Institute of Chartered Financial Analysts of India (ICFAI) University 2006 Certification Finance Security Analysis-II - Question Paper

As the lenders have to put in place the most improper risk management systems, the presence of such systems minimizes the risks to the market in particular and the financial system in general. However, even in this situation, the tendency towards volatility and price manipulation are factors that contribute to risk. In case of rising market, the client could resort to over-trading thereby exposing himself and lender to risk.
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Caselet 2

9.
The transformation of a stock exchange into a “for-profit shareholder owned company” is referred to as demutualization. Though this is not the standard definition, the main difference ranging from a traditional stock exchange and a demutualized exchange is that the latter is run on “for-profit” basis, where ownership and management are delinked. The process of demutualization can be described as moving away from a member controlled exchange to become a public by traded company.

The transformation of a mutual member-based exchange to a demutualized exchange involves the transferability of ownership from members to non-members (shareholders). This involves the conversion of existing membership to share ownership. The members of the mutual-based exchange either have the choice of selling their membership or retaining their hold on the demutualized exchange by converting their membership into share ownership. To avoid potential and hostile takeover by other exchanges and to prevent individuals and group holders with vested interests from having greater control on the demutualized exchange, regulators restrict the ownership holding of a n individual or group of holders to beneath 5% or 10%.
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10.
While listing of a demutualized exchange either can be done in itself or in other exchanges, the issue of governance particularly lies with the former. The exchange is supposed to exercise regulatory power over a listed firm, demanding that it comply with listing rules. For example, it is tough to get good enforcement by the BSE of listing rules upon the BSE. When a stock exchange goes for an IPO or goes public, and contemporary HR practices are followed, it is inevitable that managers will end up thinking like owners. This leads to a breakdown of the separation ranging from owners and managers. The listed exchange does not have a three-way separation: it only has a two-way separation, ranging from the owner/manager and the trading member.

While top exchanges internationally have indeed gone public, they operate in a very various environment of competent regulation and effective justice system. But the identical is not the case in India, where just punishment is unlikely and there is a low risk of punishment. These arguments also suggest that the core institutions of the securities industry are not ordinary firms which should progress from startup to IPO. With an ordinary firm, the corporate governance puzzle is that of making managers act as if they are shareholders. But with exchanges, the governance puzzle is that of getting managers to not think like shareholders. When the management team of an exchange thinks like an owner, it seeks to maximize turnover, and incentives are created for malpractice. In the Indian environment of weak regulators, weak judicial processes, mistakes in drafting laws, and politically well-connected exchanges, even good people can do bad things. Hence, when it comes to the core securities infrastructure, we need to stay on course with the quest for three-way separation ranging from owners, managers and trading members. What we have seen of the successful functioning of demutualised exchanges in India reflects a genuine three-way separation, with managers who are not owners, and owners who think more like users of the exchange, and less like recipients of dividends.

Earning:   Approval pending.