The battle of bourses: NSE shook Dalal Street, beat BSE's broker club

The National Stock Exchange (NSE) finally listed its own shares on the BSE on Thursday, 34 years after it was incorporated and more than three decades after it was conceived as a challenge to the old order. The irony in its market debut is unmistakable. India's biggest stock exchange had to list itself on its rival, though it was just due to regulations.

The NSE was born in a very different India, when the Bombay Stock Exchange was a powerful broker-controlled institution and liberalisation was beginning to demand a capital market that could operate on a national scale. Its rise was not just a story of better technology but of entirely dismantling a way of doing business.

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Pherwani's brain child

The story begins with Manohar J. Pherwani, the former chairman of Unit Trust of India and a towering figure in India's financial institutions. Pherwani was already known in the market as the "Big Bull". There was also a story doing the rounds that he had sought a BSE membership for a UTI subsidiary in the late 1980s and been turned down. Some believed Pherwani's desire to have a broking card for UTI was resisted because it could deprive brokers of business and could encourage other financial institutions to seek membership. One account says ICICI and IDBI had also sought entry and were denied.

Though veracity of these anecdotes can't be confirmed, these reveal a lot about the structure of the BSE at that time. The exchange was owned and governed by its broker-members. A membership card gave its holder both trading and ownership rights. Scarcity made those cards valuable and the existing members had an obvious interest in controlling entry.

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Then liberalisation arrived. After the 1991 reforms, applications were pouring into the Finance Ministry wanting to establish stock exchanges in different cities. RH Patil, who was the founding Managing Director of NSE, had later recalled that the ministry was overwhelmed by the applications and asked Pherwani to suggest a way of dealing with them. Pherwani's answer was a national exchange, more ambitious than another collection of regional exchanges.

After Pherwani floated the idea, the committee was formally constituted by the Finance Ministry in January 1991. Its report proposed a National Stock Exchange in New Bombay linked by computers to investors across the country.

The original NSE was not even supposed to rival the BSE. It was supposed to focus on medium-sized companies, bonds and debentures and was intended to complement the existing exchanges. But the BSE immediately understood the implication. It already accounted for about 70% of stock-market activity. A national computerised exchange could take away its power which came from strict control over access.

Harshad Mehta changed the urgency

The Pherwani Committee preceded the 1992 securities scam involving Harshad Mehta. But the scam transformed the environment in which the proposal was being considered.

The collapse exposed how much of India's financial market depended on opaque transactions, weak settlement arrangements and relationships between banks, institutions and brokers. The spectacle of the country's most famous broker apparently being able to move huge sums into shares made the argument for structural reform much harder for the old market to resist.

There was another confrontation that must have mattered a lot. When the newly established SEBI sought to bring brokers under its regulatory framework, BSE brokers resisted. The dispute became so bitter that trading at the BSE was shut for a week in April 1992 in protest. Finance Minister Manmohan Singh visited Bombay and went to meet the protesting brokers. The episode was a vivid reminder to policymakers that the country's dominant exchange and its broker community possessed enormous outsized power.

The government now had both the blueprint and the political justification for a new institution.

IDBI was asked to push the project. S.S. Nadkarni, its chairman, assembled a small team. Ravi Narain, Chitra Ramkrishna, Raghavan Puthran, Ashish Chauhan and K. Kumar were among those assigned to the task. R.H. Patil, an executive director at IDBI, joined soon afterwards.

Patil's unlikely revolution

Patil was not a stockbroker, and that was precisely the point of choosing him. Born in Karnataka in 1937, he had studied economics, obtained a doctorate from the Bombay School of Economics and worked at the Reserve Bank before moving to IDBI.

Patil later admitted that he knew little about equity markets when he took on the assignment. His well-wishers thought he was making a mistake. How would a mild-mannered economist like Patil control the powerful wolves of Dalal Street? His answer was not to outmuscle them but to build an exchange where strict discipline and rules, rather than broker influence, would govern the market.

Patil's view of the existing market was severe. Years later, he described India's capital market of the early 1990s as being akin to the Stone Age. Bad deliveries, fake certificates and price manipulation were common complaints. Small investors depended heavily on brokers and the open-outcry system made the trading floor central to the whole business.

Patil and his young team therefore decided not merely to build another exchange but change the architecture. Ownership, trading and management would be separated. There would be no broker-dominated board. Membership would not require buying a scarce and expensive BSE card. And trading would take place electronically. .

The computer was the weapon

The BSE had experimented with computerisation before NSE arrived. Mahendra Kampani, who served as its president, had pushed the idea of moving from open outcry to screen-based trading but jobbers and brokers feared electronic trading would destroy the spreads and informational advantages from which many made money and thus Kampani's proposal was shelved. Ironically, the very system BSE rejected would help NSE outcompete it years later.

Instead of making traders come to a ring in Bombay, NSE took the market to traders. Its VSAT satellite network connected terminals across India to a central system. Orders were entered electronically and matched through an anonymous order book. A broker in Indore no longer needed to send an order through a chain of intermediaries to Mumbai. A trader in Vijayawada could participate in the same market as someone sitting in Dalal Street. The investor did not need to know who was on the other side of the trade.

NSE dismantled the entry barriers represented by BSE membership cards, which could cost Rs 30-40 lakh at the time, by offering pan-India membership against an interest-free deposit.

The NSE was therefore attacking the geography of the BSE and the economics of its membership simultaneously.

There was no reason, initially, to assume NSE would win. The BSE had history, liquidity and the country's most important companies. NSE was a government-backed experiment operating from a new building with an untested electronic system. Many established brokers publicly dismissed it.

NSE began operations in the wholesale debt market in June 1994 and launched equities in November. NSE had overtaken BSE in equity trading in October 1995. By then it was operating in 48 cities, 32 of which did not have their own stock exchanges. The exchange was handling roughly two-and-a-half times BSE's daily volumes.

The Reliance moment

One of the most revealing episodes came towards the end of 1995. Reliance Industries accounted for roughly 15% of BSE turnover. Then BSE suspended trading in Reliance shares for three days over allegations concerning duplicate share certificates.

Reliance fought back and threatened to delist itself and some group companies from BSE and move to NSE.

That the dispute became a turning point. Reliance ultimately backed away from the threat after intervention by BSE directors and the government. But by then the message had been delivered. India's biggest companies could contemplate moving their listings to the new exchange. Ashish Chauhan, who was part of NSE's founding team, later recalled that within months transactions in Reliance group companies alone were running at around 80,000 a day on NSE. This was the kind of competition an incumbent exchange would fear.

Why BSE could not recover

The BSE too eventually computerised. Its BOLT system went live in March 1995. But by then NSE had already established the habit of screen-based trading and had built a national network.

There was also a regulatory asymmetry. NSE had been created with a national mandate. BSE's expansion outside Mumbai was constrained and it needed arrangements with regional exchanges, and exchanges in places such as Calcutta and Delhi had little incentive to invite stronger competition. By the time BSE could expand properly, NSE had already consolidated its presence outside Mumbai.

BSE had also alienated many small brokers who believed the bigger brokers received preferential treatment. NSE's strength was that it treated its members impartially.

NSE had taken the old exchange's greatest advantages and tried to turn each one into a reason to build a new institution. The anonymous order book weakened personal networks. Deposit-based membership weakened the scarcity value of BSE cards. A professional board reduced broker influence. The satellite network weakened Mumbai's monopoly over information.

The battle changes the market

Competition did what regulation alone could not. Brokerage charges, which were around 2% of transactions in the early 1990s, began falling sharply. Screen-based trading made it harder to manipulate the prices shown to customers. The national network opened the market to investors who had previously depended on intermediaries in Bombay.

NSE kept adding markets. It became dominant in equity derivatives after their introduction in 2000. The BSE, once the unquestioned centre of Indian trading, was fighting to regain ground.

Pherwani had started with the question of how India could build a national capital market. Patil answered it by building an institution in which the broker was no longer the centre of the system. That is why NSE's eventual victory over BSE was so complete. It did not beat the old exchange at the old game but changed the game itself.

On Thursday, when NSE listed on the BSE, the symbolism was hard to miss. The exchange created to break the old bourse's dominance had finally become a listed company on the old bourse's own platform.