Broken Exchanges: An Analysis of Market Quality in NSE (India) and Welfare Concerns

When should a capital markets regulator introduce competition and restrictions into business segments? This paper examines a possible basis to aid such decision making in the regulation of stock exchanges that deal with equities and linked derivatives. Market microstructure invariance hypotheses is extended to the ‘Invariance of Trades in stock exchanges’ continuing with the intuition that financial markets transfer risks in business time. The market quality of stock exchanges is examined using this hypothesis and measures such as per day Turnover-per-trade. Market quality is found to be broken in a few Asian exchanges (BSE, NSE, Korea Exchange, Shanghai and Shenzhen Exchange) that show high implied risk. Broken exchanges cannot meet their welfare role, which starts with formation of prices of underlying assets. High risk levels in these exchanges have potential to distort the welfare functions in the economy. Regulatory intervention in form of inducing competition, increased primary listing and restriction on derivative segment activity is recommended for the NSE.