Why it’s a good time for stock exchange IPOs

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What started under a banyan tree has become a thriving multi-crore business today. In the 1850s, India’s first stock exchange started as a meeting point for brokers under the shade of banyan trees at Mumbai’s iconic Horniman circle. They shifted venues as their numbers increased till they found a trading hall to rent in Dalal Street in 1874. From such humble beginnings, the BSE Ltd has grown up to become one of India’s most profitable firms in the country today, data shows. Its younger rival, the National Stock Exchange (NSE), has had an even more meteoric rise, eclipsing the older giant in size and profits over the past two decades, leading two financial market experts to characterize India’s exchange industry as a very profitable ‘duopoly’.

Today both the BSE and the NSE are larger than most of the companies listed on them, both in terms of sales and profits. An analysis of listed companies shows that the gap has widened over the last decade.

The BSE had net sales of Rs.616.19 crore in 2015-16. The NSE earned Rs. 2,353.94 in net sales for the same period. These numbers put the BSE at four times the net sales of the median listed company. The NSE’s sales are 16 times that of the median listed company.

The gap between the net sales of the median listed company and the two bourses has widened considerably, as the chart below shows.

The analysis is based on data-provider Capitaline’s figures covering 2,694 firms for which numbers were available over the last 10 years. The data for the two exchanges were culled from their respective financial documents.

The profit levels of exchanges are also significantly higher than that of the median firm, as the second chart shows.

Both BSE and NSE have higher profits than the firm at the 25-percentile mark, the firm at the 50th percentile mark (median) and the firm at the 75-percentile mark across all 10 years. BSE Ltd’s profit was Rs.96.74 crore for 2015-16, compared to Rs.1.59 crore for the median listed firm. The profit for the National Stock Exchange is Rs.654.14 crore. Profits dipped for the latest year after a one-time transfer to a fund for guaranteeing trades made on the exchange.

Reported listing valuations suggest that they would also be more valuable than nine out of ten listed companies. The proposed valuation of the listed companies was compared to the market capitalization of 3894 firms for whom market capitalization data was available from Bloomberg as of the end of the last financial year.

Mint reported earlier that the BSE Ltd is seeking to sell shares at a price that will value the firm at Rs.4,367 crore and that the NSE was seeking to sell shares at a price that will value the firm at Rs.4,5000 crore. At these valuations, BSE will be worth more than 93.19% of the listed companies under consideration while NSE will be worth more than 98.91% of listed firms. They would rank 43rd and 263rd, respectively, in the Bloomberg universe of 3,894 companies.

The commercial success of the two leading bourses points to the limited competition in the exchange business. Policymakers have been reluctant to encourage competition in this arena fearing risks to market stability, given that exchanges unlike other businesses also happen to be front-line regulators for firms.

The 2010 Bimal Jalan committee report on stock exchanges and other market infrastructure institutions noted that a large number of stock exchanges would fragment liquidity and raised other fears. “…too frequent exits of stock exchanges will jeopardize the interests of the investors and disrupt the stability of the markets themselves,” it said.

G. Sethu, professor at the Indian Institute of Management Tiruchirappalli (IIM-Trichy), who served on the Jalan committee, said that as stock exchanges act as first level regulators, it makes sense to have only a few of them with desirable ownership and governance features. This has the effect of limiting competition and perhaps explains their high profit margins. But this is not unique to India, he said.

“The high profit margin is (also) an international trend,” he said.

A comparable exercise carried out with the London Stock Exchange (LSE) shows the LSE to be doing much better compared to most firms listed on it. The net sales figures are almost comparable to Indian exchanges, at 19 times the median listed company. It was 16 times for the NSE, and four times for the BSE. The figures are based on 681 LSE-listed firms for which continuous data is available for the last 10 years.

The profits for the LSE are 106 times that of the median firm. The number is higher at 411 times for the NSE, though it is only 61 times for the BSE.

However, an important difference in the two markets is the presence of a large number of extremely small firms in the Indian market, which tend to pull down the median figures. Although many of these firms are automatically excluded from the analysis (since they do not provide adequate information to shareholders regularly, and hence data for them is unavailable), the size difference between firms listed on Indian bourses and those on LSE is still significant.

The LSE’s market capitalization is also greater than the 97.3% of the 1,146 firms listed on it, comparable to the Indian situation.

Prof. Jayanth R. Varma of the Indian Institute of Management (IIM), Ahmedabad, is of the view that regulators should try and encourage greater competition. Globally, cash equities exchanges tend to be highly competitive while derivatives exchanges tend towards monopolies in specific contracts. A derivative contract is bound to an exchange till maturity. Such contracts confer market participants the right or obligation to buy/sell certain securities. The contract is usually for a period of at least one month. These contracts themselves can also be bought and sold like stocks. Someone who takes a position in the derivatives segment also has to keep in mind the liquidity available not only at the time of purchase but also while the contract is in play. This is why globally derivative exchanges compete with different contracts often in different asset classes. The exchange which dominates in equity derivatives might be a small player in currencies or interest rates. Short term and long term interest rate contracts might be dominated by different exchanges.

“As a policy matter, more competition is always better,” said Varma.

In a 2011 Economic and Political Weekly (EPW) article, B.B. Chakrabarti and Mritiunjoy Mohanty of the Indian Institute of Management (IIM) Calcutta argued that the stock exchanges could do with more competition, noting that the exchange industry has operated as a ‘very profitable duopoly’. They suggested ways to raise competition in the exchange business without risking market stability.

“We could do this in two ways—reducing the barriers to entry by having an independent clearing and settlement corporation; and letting market dynamics decide whether competition in trading platforms will come in the shape of new entrants, new products or both,” they said.

Spokespersons for both exchanges declined comment for this story. One exchange official said that competitiveness is the policy-makers’ decision.

The regulators don’t yet seem to be moving towards introducing measures for more competition in the exchange industry. Until they do, it’s a good time for exchanges to launch an IPO.