Breaking with a dysfunctional business model
Financial Express, 27 August 2010
In the early 1990s, stock market trading took place through the BSE floor by open outcry. On a good day, BSE members did Rs.400 crore of turnover, and earned 2% off buyers and sellers, thus bringing in Rs.16 crore per day of revenues. While this was a good business for BSE members, if anyone would take two steps back, he would see that the business was a mess. But for any one CEO, it was impossible to shift the business model away from the existing one.
India's policymakers embarked on an array of reforms. Brokers were forced to unbundle the tariff charged to the customer from the transaction price on the floor. Trading was computerised. Counterparty guarantees came from the clearing corporation which produced safety by limiting leverage. Exchanges were put on a new governance model, featuring a three-way separation between trading members, managers and shareholders of the exchange. The `badla' mechanism was eliminated in favour of derivatives trading.
What was the response of the industry? Mostly, sheer outrage. The firms and their CEOs were finely optimised for playing the old game. In the short run, the reforms disrupted revenues and profits. The BSE virulently protested, saying that market structure is best left to the market (even though no one CEO is able to shift away from the prevailing market structure). In the post-central-planning age of economic liberalisation, it was argued that this was a new level of government intrusion into the affairs of the market. A gifted senior executive director of SEBI, who led the changes, was hounded out.
In the event, the reforms worked out fabulously well. India got a revolution in the stock market. NSE and BSE are now ranked 3rd and 5th in the world by number of transactions. The periodic disasters which afflicted the market have ended - we have now enjoyed 9 years without a systemic breakdown. The market is transparent and fair to customers.
Remarkably enough, securities firms have done well through these changes! Brokerage firms now have over 200,000 screens spread all across India, and equities trading has gone where it had never gone before. On a good day, NSE and BSE members put together do Rs.100,000 crore of turnover -- an increase of 250 times. The revenues per transaction have crashed by 20 times. Still, the securities industry takes in revenues of roughly Rs.200 crore a day, which is vastly bigger than the starting point of Rs.16 crore a day. So the reforms were good for the public interest in terms of issues of transparency and systemic risk, they were good for customers, and they were even good for the financial firms.
Now let us turn to the business of fund management. If we looked at the starting point of a few years ago, it was made up of mutual funds and insurance companies, who competed on inventing opaque products, taking money from customers and paying it to distributors, and thus increasing their assets under management. While this was a good business for fund managers and particularly for distributors, if anyone would take two steps back, he would see that the business was a mess. The people of India were being ripped off to the tune of over Rs.100 crore per day. But for any one CEO, it was impossible to shift the business model away from the existing one.
Policymakers could embark on an array of reforms. The sales agent should clearly show what is being invested in the fund, what is paid as sales commission, and what are the fees. A full unbundling of fund management products versus insurance products is required. Special tax breaks for insurance products, and the tax arbitrage for corporate treasuries, need to be ended. Manufacturers need to be fully responsible for misdeeds of the sellers. The immense transaction efficiencies of exchanges and depositories will help. Direct sale from manufacturers to customers through the net should flourish, free of sales charges. The New Pension System should be our role model.
What is the response of the industry? Mostly sheer outrage. The firms and their CEOs are finely optimised for playing the old game. In the short run, the early reforms disrupted revenues and profits. Fund managers virulently protested, saying that market structure is best left to the market (even though no one CEO is able to shift away from the prevailing market structure). In the post-central-planning age of economic liberalisation, it is argued that this is a new level of government intrusion into the affairs of the market.
In fund management, we are trapped in the wrong equilibrium. The industry is mired in toxic sales practices, and only serves a tiny slice of India. We need an industry that genuinely serves the length and breadth of India, while enforcing consumer protection. Fundamental reforms will give a 100 fold increase in revenues. But the fund industry has shown their muscle by getting a custom built ordinance and then legislation.
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