Contemporary Concerns Study

The battle between the Bombay Stock Exchange and

the National Stock Exchange

presented to:
Prof. Ashok Thampy and the Jury

On 19 November 2008 by:
Daan Struyven
with significant support of and inspiration provided by
Estelle Cantillon



Indian Institute of Management (IIM)

Bangalore


2

Table of content


1. Need for the proposed work and objectives:............................................................... 3
2. Literature review ......................................................................................................... 3
3. Genesis of NSE ........................................................................................................... 3
a. What were BSEs weaknesses before NSEs establishment? .............................. 3
b. What was the mid-term context for NSEs establishment?.................................. 3
c. What was the short-term trigger for NSEs establishment? ................................. 4
d. Policy response to the scam ................................................................................. 4
e. Chronology of NSEs genesis .............................................................................. 5
4. Relevant aspects of competition ................................................................................. 5
a. Impact of technology on transaction costs and access ......................................... 5
b. Governance & Management................................................................................. 6
c. Product scope. ...................................................................................................... 6
d. Geographical reach ............................................................................................... 6
5. Overview of key facts and figures over time for both exchanges ............................... 7
6. Hypothesis and analysis ............................................................................................ 14
7. Conclusion ................................................................................................................ 21
8. Sources ...................................................................................................................... 22
a. Websites ............................................................................................................. 22
b. Databases ............................................................................................................ 22
c. Scientific articles ................................................................................................ 22
d. Interviews ........................................................................................................... 22
e. Other sources ...................................................................................................... 22
9. Appendices ................................................................................................................ 24
a. Literature review ................................................................................................ 24
i. E. Cantillon & P. Yin: Competition between exchanges................................ 24
ii. Christensen: The Innovators Dilemma .......................................................... 27
b. Indian financial sector in the beginning of the nineties ..................................... 29
c. Mehta scam ........................................................................................................ 30
d. Relevant aspects of competition ......................................................................... 32

3
1. Need for the proposed work and objectives:
The National Stock Exchange was launched in 1994. The NSE surpassed BSE in
one year although the natural monopoly-character of the liquid stock market. This
study aims to identify the reasons for this shift.
2. Literature review
This study is related to literature on competition between exchanges, the literature on
technology adoption and the literature on competition between networks. I read 3 papers
including the study of E. Cantillon and Pai-Ling Yin: Competition between exchanges,
Lessons from the Battle of the Bunds. This paper studies the determinants of traders
exchange choice in the DTB-LIFFE case. I tried to incorporate its following aspects:
The methodological steps: related literature, qualitative and historical description
of relevant aspects of competition, key charts, model and hypothesizes, testing of
hypothesizes and conclusion.
The role of vertical and horizontal differentiation, access and product scope.
3. Genesis of NSE
a. What were BSEs weaknesses before NSEs establishment?
Since its foundation in the 1850s, BSE had always functioned as a club like
regional exchange run by powerful groups of Gujarati operating with high margins, low
transparency, bureaucracy and unreliable clearing and settlement systems.
b. What was the mid-term context for NSEs establishment?
1

Until the late 1980s Indian state dominated the inefficient financial sector. This
led to rents captured by insiders dominating the market.
2
Towards the end of the 1980s,
new economic forces, the economic growth and currency crisis emphasized the need for
modernization of the financial system. Government created the Securities and Exchange
Board of India (SEBI) in 1988 whose reforms were blocked by BSE.

1
Based on Susan THOMAS -How the financial sector in India was reformed
2
R. RAJANR, L. ZINGALES(1995). What do we know about capital structure? Some evidence
from international data. Journal of Finance, 50, 14211460.
4
c. What was the short-term trigger for NSEs establishment?
As shown on chart 1,the Indian stock market crashed in April 1992. Investors like
Harshad Mehta diverted 35 Bn INR
3
from the bank system via Ready Forward Deals to
the equity market which they manipulated.

Chart 1: The performance of Indias main equity index Sensex in 1991-1992:

Source: http://www.bseindia.com/histdata/hindices.asp
d. Policy response to the scam
Minister of Finance Singh stressed prima facie evidence of a nexus between
brokers and bank officials
4
and the need to create competition between exchanges. He
tapped the Industrial Development Bank (IDB)to take the lead of the project of creating
competition for BSE.

3
Samir BARUA and Jayant VARMA,Securities Scam: Genesis, Mechanics and Impact, Journal of the Indian Institute of
Management,18, no.1
4
http://parliamentofindia.nic.in/lsdeb/ls10/ses4/2004089210.htm -last access on 23rt October 2008
5
e. Chronology of NSEs genesis
NSE has been incorporated in November 1992. It started with trading on the
Wholesale Debt Market in June 1994 and it launched the Capital Market Segment in
November 1994.
Table 1: Timeline of NSEs genesis
Event Date Time elapsed (years)
First proposal idea June 1991 0
Mehta scam induced crash April 1992 0,8
NSE Incorporation November 1992 1,3
Managerial team in place January 1993 1,5
Regulatory recognition as exchange April 1993 1,8
Market design and B-plan readied May 1993 1,9
Trading Debt Market June 1994 2
Trading Equity Market November 1994 2,3
Sources: NSE facbook 2007 and www.nseindia.com
4. Relevant aspects of competition
a. Impact of technology on transaction costs and access
5

Trading system. NSEs trading system was cost-efficient, order driven, electronic and
based on satellites which reached locations all over India which resulted in a conversion
rate
6
of 90% vs. 30% for BSE, 4 times lower membership costs and spreads narrowed by
75%.
Table 2 : Trading system timeline
Event Exchange Date
Start electronic trading NSE Debt Market NSE June 1994
Start electronic trading system BOLT BSE 1995
Launch website NSE NSE May 1998
Launch website BSE BSE 2000
Launch online trading NSE February 2000
Launch online trading system(BOLT) BSE 2002
Sources: http://www.bseindia.com/about/st_key and http://www.nseindia.com/

Customer oriented clearing and settlement. NSE reduced effective delivery lags from
1 month to +- 7 working days and eliminated counterparty risk with the establishment of
NSCCL.

5
Figures based on Tarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and Yours, HBS press
(Penguin Asia) and http://www.businessweek.com/archives/1996/b3490154.arc.htm -access on 22th October 2008
6
In this context, conversion rate is defined as the percentage of orders which result in transactions.
6

b. Governance & Management
Governance NSE. NSE started as a limited liability tax-paying company owned by
public sector financial institutions with a management separate from owners and brokers.
Governance BSE. BSE had always functioned as a club like run by powerful groups of
Gujarati and Marwari businessmen
7
with entry barriers to membership and governance.
In 2005 BSE has been corporatized and demutualised.

c. Product scope.
Today, both stock exchanges trade equity, bonds, options & derivatives. NSE first
entered the bond and equity market in June and November 1994. NSE & BSE introduced
simultaneously options and derivatives between June 2000 and November 2002. The
O&D segment was contested from June 2000 until July 2001 before NSEs quasi
monopoly. During the period of shifting, options and derivatives were not traded yet.
Hence, product scope cannot be the uttermost factor explaining NSEs victory.
Table 3: product scope timeline









Sources: http://www.bseindia.com/about/st_key and http://www.nseindia.com/
d. Geographical reach
Access of brokers to BSE was restricted to Bombay until 1995 with the introduction
of the Bombay Online Trading System (BOLT) system.


7
Tarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and Yours, HBS press (Penguin Asia)
Event Exchange Date
Launch of Bonds NSE June 1994
Launch of Equity Stock NSE November 1994
Launch of Derivatives trading (Index futures) NSE June 2000
Launch of Derivatives trading (Index futures) BSE June 2000
Launch of Index Options NSE June 2001
Launch of Index Options BSE June 2001
Launch of individ. securities Options NSE July 2001
Launch of individ. securities Options BSE July 2002
Launch of individ. securities Futures NSE November 2001
Launch of individ. securities Futures BSE November 2001
7
5. Overview of key facts and figures over time for both exchanges
Chart 2: Equity market share measured as share in total Indian equity turnover

NSE increases its markets share-defined as NSEs average daily equity turnover
divided by the sum of NSEs and BSEs average daily equity turnovers- from 2% in
November 1994 to 59% in November 1995.




Sources: http://www.bseindia.com/about/st_key and http://www.nseindia.com/
8
Chart 3: O&D market share measured as share in total Indian equity
turnover


Source: Prowess database and NSE factbook 2007

9
Chart 4: Market capitalizations of traded companies

Rather than obtaining listings, NSE announced from the beginning a list of stocks
in which trading was permitted-which was facilitated by Indian law
8
. Since this list
contained almost all the most valuable companies, market capitalizations for traded
companies at each exchange are almost equal from November 1994 until now.




Sources: Prowess database and NSE factbook 2007


8
Ayay SHAH and Susan THOMAS, David and Goliath: displacing a primary market: How the start-up NSE surpassed Indias
largest stock market BSE in only one year , Global Financial Markets, 2000
10
Chart 5: number of traded/listed companies

In the beginning NSE opted for the system of permitting companies to be traded
rather than being listed. Thats why data for the number of listed companies at NSE are
only available since April 1999.




Sources: http://www.bseindia.com/about/st_key and http://www.nseindia.com/

11
Chart 6: distribution of listing places



Source: Prowess Database

12
Chart 7: number of members

For NSE, we have the yearly number of members from March 1995 until March
2002 after which we have monthly data until March 2007.For BSE, we have monthly
data for 1994 and 1995 from the Key Statistics from the Mumbai Exchange for the year
1995 and from January 1999 until now from BSEs website.




Sources: http://www.bseindia.com/about/st_key ,http://www.nseindia.com/ and Key Statistics from the
Mumbai Exchange for the year 1995

13
Chart 8: city distribution of trade volumes in March 1995



Sources: Annual Report NSE 1995 and www.nseindia.com
14

6. Hypothesis and analysis
Chicken & egg problem
Our research question gives rise to the chicken & egg problem: to attract investors and
brokers, an exchange should have a large base of traded companies, but these will be
willing to be traded/listed only if they expect many investors or brokers to trade.
Scheme 1: the 4 actors at the core of the multiple market



Hypothesizes
We can breakdown the research question: Why did NSE surpass BSE in 11 months on
the equity segment of the stock exchange market? into 3 mutually exclusive
9

hypothesizes:
1. NSE surpassed BSE primarily because NSE was more successful than BSE in
attracting traded companies;
2. NSE surpassed BSE primarily because NSE was more successful than BSE in
attracting brokers(category of intermediates);
3. NSE surpassed BSE primarily because NSE was more successful than BSE in
attracting investors and traders ( category of end-users).

9
Theoretically, we could imagine that attracting 2 or even 3 of those actors is equally critical.
15

Suppose now the 2
nd
hypothesis
10
is true. Since not all the brokers started trading
at NSE at the same moment (chart 7),one could wonder:
Which types of brokers started trading at NSE first and why did they do so?
To answer this question we have to:
analyze sources of heterogeneity among brokers (SOH);
understand key exchange decision factors for brokers (KEDF);
analyze which key exchange decision factors convinced brokers to trade at NSE
rather than at BSE.
Scheme 2: three hypothesizes





10
Similar reasoning for hypothesizes 1 and 3 can be developed.
16

Hypothesis elimination
There is some evidence for eliminating the 1
st
hypothesis since almost all valuable
companies were double traded from day 1 and since the system of permitted trading
allowed exchanges to trade shares without having to convince the companies to list.
2
nd
and 3
rd
hypothesis cannot be directly eliminated since the attraction of critical
masses of brokers, traders and investors was relatively slow and since NSE and BSE
were heterogeneous with respect to several key exchange decision factors for brokers and
brokers.

Five stories
According to the 1
st
story (vertical differentiation 1- economic factor
liquidity), traders and/or investors with low liquidity needs were predominantly attracted
by the fee structure and customer oriented clearing-, settlement- and dematerialization
processes of NSE. Investors with high liquidity needs - being involved in high volume
trades with high market-impact costs are the domestic institutional investors (banks,
mutual funds, insurance companies) and FIIs.
According to the 2
nd
story (horizontal differentiation 2- non economic factor -
ethnicity), non-Gujarati brokers, traders and/or investors with low needs to be part of the
Gujarati financial community were predominantly attracted by the fee structure and
customer oriented clearing-, settlement- and dematerialization processes of NSE.
According to the 3
rd
story (vertical differentiation 3- dynamic economic and
political factors), traders, investors and public policy makers with a important long-run
financial and/or political interest to transform the Indian equity market into a
competitive and attractive market were predominantly attracted by the fee structure and
customer oriented clearing-, settlement- and dematerialization processes of NSE.
According to the 4
rd
story (geographical access) traders and/or investors -who
originally used brokers -became member of NSE because of the possibility to trade
electronically outside Bombay.
According to the 5
th
story (vertical differentiation- economic factor- arbitrage
needs) traders and/or investors with high needs to participate in risk-free arbitrage
17
transactions -occurring because of price differences for equal securities between BSE
and NSE- were among the 1
st
to execute a part of their orders at NSE.
11


In table 5 the idea is to formalize how exchange features can create and/or destroy
investor value generated by a transaction in which an investor buys a security. The core
idea is to breakdown the net present value generated by a security transaction into costs
and incomes cashed and discounted over time. For the monetary costs, we illustrate that
liquidity (see chart 2) and pricing policies (see 4.a and 9.d) impact customer value. For the non-
monetary costs, opportunity costs of time arise from the transaction ,clearing, settlement
and dispute resolution (see 4.a and 9.d). On the income side, we distinguish on the one hand
cash-flows linked to the ownership of the security- which exchanges cannot impact- and
on the other hand future incomes which can be expected to rise from better market
conditions such as lower margins, lower spreads, etc. By buying a security at an
exchange which offers those transformational perspectives competition is fostered. The
discount factor depends on the one hand on the risk-influenced by the degree of coverage
of counterparty risk by the clearing house (see 4.a and 9.d). - and on the other hand on the
timing of cash-flows influenced by the clearing- and settlement policies.

11
Construction arbitrage cannot explain tipping because an arbitrage transaction generates the same volume on both exchanges. But
significant volumes created a new market on both exchanges.
18

Table 5 : Linkages between transaction value creation and features exchanges

NPV
building
block
Element 1
st

Break-Down
Element 2
nd

Break-Down
Element 3
rd
Break-Down
Value Driver
Exchange
Feature

Total Cost
monetary costs
=price for investor
margin broker -
Price for broker Midmarket rate -
1/2 spread -

market
impact- cost Liquidity
Exchange fee Pricing
Clearing margin Pricing

Non monetary
costs
Opportunity cost
time transaction t/ succesf. order time/order Trad. system
Trad. tech
Conv. rate Trad. tech
t (clearing) Clear. policy
t(settlement) Set. policy
Op cost t. (disp.)
unit price time
Disp. Res. P.
Total
Income
Y(ownership
security ) -
Y(transf. market) Tranf pers.
DCF risk
risk (Y(own
security)) -
risk (trans.) risk (non deli.) non deli. rate technology
risk policy
risk(Y(transf M)) Transf persp
discount period avg t(Y own secur) -
avg t(deliv) Theo. t (deliv) Set. policy
avg t(delay) delay rate Set. policy

Avg. cond.
delay Set. policy

Table 6: Legend for Table 5:
Abreviation Meaning Abreviation Meaning Abreviation Meaning
avg. average disp. dispute set. settlement
clear. clearing M market succesf. succcesful
cond. conditional p. policy trad. trading
conv. conversion res. resolution transf. transforming
deli. delivery sec. security Y income


19
Evidence for 5 stories
The 1
st
story would be supported by data showing that:
a) Initial liquidity
12
and fees
13
are lower at NSE;
b) Brokers/investors with low liquidity needs -with small transactions-start trading at
NSE (rejected since Indias biggest financial institutions were at the basis of NSEs
creation. Moreover, interviews show that FIIS, investment funds and insurance
companies shifted early).
Because of lack of support by b), the 1
st
story is not the most plausible story.

The 2
nd
story would be supported by data showing that:
a) Initial liquidity and fees are lower at NSE;
b) Share of Gujarati traders/investors in transactions at NSE is much lower than at
BSE
14
.
The 2
nd
story is thus supported by a) and b).

The 3
rd
story would be supported by data showing that:
a) Initial liquidity and fees are lower at NSE;
b) Historical evidence proving the dynamic motives of the actors having created
NSE to transform the Indian equity market to be better off in the long run;
15

c) A dynamic financial/political model proving the positive net present value for
NSEs main investor and public shareholding banks/policy makers like Mr. Singh
to execute/encourage NSE transactions which are more expensive today than
similar ones at BSE- knowing that this would contribute to the creation of long-
run liquid, efficient and competitive Indian equity market- which would result in
long-run positive impacts on future transactions. This model should also take into

12
Supported by chart 2: Equity market share on p. 7 assuming that NSEs lower initial equity turnover is a good proxy for its lower
initial liquidity and higher initial market-impact cost.
13
Supported by part 4.a) on p.5 (and Tarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and
Yours, HBS press (Penguin Asia)
14
Supported by paper Ayay SHAH and Susan THOMAS, David and Goliath: displacing a primary market: How the start-up NSE
surpassed Indias largest stock market BSE in only one year , Global Financial Markets, 2000 and by interviews with Finance Phd
students with trading experience Vishwesh MEHTA and Lakshman MUDDU.
15
Khanna confirms that the finance Minister Singh and senior decision makers of public banks like Nandkari, the chairman of IDBI,
committed themselves to support NSE by providing liquidity to NSE in a coordinated manner in Tarun KHANNA, Billions of
Entrepreneurs: How China & India are reshaping their Futures-and Yours, HBS press (Penguin Asia).
20
account the free-rider and coordination-costs problems. Game theory, finance and
strategic economics could be combined provided sufficient data;
d) Historical evidence proving the tremendous progress of the efficiency of the
Indian equity market- equivalent to the long-run pay-out of the initial market
impact cost investment
16
- and evidence for the control of the coordination
problem
17
.
Overall support for the 3
rd
story seems relatively strong.

The 4
th
story can be supported by a snapshot on the 1
st
March of 1995 of the
geographical scope of both exchanges.
18
NSE allows trade in 5 cities through 233 VSATS
with already more than 50% of trade outside of Mumbai whereas BSE is still a monocity
exchange.
The 5
th
story is supported by literature. In the mid 90s huge volumes were due
to arbitrage across the exchanges
19
. The initially large price differences- running up to
10 INR on a Reliance base price of 300 INR- resulted in very high net returns in a week
between 1 to 3 % and then dropped because the risk free arbitrage attracted more and
more participants.

16
The paper Susan THOMAS -How the financial sector in India was reformed gives an impressive overview of how reforms of the
financial market led to higher transparency, higher liquidity, higher rate of diffusion of innovations, etc.
17
Government intervention- described inTarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their
Futures-and Yours, HBS press (Penguin Asia) has been dynamic factor behind the solution of the coordination problem.
18
See also chart 8: city distribution of trade volumes in March 1995, p.13
19
A. JOGANI,K. FERNANDES, Arbitrage in India: past, present and future, October 11, 2002

21
7. Conclusion

NSE surpassed BSE on the equity segment in only 12 months because of 4 main
raisons.
First of all, non-Gujarati traders and/or investors with low needs to be part of the
Gujarati financial community were predominantly attracted by the fee structure and
customer oriented clearing-, settlement- and dematerialization processes of NSE.
Secondly, traders, investors and public policy makers with a important long-run
financial and/or political interest to transform the Indian equity market into a competitive
and attractive market were attracted by this potential to reshape the market and by the fee
structure and the customer oriented clearing-, settlement- and dematerialization processes
of NSE.
Thirdly, traders and/or investors -who originally used brokers -become member of
NSE because of the possibility to trade electronically outside Bombay.
Fourthly, price differences attracted arbitrage traders who supported liquidity at both
exchanges.
On the other hand, we could wonder why order flow did not completely drop to
nearly zero-levels
20
once spreads at NSE were much more narrow. The strength of the
relationships build during the former decades between intermediaries and investors is
probably part of the explanation.

The synthesis is that the governmental intervention in this inefficient market was
successful because of BSEs weaknesses (unfavorable transaction costs, customer
processes and narrow geographical scope) and because of visionary market design-,
technology- and governance innovations implemented by a strong NSE management.


20
Which happenend in the DTB-liffe Case
22
8. Sources
a. Websites

www.business-standard.com
www.financialexpress.com
www.sebi.gov.in
http://parliamentofindia.nic.in/lsdeb/ls10/ses4/2004089210.htm
www.nseindia.com
http://www.bseindia.com/about/st_key
http://www.businessweek.com/archives/1996/b3490154.arc.htm
http://news.oneindia.in/2007/04/12/bse-receives-overwhelming-interest-for-41-per-cent-stake-1176386869.html

b. Databases

CMIE Prowess Database
c. Scientific articles

Samir BARUA and Jayant VARMA,Securities Scam: Genesis, Mechanics and Impact, Journal of the Indian Institute
of Management,18, no.
E. CANTILLON, P. YIN: Competition between exchanges: Lessons from the battle of the Bund.February 2008
B. CAILLAUD, B. JULLIEN: Chicken & Egg: competition among service providers. Rand Journal of Economics,
Vol.94, No.2,Summer 2003 p.900-928
C.M.CHRISTENSEN: The Innovators Dilemma :When New Technologies Cause Great Firms to Fail, Harvard
Business Review Press, 1997
A. JOGANI,K. FERNANDES, Arbitrage in India: past, present and future, October 11, 2002
R. RAJANR, L. ZINGALES(1995). What do we know about capital structure? Some evidence
from international data. Journal of Finance, 50, 14211460.
Kaolo RAO, The Banker, Asia: India - Decade Of Reform - India's Securities Went From Third To First World In
Record Time. But Is T+1 A Step Too Far,.(T+1, securities settlement system), 2004
Susan THOMAS -How the financial sector in India was reformed
Ayay SHAH and Susan THOMAS, David and Goliath: displacing a primary market: How the start-up NSE surpassed
Indias largest stock market BSE in only one year , Global Financial Markets, 2000
d. Interviews

Interviews with IIMB Finance Phd students with trading experience ;Vishwesh MEHTA and Lakshman MUDDU on
15th and 25th of September 2008.

e. Other sources

NSE facbook 2007
Key Statistics from the Mumbai Exchange for the year 1995
Annual Report NSE 1995
Indias Securities Markets- A brief history, ABN AMBRO Publications, 2007SRINIVISAN, From brokers club to
world-class exchange... -- BSE's tale of transition ,Business line investment World, 14 May 2000
VAIDYANATHAN, The Coming of Dematerialization- Business Line Financial Daily- 6 February 2000
23






24


9. Appendices
a. Literature review
i. E. Cantillon & P. Yin: Competition between exchanges
Introduction This paper studies the determinants of traders exchange choice in a
famous 8 year-lasting episode. In this case the market for future on the Bund moved
entirely from LIFFE, the incumbent London-based derivatives exchange, to DTB, the
entering Frankfurt-based exchange. The paper tries to understand why both exchanges-
trading the same products- could co-exist although LIFFEs liquidity advantage. The
starting point is that trader heterogeneity must be part on any explained since dynamic
market share charts show that some traders shifted earlier than others. The paper builds a
model of exchange membership choice that clarifies the relationship between the decision
of where to trade and the decision of joining an exchange as member when membership
is not required for trading.
Relevant aspects of competition Firstly, the paper presents relevant aspects of
competition. LIFFE is portrayed as a member-owned exchange open outcry exchange
who launched automated trading in 1989. DTB is portrayed as member-independent
exchange where trading was conducted electronically from establishment in 1990 where
clearing was provided by DKV, a German company.
DTBs volumes were very low until mid-1991 where leading German banks with
a stake in DTB signed a Gentlemens agreement to support liquidity on DTB by acting as
market makers. DTB and LIFFE competed in the product space by launching options,
futures and new services such as simultaneous trading.
DTB realized early that access of trading firms was critical. By signing
agreements with the French exchange MATIF(1993) and the Dutch regulatory authorities
(1994) and thanks to the Investments Services Directive(1996), EU-based trading firms
could have remote access to DTB. Contrarily, LIFFE members were forced to have staff
in London because of the open outcry feature of LIFFE for most of 1990s.
Finally, the electronic trading versus open outcry-debate , the macro-
economically driven growth of the bund future market and mergers were also relevant
aspects of competition.
25
Exchange choice model In the exchange choice model, traders decide to be
members of DTB, LIFFE, both exchanges or neither of them. Members are assumed to
take choice decisions function of the profits of those 4 options. Membership profits
consist of a fixed component- that does not vary with traders trading in the Bund-, a
variable component, and an admission cost to the exchange.
Variable profits are the product of traded volumes and profits per contract. The
profits per contract depend on the average revenue on each contract, the transaction fee
paid to the exchange, the margin deposited at the clearing house (which has an
opportunity cost) and the impact cost which is negatively correlated with liquidity- and
a broker fee paid if hes not member. This model has two distinctive features: exchange
membership is not necessary to trade on a market and traders can become members of
both exchanges.
Four hypothesizes According to the 1
st
story (vertical differentiation), traders with low
liquidity needs were predominantly attracted by the fee structure and market organization
of DTB.
According to the 2
nd
story (access and adoption costs), traders who originally used
brokers become member of DTB because of the geographically determined access costs
who decreased because of access deregulation in the EU and because of electronic
trading at DTB.
According to the 3
rd
story (horizontal differentiation 1), DTB was more dynamic
in broadening its product portfolio.
According to the 4rd story (horizontal differentiation 2- non economic factors), political
nationalistic factors pushed German banks to trade on DTB.
Data The novel panel dataset contains individual trading firms membership status at
each exchange together with other firm characteristics, and pricing, marketing and
product portfolio strategies by each exchange.
The authors check to what extent the increase in membership of DTB is due to
newcomers or to traders switching from DTB to LIFFE. Since newcomers chose DTB at
a ratio of 4 to 1 and since the size of the market for exchange members increased
significantly, the battle of the Bund is a story of newcomers rather than switchers.
26
Cumulative distribution functions of the time at which groups joined DTB proof
that the country (driving degree of access deregulation)and business type of the groups
matter: German, Dutch and French groups who can have early access- and investments
banks switch earlier.
The empirical model contains several sources of variation. Traders vary by
geographical presence, headquarter locations and business models. There are also three
sources of variation over exchanges and time: (1) access deregulation (time-and country
specific) , (2)exchange fees, margins, liquidity and volatility (time- and exchange
specific) and (3) product scope (time- and exchange specific). The empirical model
estimates the variables in the traders profit functions with a multinomial logit model
wherein trading reoptimize every period.
Geographically-determined access costs are highly significant and explain most of
the variation in the data.
Linking the results to the four stories For 1
st
story (vertical differentiation-liquidity),
regression results show that traders took liquidity into account. However, which traders
variable signals value for liquidity? For the 2
nd
story (access and adoption costs), the
figures- showing that its a newcomers rather than a switchers story- suggest that DTBs
success was due to its ability to attract new members and that this ability was related to
deregulation.
For 3
rd
story (horizontal differentiation 1),econometric results are mixed. For the 4rd
story (horizontal differentiation 2- non economic factors), there is no evidence that
German headquartered traders were biased in favor of DTB.
Conclusions Liquidity matters but national regulation, product portfolio and user
convenience all provide scope for differentiation. The battle of the Bund is a story of
newcomers rather than switchers. Geographical presence is a key determinant of adoption
time, and it is clearly linked to the timing of access deregulation.
Lessons for this case: I would like to incorporate the following aspects of this excellent
paper in my study:
The methodological algorithm: related literature-> qualitative and historical
description relevant aspects of competition -> key charts -> model and
hypothesizes -> testing hypothesizes -> conclusion.
27
The role of vertical differentiation
The role of access costs: NSEs remote access and the relative densities of the
exchanges office networks across India
The role of product scope: NSE market domination in the O&D segment is
overwhelming
The role of service scope: NSE has always been 1
st
mover in IT-applications and
user convenience
Interview sessions with E. Cantillon, Lakshman Vijay Muddu
21
and Vishwesh Mehta,
highlight the following extra dimensions and/or differences:
A multiple stock exchange is three-sided market linking not only traders and
investors but also listed companies.
The inefficiencies before NSEs entry which were the trigger for the
governments intervention to open the market
The role of official and unofficial membership requirements: the Gujarati- and
club-based membership model of BSE vs. the open model of NSE
The role of dematerialization, technology and the clearing- and settlement
agencies as key drivers behind NSEs cheaper, faster and more efficient service
a. Christensen: The Innovators Dilemma
Objectives and introduction Christensen wants to solve the puzzle of why well
managed companies that are competitive, listen to their customers and invest
aggressively in new technologies- fail to stay atop their industries when they confront
certain types of markets and technological changes.
His research began with a study of the collapse at the end of the 80s of Digital
Equipment, the leading manufacturer of minicomputers. The decisions to consider Unix
as unimportant and to consider the personal computer as an architecture not to worry
about led to the demise of this company and were made when everyone thought that is
was one of the best run companies in the world.
Threat, opportunity of disruptive technology The disruptive technologies model has
three pieces. The first concept the performance that customers can absorb- suggests
that there is a trajectory of improvement in the product or service that the customers can


28
absorb over time. This line is a distribution of customers around a median that varies
from demanding customers to undemanding customers.
The second concept- the improvement trajectory- is a separate trajectory of
improvements that innovators make available by introducing new and improved product
generations generation after generation. This curve slopes upward faster than the ability
of customers to absorb it: companies targeting demanding customers often overshoot
their customers absorptive ability.
The third concept relates to the difference between sustaining technological
improvements and disruptive technology. Sustaining technologies make much better
products for the best customers that could be sold for higher margins. Disruptive
technologies bring to the market something that is worse, in terms of performance valued
by the mainstream customers. Disruptive technologies are simple and missed by
established companies because their customers dont use them.
Management of sustainable and disruptive technologies The successful use of
disruptive technologies begins in the low-end, low-profit market segments and then
moves as quickly as possible into the mainstream markets by coming in at the bottom of
the markets in terms of desirable niches of the mainstream market. Examples of
disruptive technologies are minimills in the steel industry, self-administered distance
education programs and internet telephony.
When new, disruptive technologies are first on the horizon, there are two strategic
tracks that can be taken in commercializing those technologies. The first track is to
stretch the technology until it can be used in the existing market segment, with existing
customers. The second track is to find or create a new market segment. Those
companies know the technology is not good enough, but they create a market that will
value the attributes of the technology as it exists today. Only companies who follow the
2
nd
track succeed. The ability of on organization to succeed using disruptive technologies
depends on whether or not corporate resources, values and processes give the
organization capabilities to properly frame the question of whether the disruptive
technology is a marketing rather than a technological problem.
The probability of a company surviving one of these transitions by trying to address it
from within the main company, or somehow by trying to change the main company so it
29
can be competitive in the next wave, is zero. However, successful cases such as the
creation of a separate IBM pc organization and the shifts from Charles Schwab over
Merrill Lynch to E-trade prove that setting up a new organization rather than trying to
transform the old one can allow the established groups to stay at the top in their
profoundly changed market.

Lessons for this case Electronic trading could be considered as a disruptive technology
for which challenger NSE creates a new market for traders and investors outside
Mumbai. The technological aspect in this case should not be neglected. Nevertheless,
analogy is not complete since BSE in 1994 could not be considered as a well managed
company for which Christensens theories explain failure.
b. Indian financial sector in the beginning of the nineties

Until the late 80s Indian state dominated the inefficient financial sector
through
22
:
Outdated state-owned banks;
the enforced purchase of government bonds for banks, pension funds and
insurers;
the absence of a developed derivatives market;
control of financial transactions by the RBI( setting interest rates on
various products) and the Ministry of finance (price control at security
issuing);
entry-barriers in sectors of banks, mutual funds, brokerages firms,
insurance company and securities exchanges;
capital controls such that Indian households and companies had to limit
their funding to the domestic market;
This inefficient way of organizing markets in emerging economies-which are
especially vulnerable to the risk of being captured by vested interests
23
- led to rents
captured by insiders dominating this market.

22
Susan THOMAS -How the financial sector in India was reformed
23
R. RAJANR, L. ZINGALES(1995). What do we know about capital structure? Some evidence
from international data. Journal of Finance, 50, 14211460.
30
Towards the end of the 1980s, new economic forces emphasized the need for
modernization of the financial system:
1. The higher economic growth and boom in IPOs underscored the
limitations of the BSE club-based market practices;
2. The balance of payments crisis in 1990 pushed policy makers to attract
FDI and portfolio flows by making market design more appealing to
Western investors.
Both financial institutions and policy were facing the dilemma of choosing
between creating new institutions and reforming existing ones. When Mr. Manmohan
Singh came to Government in June, 1991 he appointed within a few weeks the
Narasimhan Committee to look into the financial aspect when he was introducing his
macro-economic restructuring
24
.
The problems in the secondary equity market liquidity led domestic financial
institutions to create the Over the Counter Exchange of India,Ltd (OTCEI). OCTCEI
was inspired by the NASDAY system of using multiple, competing market makers.
25

This national market trading shares that had very low liquidity on BSE was unable to
create a liquid market. This case showed that international market design cannot always
be transplanted and raised the level of complacency among the incumbent exchanges
and brokers.
26

Government created the Securities and Exchange Board of India (SEBI) in 1988. The
independence and the clear and sole focus on regulation of securities markets were the
first modern elements in Indias financial architecture. SEBI imposed some focused
reforms reducing freedom of existing exchanges (e.g.; unbundling the brokerage free
from the price for a share when a broker issued a contract note to a customer). Those
reforms were blocked by BSE which persuaded policy makers that incremental reform
was not feasible and that a new exchange should be created
c. Mehta scam

The short-term trigger for the creation of NSE was the Harshad Mehta scam.in
1992. This scandal led to the crash of the Indian stock markets in April 1992. Harshad

24
http://parliamentofindia.nic.in/lsdeb/ls10/ses4/2004089210.htm -last access on 23rt October 2008
25
Susan THOMAS -How the financial sector in India was reformed
26
Susan THOMAS -How the financial sector in India was reformed
31
Mehta poster boy of the new can-do attitude of the Indian investor
27
- and other
brokers had manipulated the Indian banking system to siphon off the funds from the
banking system and builded large stock positions. They diverted funds to the tune of
over 35 billion INR
28
from at least ten major Indian commercial banks, foreign banks
like Citibank, Standard Chartered PLC and ANZ Grindlays and the National Housing
Bank-which is a subsidiary of Reserve Bank of India- during the period April 1991 to
May 1992.
The used mechanism was the Ready Forward Deal (or repurchase agreement); in
essence a secured short term inter bank loan done against government securities.
Normally, the borrowing bank sells the securities to the lending bank and buys them back
at the end of the loan period at a higher price-which represents the interest on the loan.
During the scam the RF was transformed from a secured inter bank loan to a unsecured
loan to a broker by three crucial steps:
i) The intermediation of a broker in the settlement process;
ii) The crediting of the brokers account;
iii) The persuasion of the lending bank to dispense with security for the loan
by the broker.
The money would have gone to share purchases by Mehta and the equally
powerful bear cartel, represented by Hiten Dalal,A.D. Narottam and others, to bribes
and to foreign currency purchases. The immediate impact of the scam was a sharp fall of
the share prices (Sensex decrease of 35% in 3 months between the peak on 1
st
of April
and 1
st
July); a market capitalization loss of 1000 billion INR. Technically speaking,
scam resulted in withdrawal of 35 billion INR, which is a relatively small amount with a
little impact on prices. But the phenomenons of tainted shares and perceived slow down
in reforms were the two main raisons for the fall.
Policy response to the scam
Government reacted by discovering and punishing the guilty, recovering the
money and investigating more radical financial reforms. The task of discovering and
punishing the guilty had been allocated to the Central Bureau of Investigation and the

27
Tarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and Yours, HBS press (Penguin Asia)
28
Samir BARUA and Jayant VARMA,Securities Scam: Genesis, Mechanics and Impact, Journal of the Indian Institute of
Management,18, no.1
32
Joint Parliamentary Committtee which affected people -holding key positions in the
India's financial sector
29
.
In parliament, Minister of Finance Singh stressed prima facie evidence of a
nexus between brokers and bank officials and the need to create competition between
exchanges as it is the case in China where the new stock exchange in Chenzen allowed
computerized transactions and the state exercising a highly regimented control on the
listing of companies.
30

Government tapped the Industrial Development Bank to take the lead of the
project of creating competition for BSE. The Industrial Development bank of India
(IDBI) was a government-owned institution dedicated to providing long-term finance in
India. Nandkari, the chairman of IDBI, asked Ravain Narain- now managing director and
CEO of the NSE- and 4 other employees of IDBI to build this online exchange rapidly.
Among those who drew up the blueprint for the National Stock Exchange (NSE),
was-besides Narain- R H Patil, a development banker who later became the NSE's
founder chairman. "Our mandate was to set up a nationwide securities exchange that
would offer modern trading facilities across the breadth of the country," he says. A Hong
Kong-based consultant was appointed and in eight months the plan was ready
31
.
Intelligentsia and BSE brokers who called the new exchange the sarkari share bazaar
(government stock exchange)were confident that NSE would put no challenge because
exchanges are not about technology, they are about people
32
.
d. Relevant aspects of competition

Trading technology NSE has been systematically 1
st
mover in the technological field by
introducing respectively:
Satellite and terminal- based real-time trading outside Bombay
from day 1;
A website in May 1998;
Online trading in February 2000.
NSE received several awards rewarding its IT performances:

29
Including K. M. Margabandhu, then CMD of the UCO Bank who was arrested and V. Mahadevan, one of the Managing Directors
of Indias largest bank, the State bank of India who was had to quit his job.
30
http://parliamentofindia.nic.in/lsdeb/ls10/ses4/2004089210.htm -last access on 23rt October 2008
31
Kaolo RAO, The Banker, Asia: India - Decade Of Reform - India's Securities Went From Third To First World In Record Time. But
Is T+1 A Step Too Far,.(T+1, securities settlement system), 2004- http://goliath.ecnext.com/coms2/summary_0199-95177_ITM -last
access on 23rd October 2008
32
Tarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and Yours, HBS press (Penguin Asia)
33
Award for 'Best IT Usage' by Computer Society of India in 1996 &
1997
Dataquest Award for Top IT User in 1996;
Cyber Corporate of the Year Award in 2008
CHIP Web Award by CHIP Magazine in 2009.
Trading system The key characteristics of the trading system at the NSE were the
following:
Trading was order-driven and orders were placed in an electronic central limit
order book
Satellite technology was used to reach locations all over India from a central
trading computer located in Bombay
The tick size was uniformly set at INR 0.05 for all stocks.
The decision to be order-driven was controversial because of 2 reasons. The 1
st
reason
concerns both national (BSE, OTCEI) and international (NYSE, LSE, ) prevalence of
quote-driven exchanges. Secondly, quote-driven markets reduce the risk of buyers and
sellers not finding counterparts in a timely fashion in illiquid securities. But the symmetry
among all agents and the elimination of market dealers and their complex monitoring
were determining factors for NSE to go for a order-driven market in the aftermath of the
scam.
NSE chose very small aperture terminals (VSATs) for satellite-based
communications as distribution channel. Reliability and flexibility in deployment were
main drivers for this technological choice. NSEs current Managing Director explains the
necessity to set up an own telecom company: There was no viable telecom infrastructure
on the basis of which a state-of-the-art exchange could be launched. We obviously could
not rely on terrestrial lines.
33
Equipment and software from vendors in the U.S., Canada,
France and Israel were put together in a consortium led by Tata Consulting Services.
Investors had real-time access to a single screen through the VSAT network which as
linked to the computers in brokers offices. Knowing the exact time and price of each
transaction reduced uncertainty and transactions costs. This electronic trading resulted in

33
Tarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and Yours, HBS press (Penguin Asia)
34
a conversion rate of 90% in sharp contract with the 30% conversion rate for BSEs open-
outcry 30% conversion rate.
Since BSE had to react, BSE installed all the equipment needed by brokers offices,
including the VSATs, antennas, Uninterrupted Power Systems and other internal
connections.
34
. It started to operate the Bombay Online Trading System (BOLT) which
was still restricted to Bombay, a far cry from NSEs national reach.
The tick size on the BSE ranged from Rs.0.25 to Rs.1.00. BSE members lobbied for
large ticks in order to maximize spreads. In order to favor the interests of NSE chose a
uniform tick size of Bs.0.05 for all stocks.

Clearing system Clearing consist of checking that both sides agrees with the exchange
records and can consist of netting of trades. Futures-style settlement involves significant
counterparty risk.
On the BSE, counterparty risk was handled by appealing to the ethnicity that
linked the BSE members. Delays were accepted and collective accommodating loans
were granted to the member in distress. This practice was harmful to investors and new
brokers. In NSEs first months, no alternative to this ethnical-club-like-solidarity-system
was provided. But the National Securities Clearing Corporation (NSCC), a wholly owned
subsidiary of the NSE, was created in April 1996.
NSCC requires collateral in the form of initial margins and mark-to-market
margins. As counterparty to the net settlement obligations of all brokers, it fulfills those
obligations in the case of a brokers default.
Today, trades are guaranteed both by NSCCL and the Bank of India
Shareholding (BOISL) and each exchange assumes the counter-party risk of each
member.
35

Settlement system Settlement is the actual delivery of cash and securities.

Before NSEs entry, BSE followed an account period system in which
transactions made in a single account during each two week trading period were netted.

34
Tarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and Yours, HBS press (Penguin Asia)
35
Indias Securities Markets- A brief history, ABN AMBRO Publications, 2007

35
In practice, trades were netted over a month because of the system of badla and
administrative delays In addition, 6900 of the 7000 shares traded were not settled
centrally through the Clearinghouse but bilaterally between BSE members, which
increased the administrative complexity and settlement risk. It took from one to three
months before share selling price amounts were obtained.
In 1994 NSE opted for a netting period of one week, using physical share
certificates, with a highly efficient implementation. The money- equivalent to the net
open position at the end of the week- was obtained with a lag of 5 working days after
netting and thus a total lag of 5 to 10 working days. Since April 1996, The National
Securities Clearing Corporation (NSCCL) determines the funds/securities obligations of
members and ensures that trading members meet their obligations.
In 2002, SEBI obliged all listed securities- both at NSE and BSE- to be settled
on a rolling T+5 basis and the Account Period settlement was discontinued . Initially BSE
was opposed to the introduction of this rolling system and preferred a modified system
of badla to suit the rolling settlement system. Managing Director Rathi favoured the
introduction of the rolling settlement only with adequate supportive tools that would
ensure liquidity in the market-place.
36

Since 2003, all securities are settled in a T+2 rolling settlement. On the trade day,
NSCCL (in the case of NSE)/the Clearing House (in the case of BSE) notifies the trade
details to clearing members and custodians. The custodians affirm the trades to
NSCCL/The Clearing house by day T+1 which nets the position of counterparties do
determine their obligations. The transfer of securities/funds is done on day T+2.
Dematerialization The introduction of dematerialized trading was the precursor to the
next big changes- rolling settlements and paperless trading.
37


36
SRINIVISAN, From brokers club to world-class exchange... -- BSE's tale of transition ,Business line investment World, 14 May
2000
37
VAIDYANATHAN, The Coming of Dematerialization- Business Line Financial Daily- 6 February 2000
36
The holding and trading securities in paperless mode was an alien concept in
India before 1995. As the FIIs complained about the paperwork as a major constraining
factor, the government and SEBI passed the Depositories Act in 1996 was passed and
the NSE launched the National Securities Depository Ltd (NSDL). NSE started
dematerialized trading and settlement in December 1996.But the depository concept did
not gain popularity because of the lack of liquidity. Therefore SEBI made demat trading
in stock mandatory in phases.
Governance
Governance NSE The NSE started as the first public sector exchange in the world. The
governance structure adopted at the NSE differs from the BSE model along 3 dimensions
1.Ownership: The exchange is a limited liability tax-paying company owned by public
sector financial institutions, particularly the Industrial Development Bank of India
(IDBI).
38
The government-owned IDBI played a leading role in the establishment of the
NSE. The chairman of IDBI - Nandkarni - served as the chairman of the NSE, and the
task of building the NSE itself was handed to a team of five that left IDBI for this
purpose. Nandnkarni gave full power to Narains team and he urged them to go do this,
do it quickly and dont tell me what youre doing.Ravi Narain became Managing
Director of NSE. As an MBA from Wharton, he was an unusual choice.
39

2. Management: The shareholders appoint a board of directors and a management team.
Brokerage firms do not own the exchange and are represented neither on the board of
directors nor the management team. This means that while BSE elected one of the
brokers to administer the exchange, the NSE was run professionally by a Managing
Director.
40
At NSE the principles of separation between management and ownership and
value-maximization are reflected by this governance form.
3. Role brokers: Brokerage firms are franchisees of the exchange and express their views


39
Tarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and Yours,
HBS press (Penguin Asia)
40
Tarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and Yours,
HBS press (Penguin Asia)
37
through membership on a variety of Exchange-appointed committees working on such
things as market design and dispute resolution. By opening barriers, brokers were no long
assured of fat-cat profits, but where disciplinized by fair competition.



Governance BSE Before NSEs entry, BSE had always functioned as a club like run
by powerful groups of Gujarati and Marwari businessmen
41
with entry barriers to
membership and governance. In 2005 BSE has been corporatized (from an Association
of Persons) and demutualised under the provisions of the Companies Act, 1956, pursuant
to the BSE (Corporatization and Demutualization) Scheme, 2005 notified by the
Securities and Exchange Board of India (SEBI).
Core points of this demutualization scheme are:
Voting rights of trading shareholders are restricted to 5%;
Trading members representation in Board may not exceed 25%
42
;
The CEO has to be ex-officio director
43
;
Rights trading shareholders should rank pari passu with trading rights other
members
44


In April 2006, the remaining 41% was sold to international and national institutional
and individual investors with overwhelming interest.
45


41
Tarun KHANNA, Billions of Entrepreneurs: How China & India are reshaping their Futures-and Yours,
HBS press (Penguin Asia)
42
Nevertheless, from table 4 we imply that 3 out of 9 directors are trading member directors.
43
http://www.sebi.gov.in/stkexchange/BseCorpDMut.html - last access on 26
th
October 2008
44
http://www.sebi.gov.in/stkexchange/BseCorpDMut.html - last access on 26
th
October 2008
45
http://news.oneindia.in/2007/04/12/bse-receives-overwhelming-interest-for-41-per-cent-stake-
1176386869.html - last access on 26
th
October 2008

38



Table 4: BSE Board of Directors


Non-Excecutive Chairman
Mr. Jagdish Capoor
Chairman, HDFC Bank Limited
Public Interest Directors
Mr. Jitesh Khosla
Joint Secretary, Ministry of Corporate Affairs, Govt. of India
Mr. S. N. Menon - IAS (Retd.)
Chairman, Nicco Parks & Resorts Limited
Shareholder Directors
Mr. Ishaat Hussain
Finance Director, Tata Sons Limited
Mr. Vivek Kulkarni - IAS (Retd.)
Chairman and CEO, Brickwork India Pvt. Ltd.
Mr. Sudipto Sarkar
Senior Advocate, Kolkata High Court
Trading Member Directors
Mr. Prakash R. Kacholia
Designated Director
Emkay Global Financial Services Limited
Mr. Balkishan Mohta
Mr. Siddharth J. Shah
Designated Director
J.G.A. Shah Share Brokers Private Limited

Product scope Today, both stock exchanges trade equity, bonds, options & derivatives.
NSE first entered the bonds market in June 1994. Then NSE wanted to compete with
BSE in equities trading-which it launched in November 1994. Rather than obtaining
listings-which involved delays and the risk of non-persuasion- of the firms- the NSE
chose to permit trading in the 1200 most liquid stocks. Gradually, NSE obtained
significant income-generating listings.
For the options & derivatives, NSE & BSE introduced simultaneously index
futures, index options and options and futures on individual securities between June 2000
and November 2002. The O&D segment was heavily contested with capricious market
share jumps from June 2000 until July 2001. Since July 2001, NSE has always dominated
the O&D market with market shares above 90%.

39



Service scope
BSE has been the first exchange in selling information products and providing financial
trading. More recently, NSE innovated by launching a NSE research unit and 18 media
channels in joint venture with CNBC.

Table 5: service scope timeline
Event Exchange Date
Launch selling information products BSE Since 80s
Launch selling information products NSE 1994
Launch Training Institute BSE 1989
Launch Training in Financial Markets NSE July 1998
Launch of NSE Research NSE February 2000
Launch of NSE-CNBC TV 18 Media Centre NSE January 2007