Making the case for NSE

The Financial Express, July 14, 2011

By Pradeep S Mehta

CCI grabbed headlines and spurred numerous editorials in the financial press when it levied a penalty of R55mn on NSE for abuse of dominance. NSE was charged with leveraging its dominance in one market to gain or protect its position of strength in the other by way of fee waivers and exclusionary denial of integrated market watch facility. Many have welcomed the order as a good lesson for the largest bourse in the country to deter it from engaging in anti-competitive practices, while many have also argued that NSE did not enjoy a position of dominance in the currency derivatives market and the zero pricing model adopted by it was not indicative of predatory pricing. The CCI order is interesting in how well it articulates majority and minority views (4:2). The case has significant implications for the need for regulatory reforms in the stock market, given the silent treatment accorded by Sebi to the issue.

Predatory pricing is one of the exclusionary abuses in pricing policy adopted by a dominant firm in a relevant market. The firm sets very low prices over a long period of time, with an intention to interfere with others’ ability to compete and drive them out. It also aims to foreclose the entry of new players and make high monopoly rents thereafter.

The zero pricing model adopted by NSE need not imply that there was predatory pricing in the market. The stock exchange industry displays the characteristics of a network industry, wherein it is a sound business strategy to charge low prices initially in order to attract more customers, increase liquidity and expand the market. In such network industries, it is a common feature of the business model to charge nothing to one side of the market (supply side) and recover costs from the other side (demand side). Such is the economics of two-sided markets where businesses need to get two different groups of customers on board in order to succeed.

Pricing below marginal cost or negative prices can arise in such two-sided markets. For example, Microsoft sets the prices to developers well below the cost of serving them, which leads to their increased participation. This attracts greater number of customers who are willing to pay high markups over the marginal costs for the enhanced value resulting from developer participation. So, it recovers the foregone profits in the case of the developers from the other side, the end users. Such a pricing model does not necessarily amount to predatory pricing even though it may result in the exit of some small firms, which is an outcome of the competitive process.

A similar debate arose in 2008, when NYSE proposed a 100% rebate on trade reporting facility (TRF) market data. In order to stay at par with the NYSE TRF rebates, exchanges such as NASDAQ and FINRA, which jointly own a TRF, proposed an increase in their rebates from 50% to 100%. Exchanges such as the US NSX also felt the heat and proposed to increase their rebates from 50% to 75%. The exchanges expressed concerns that such price competition has hurt their operating performance. The Securities Industry and Financial Markets Association wrote to the Securities Exchange Commission (SEC) on February 14, 2008, arguing that such a move by NYSE would drive the smaller exchanges such as NSX out of the market. It accused NYSE of cross-subsidisation of the excessive market data fees that the investors and broker-dealers pay for data to exchanges, in order to fund other commercial activities. SEC did not find much substance in the allegations and approved the pricing proposal of the stock exchanges to increase the market data rebates, and took no action against NYSE.

Establishing predatory pricing is quite challenging as in such cases intent to eliminate competitors (predatory intent) and a subsequent recoupment of profits once competitors are driven out needs to be clearly demonstrated. Such predatory intent seemed to be absent in the NSE case, given the entry of MCX in 2008 and of United Stock Exchange in 2010, after NSE had started operating in the market, substantiating that the fee waivers did not result in any anticompetitive foreclosures. The subsequent entry of players shows that the barriers to entry are low and, hence, making high profits would be difficult as new players would push the prices down, thanks to competition, which happened in this case.

A useful way to think about this case (as with the current FTC investigation of Google) is whether NSE excluded competitors in a way that hurt consumers. In fact, if the majority order erred in its analysis in the current case, it would effectively be protecting specific competitors who may be inefficient and hurting consumers who were earning the benefits of a free service that the NSE was providing until now. It would be contrary to the spirit of competition law. Any intervention of CCI should have been assessed on this touchstone.

This case also has significant implications for the existing regulatory regime in the stock market. It highlights the need for a comprehensive framework with an active role of Sebi in the stock exchange space as recommended in the controversial Bimal Jalan Committee Report released last year. It is disturbing to see that Sebi, which is vested with powers to regulate the stock market and promote its development, took note of the waiver in transaction fees by NSE in the currency derivative market back in 2009, and remained silent in face of policies and practices that were seemingly price distortive and potentially hampering the development of the stock market. It failed to initiate an investigation when it is well empowered to do so and instead sat back, saying that the matter involved predatory pricing (prima facie) and falls under the purview of CCI. Both the market regulator and the competition regulator have distinct core and overlapping competencies, and their coordination would have been helpful when dealing with such issues. The case needed Sebi’s intervention for a comprehensive understanding and analysis of the pricing policies being administered by the players in the exchange market and the development/market expansion objectives behind such policies.

While one can say of the main order that it is full of grave errors of judgment, the dissenting order is an excellent piece of economic analysis using the latest well-received economic theories that have been brought to bear on the case at hand in a highly commendable way. One hopes that this order will set the precedent for subsequent orders of the Commission, as far as the quality and rigour of analysis are concerned. While there are some debatable issues in it, particularly the definition of the relevant market and the means by which this has been derived, one hopes this marks a new phase in the deliberations of the CCI.

Pradeep S Mehta Secretary General, CUTS International

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