special legislation called SEBI Act. But it was soon realised that merely empowering SEBI with more powers was not enough. Since the governance of the stock exchanges was very poor something more in the nature of a setting up of a new model stock exchange was needed so that its competitive pressure would force other stock exchanges to reform themselves. GoI agreed to bless/support the lead taken by IDBI to set up such a modern stock exchange that would help in introducing in India best international practices, both in the areas of trading and settlement.

It is worth noting in this context that, in the initial stages, there was not much enthusiasm in favour of setting up of a new stock exchange even among the influential official circles. There was some scepticism as whether there is any need for such an exchange that would compete with the broker-owned-dominated stock exchanges. It was widely believed that the right course of action should be that SEBI should crack its regulatory whip. It was hoped that this would ensure good corporate governance among the stock exchanges, make markets to function more efficiently and protect investors’ interests. The then chairman of SEBI Mr G V Ramakrishna did act tough to make stock exchanges to fall in line. But the well entrenched brokers were in no mood to listen to wise counsel. Prominent broker associations as also some of the stock exchanges were almost on a collision course with the market regulator. Militant brokers were more concerned with their own fundamental rights to conduct their business on lines which they considered to be appropriate rather than being unduly bothered about the rights of investors for fair play and justice. Soon it became abundantly clear that, in the absence of competitive pressure from a well functioning and professionally managed stock exchange, market standards cannot be significantly improved.

The second point that needs to be noted is that the National Stock Exchange as it has now emerged was not the one to which we find a reference in Pherwani Committee. The concept of the stock exchange given in Pherwani Committee was quite a timid one.  The NSE as proposed by the Pherwani Committee was primarily meant for creating a corporate debt market as also create liquidity in mid-range stocks that lacked liquidity on the main stock exchanges like the BSE. Foreseeing the opposition such proposal would meet with from BSE and the powerful broker lobby the Pherwani Committee had suggested that such a stock exchange should be set up in New Bombay. Despite the fact that the NSE as recommended by the Pherwani Committee would have posed hardly any threat to the strongly entrenched BSE and other exchanges there was tremendous opposition to the very idea of an exchange with different feathers. At that time the broker community was having a strong conviction that the area of stock exchanges was their exclusive preserve and that they would not like any one else to trespass in their territory.

It was certainly a difficult journey as we faced several difficulties, often from quarters which should have, in the fitness of the things, supported us in our difficult task. My intention today is to share with you an insider’s story so as to dispel the wrong impression some people have that it was cakewalk for us. It is also my desire to emphasise that the changes that NSE has been able to bring about may appear to be irreversible; but it need not necessarily be so. History of our civilisation is replete with examples that human beings are accustomed to behave in a pendulum like fashion. Often we do not learn from history; hence we are warned by philosophers that we are often condemned to repeat it. But that has never deterred many-- especially the selfish and short sighted people--- not to roll back progress that has already been achieved. Hence we are often reminded that price of freedom is eternal vigil. If we are keen that our journey on the path of capital market reform is not slowed down or that the reform process does not get reversed we should remain ever watchful of the games that the detractors play. We should try to see through the clever games which a number of powerful market operators repeatedly play to achieve their selfish objectives.

NSE as a trend setter

The anonymous order matching system adopted by NSE is perhaps one of the best in the world. The NYSE for example would have remained free from the bad name that the floor specialists brought to NYSE had it adopted NSE’s automated trading system. In terms of geographical reach of the real time trading facilities to the nooks and corners of the country the Indian capital market is way ahead of most of the global capital markets. Investors can trade from close to 400 cities/towns across the length and breadth of the country on a real time basis. Today, investors in distant parts of the country feel happy that they enjoy parity with investors located in Mumbai as they also have the same type of access to the best prices as are available to investors in Mumbai. Currently  T+2 settlement systems India is well ahead of even the sophisticated markets like that of the US or UK where equity trades are still settled on T+3 bases. Before NSE came into existence the country was not even aware of the ironclad settlement guarantee for all the trades done on an exchange. NSE is the only exchange in the country which has set up a clearing corporation which acts as the central counter party guaranteeing all settlements.

NSE happens to be the first truly demutualised stock exchange of the world; it has almost fully resolved the conflicts of interest issues that arise when brokers are in control of the boards of the stock exchanges.  NSE represents a basic paradigm shift as the ownership and management of the exchange have been fully separated from the trading rights. NSE is owned by a set of premier financial institutions/banks and is managed by professionals who do not trade directly or indirectly on the exchange. NSE is the only stock exchange in the country which decided not to seek exemption from corporate tax which all other stock exchanges in the country routinely enjoy. NSE has been paying sizable corporate taxes every year right from the first year of its operation.

NSE believes in the philosophy of fully competitive system in so far as its trading membership is concerned. There are no entry or exit barriers in regard to NSE membership. Since NSE does not limit arbitrarily as to how many members it will admit in any of its trading segments any eligible corporate or non-corporate entity can aspire to become its trading member by paying the required security deposits and meeting other normal membership requirements. Similarly, its members are also to free to exit later if they find that they have other more profitable business opportunities; such exiting members can seek refund of all the membership deposits kept with NSE once they meet the dues of the exchange and their clients.     

Unique Architectural Design

I still vividly recall the meeting in the Ministry of Finance, GoI, which was convened by Mr Montek Singh Ahluwalia in August 1992. The other participants at that meeting were Mr G V Ramakrishna, Mr S S Nadkarni, Dr P J Nayak, and I. After listening to the proposal for setting up of a state-of-the-art NSE, government gave the mandate to IDBI to set it up. Mr Nadkarni knew my deep interest in the capital market area as I had come in contact with him very closely earlier even before he became chairman of IDBI during the deliberations and drafting of the G S Patel Committee Report on Capital Market. He therefore asked me take up the responsibility of setting up the brand new stock exchange. Being a visionary he was not in favour of one more ordinary stock exchange that would end up merely being counted as one more “also ran” category stock exchange. He was clear in his mind that the new stock exchange should make perceptible difference in the way the capital market functioned in India. Typical of him he gave me not only full freedom to prepare and finalise its architectural design he also did not raise many questions at the way we were planning for large capital expenditure in software, mainframe computers, and the satellite communication system. Without his full support and understanding it would have been an impossible task to implement the grand NSE project that has made such a huge difference to the quality, efficiency, and dynamism of the Indian capital markets.  

After a lot of deliberations we came to the conclusion that we should engage a global consultant to guide us in this area. Our search finally ended up with appointing a Hong Kong based consultant called International Securities Consultants to suggest a business model for NSE. We felt that before we crystallise our architectural design for the propose stock exchange we should have some idea as to how some of the best stock exchanges in the world functioned. Some of the core group members undertook a study tour of stock exchanges of Asia (Australia, Bangkok, and Hong Kong,) Europe (London, Paris,) America (NYSE & NASDAQ, Vancouver). Our study visits as also our extensive discussions with the consultants convinced us that an eclectic approach should be adopted so that we incorporated in the conceptual design of the new stock exchange the best features that we found in different exchanges of the world. NSE thus incorporates today the feature of big board of NYSE dealing mainly in very large stocks that will be widely known across the length and breadth of a vast country like ours, nationwide presence of trading terminals on the pattern of NASDAQ, computerised order-driven trading system of the type of Paris bourse or Vancouver which is free from the manipulative behaviour of the market makers or specialists, and settlement guarantee system of the Chicago’s futures exchanges.

We needed also a communication technology that would help us to connect trading terminals of our members to the exchange computers. In this area we borrowed the idea of the nationwide department stores of USA which rely on their captive satellite communication network for executing instantaneously cash settlements. There was also another strong reason for choosing satellite-based communication technology (SBCT) in our context. When NSE was being set up, the terrestrial communication system provided by BSNL would not have provided a fault tolerant, time critical, and high bandwidth communication link between NSE and its members. Even within Mumbai city broadband telecommunication links were not highly reliable, besides the fact that they were relatively more expensive. For example, in Mumbai an end-to-end 64 kbps leased line from MTNL was costing NSE members almost Rs 2 lakh per annum whereas NSE’s highly reliable satellite link cost around half of that amount. Secondly, quick availability of leased lines was also a problem in those days as there was no competition to the BSNL or the MTNL. In retrospect NSE’s choice to go in for its own captive VSAT network proved to be a very wise decision. Such a highly reliable telecom link that enabled NSE to establish links with its rapidly expanding member community with minimum time lag put NSE way ahead of all its competitors. This was perhaps one of the most important reasons which helped NSE’s trading volumes to grow almost exponentially. Secondly, given the state of the terrestrial telecom infrastructure of BSNL and MTNL when NSE started its operations in 1994 it would have been practically impossible to establish NSE’s nationwide trading network, connecting such far off places like Srinagar, Johrat (Assam), Nagercoil (Tamil Nadu), Nainital (Uttaranchal), and Salasar (Rajasthan).        

Opposition to NSE

The proposal to set up NSE was met with tremendous hostility. Broker community was up in arms against any such idea for the simple that it was against their interests. They sincerely believed in the concept of mutuality of a stock exchange and were dead sure that only brokers should own and manage a stock exchange. They could sell such an idea to the lay people as global history of the stock exchanges supported their contention. All over the world almost all the stock exchanges are broker owned and managed. Even in India the history not only was in their favour but that the spirit of SCRA was also in sympathy of their contention. The SCRA defines the stock exchange as follows: 

Quote “stock exchange means any body of individuals, whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities” Unquote  

The second objection of theirs was that NSE was given a mandate to spread to all the parts of the country whereas then existing stock exchanges were permitted to operate within a strictly defined narrow geographical territory. The area in which a stock exchange could operate, most of the time, was co-terminus with city limits where the particular exchange was set up. For example, the area of operation of BSE was confined to municipal limits of Mumbai and that of DSE to Delhi. The design accepted by the authorities at that time was to divide the country into geographically non-competitive securities markets; in other words the then accepted policy frame was to create geographical monopolies for respective stock exchanges and to protect them from competition with other stock exchanges. With the arrival of NSE with a mandate to operate in all parts of the country the monopoly status of all the stock exchanges came to an end abruptly. The smaller stock exchanges were particularly worried that they would have to compete with the proposed exchange which was backed by powerful financial institutions of the country.   

They also took a great objection to the proposition that NSE would enter in a big way into the equity segment by setting up computerised trading facilities in equities all over the country. Most of those who opposed to NSE were under the wrong impression that we were implementing NSE as was conceived in the Pherwani Committee Report. However, our design of NSE was radically different. All that we borrowed form Pherwani Committee Report was the attractive name of National Stock Exchange for the proposed stock exchange. The broker community therefore accused us that we were going beyond our charter which according to them was merely setting up of an exchange for trading in debt instruments. 

Misplaced fears

It was then very widely believed that computerised trading would not succeed especially in a country like India where computer literacy was quite poor, especially among the stock market fraternity. When NSE was being set up, most of the people that took up broking activity were not only not very well educated community but that most of them had not even touched the computer key board. In view of this it would be very difficult to attract truly business savvy brokers into NSE’s fold as they would detest computerised trading systems. It was widely believed that computerised trading requires highly complex computer skills and those who have such skills are unlikely to be good brokers. In a way, we were also worried about the difficulties of enticing broker community into the fold of NSE. Hence we planned to provide training in computerised trading to our members before we actually commenced our formal trading on the NSE. We set up trading floors in NSE’s office premises by setting up a local area network (LAN) where members could be actually trained to do computer trading. We estimated that it will require at least three full days’ training for each dealer. Our LAN could accommodate almost 100 dealers at any point of time. After the training started we were in for a major surprise. Most of the dealers at these training courses took just about two hours to learn all the tricks of the trade and became quite proficient in computerised trading system. The main reason for dealers learning the skills fast was due to the high quality trading software that we had procured from a foreign software company and the subsequent improvements/modifications/customisation done by Tata Consultancy Services (TCS), our main software vendor at NSE. The trading software had kept all the complexities at the host computers at NSE and the dealer terminal or front-end was kept as simple and user friendly as possible.

NSE as Market Reformer

A. The Concept of a Demutualised Exchange

The NSE brand of demutuality is perhaps unique in the world as it aims at a total separation of exchange ownership and management from the trading rights of members. In other parts of the world demtualisation has meant converting the mutualised exchange into a corporate entity, with trading members having both ownership rights as also representation on the board of the company. Australia was the first country where a mutualised exchange got transformed into a demutualised corporate body in the latter half of 1990s. In the Australian demtualisation case brokers still have a strong voice in management as their shareholding in the exchange company continues to be sizable. A true demutualisation is one in which ownership and management of an exchange are totally separate from members’ trading rights in the exchange. The problem a broker owned and managed exchange is like playing cricket match where the players also act as umpires by turn. Such a game will never have umpiring being done impartially since each umpire’s decisions will be biased because of the conflicts of interests he faces. In a broker dominated exchange all the office bearers such as the president, vice-president/s, treasurer, and other board members are all elected by the general body of members who are trading members. It is also obvious that, once you resort to election as a method for choosing office bearers of the exchange, group politics is bound to emerge. Members in such an exchange do not seek board positions for altruistic reasons but to enjoy the advantages that accrue to the office bearers. Hence desire to win an election becomes a strong motivation for protecting self and/or group interests. As office bearers of an exchange continue to remain active in their own day-to-day brokerage business there is always a temptation to misuse their official position to have access to information about other members’ market position in different stocks. It is not possible to prevent all such malpractices unless all the office bearers in control of the affairs of an exchange are not its trading members.

This argument is sometimes countered by pointing out that a number of chief/senior executives of brokerage firms also sit on the board of NYSE. It is further argued that if that is considered to be reasonable in the case of NYSE----a premier stock exchange of the world----what is wrong in having brokers on boards the Indian stock exchanges? The major point that should be noted in this context is that the senior member representatives on the board of NYSE are not only very far removed form the normal trading desks of their firms but that they scrupulously avoid having any contact even remotely with all those departments which are involved in the actual exchange activity. In spite the self discipline observed by NYSE board members there has been frequent criticism about the influence of powerful trading members on the management quality of functioning of NYSE. Recently, there has been intense criticism about the detrimental influence of the floor specialists on the price discovery process of NYSE and the role of powerful NYSE members firms in this.   

As of now there is hardly any disagreement in our country with the necessity of having demutualised stock exchanges. After the stock exchange crisis in 2001 the government announced that demtualisation will be made mandatory. However, actual move in that direction has got considerably delayed. The main difficulty that arose in this area is about the beneficial ownership of the property that belonged to the exchanges after they got demutualised. Many people including me have argued that most of the property that the exchanges had accumulated has been due to the favours passed on by the government to the exchanges. They were exempt from all types of taxes besides the fact that the land on which the buildings of most of the stock exchanges were constructed was given at almost throwaway prices to the exchanges. Since the exchange was considered to be a public utility it enjoyed so many other benefits including listing fees that are to be paid by the listed companies. Recently SEBI has come out with a broad  demtualisation scheme for the exchanges where brokers will have 49% of the share capital of the new exchange company and broker representation on the governing board will be to the extent of 25 % of the total. It should be noted in this context that this scheme of demutualization is materially different from that of NSE. Hence one is not fully sure as to what this will mean in reality to the quality of governance and resolution of the issues relating to conflicts of interests as noted above with broker members sitting on the boards of the stock exchanges. There is also one more puzzle that needs to be noted in this context. In response to the recommendations of a SEBI Committee on uniform set of Rules and Bye-laws to be adopted by the stock exchanges SEBI came out with a circular in December 2001 mandating a model set of rules applicable to all exchanges uniformly including the demutualised exchanges like NSE and OTCEI without realising that many of the clauses in the model rules are actually not only contrary to the principle of demutalisation but also that they negate some of the best practices already adopted by the demutualised exchanges. These new model rules are still in the process of being adopted by all the exchanges. There are therefore two important points that need to be noted in this context. Firstly, since SEBI now wants all the exchanges to be demutualised will it still insist on adoption of rules that negate the basic principles and practices adopted by exchanges like NSE? Secondly is it desirable that we should get back to a philosophy of forcing a common set of rules which, often are worked out on the principle of least common denominator? One would say that ideally it would be desirable to prescribe minimum standards/rules that all the stock exchanges should adopt so that more dynamic among them have incentives to move faster in the right direction.     

Before I turn to NSE’s attempt to set up a nationwide exchange let me draw your attention to the tremendous pressure that was brought to bear on NSE from highly powerful quarters to have broker members on its board. Very ingenious arguments were being put forth in justification of having brokers on the board of NSE. It was said that just as we cannot have bar councils without lawyers on the bar or medical councils without doctors as its members how can we have stock exchanges without stock brokers on their boards? The major point that was missed all along was that bar councils or medical councils are like clubs of their own members and they are not on par with stock exchanges which are granted recognition by the regulator so that they scrupulously follow a code discipline, protect integrity of the market and fully protect investors’ interests. Common citizen do not deal with the bar councils or the medical councils in the same fashion that investors deal with the stock exchanges. Hence it is meaningless to compare bar councils or medical councils with stock exchanges. Although NSE’s trading members were fully aware that NSE’s trading membership does not grant them any rights to its board membership they also started an agitation to have board representation. They were being instigated by those putting forth bar/medical council arguments as also broker activists from other exchanges. However, NSE's board stood firm on this issue and refused to yield to pressures of the vested interest groups.           

B. Concept of nationwide exchange

When NSE got its recognition as a stock exchange these powers were being exercised by the Ministry of Finance, GoI. When NSE was given a clear mandate that permitted it to extend its operations to all the parts of the country it was not clear to the stock exchange community as to how we would be able implement such a difficult project. Hence most of them felt that this nationwide trading mandate would remain merely on paper. It is possible for this reason that most of the regional stock exchanges were not worried in the beginning that NSE would ever compete with them for business. With the resounding success of NSE’s order driven anonymous computerised trading system, which rode a highly reliable satellite communication system, all the stock exchanges got very much worried about its competitive threat. BSE also got much more worried as we started eating in a big into its order flow that used to originate from the rest of the country. As NSE’s trading volumes started spurting all the stock exchanges started putting pressure on the regulator not to permit spread of NSE to centres where the regional stock exchanges were located. We from the NSE took a stand that since NSE had been given a mandate to spread its trading network to provide real time and equal access to investors spread across the length and breadth of the country we cannot stop our drive of going to newer and newer places where investors existed.

This became a highly contentious policy issue; hence it had to be finally referred to the Government as the original mandate to NSE for nationwide trading was given by the Government itself. Government was requested to review the policy in regard to NSE so that it is also obliged to seek appropriate approvals for all its future plans to expand its network to new geographical locations. The logic was that since other exchanges had to obtain approval before spreading their trading terminals to locations outside their licensed areas NSE should also be subjected to the same rule. However, we from the NSE were vocal that the ban put on other exchanges from spreading to locations outside their pre-approved areas of operations should be removed so that all the recognised exchanges freely spread their operations to places of their choice. Since NSE was conceived from the beginning as a model exchange to significantly upgrade capital markets of the country and put competitive pressure on the existing exchanges to reform themselves it was not necessary to set up different NSE type model exchanges in all places where the stock exchanges already existed. The technology adopted by NSE facilitates spreading its trading network to all the parts of the country; therefore it is a cost effective option to provide exchange infrastructure rather than duplicating NSE model in different cities and towns. The NSE model discards the archaic then prevailing capital market concept which identified a market with a particular geographical location. Prior to NSE the capital market of the country was divided into isolated markets which were identified with the cities of their location viz., BSE in Mumbai, DSE in Delhi, etc. When the policy about NSE’s expansion was being reviewed NSE had put on hold its expansion plans. However, it did not take much time for the Government to reaffirm its earlier decision that NSE should be allowed to spread its trading network without any hindrance to all the parts of the country.

C. Settlement guarantee

The concept of a settlement guarantee as NSE currently operates was almost unknown in India until 1995. Interestingly the SCRA also does not talk much about settlement of trades done on the exchanges except mentioning that the exchanges can set up their own clearing houses. We realised this was one area where a major reform was overdue. Our review of global practices indicted that even some of the major stock exchanges like NYSE, NASDAQ, and LSE, did not have their own clearing and settlement infrastructure/entities. Even today brokers of these exchanges trade on their respective exchanges but take their trades to an independent clearing corporation for the settlement. For example, NYSE brokers report all their trades to a clearing corporation which also clears and settles trades on other exchanges. But we realised this model was not suitable for the Indian conditions as there are even today no such independent clearing corporations that could take the responsibility of settlement by offering iron-clad settlement guarantee. NSE therefore decided to set up a wholly owned subsidiary called National Securities Clearing Corporation Ltd (NSCCL) for this purpose. The major advantage of NSE owning the NSCLL is that there is seamless integration of the two most important functions of trading and settlement with full guarantee. Investors' interests can be thus fully protected fully.

Some argue that NSE itself could settle all the trades with settlement guarantee by having an in-house clearing and settlement arrangement called a clearing house. But this is not a highly satisfactory solution for some important reasons. The major reason for setting up a separate legal entity for handling clearing and settlement is that such an activity is a commercially risky proposition which the stock itself should not undertake as an in-house activity. A clearing corporation may face the prospects of bankruptcy in extremely volatile market conditions if the margin money and other funds on the basis of which settlement guarantee is extended to the clearing members is not adequate to cover the risks that emanate if some of the clearing members become bankrupt and the guarantee fund is not enough to complete the settlement. From an overall point of view an exchange is considered to be a public entity which should not ever face the prospects of bankruptcy. Hence there is justification to segregate the clearing and settlement activity by entrusting it to anther corporate entity and not make it part of exchange activity.