Electronic copy of this paper is available at: http://ssrn.com/abstract=962033

CAPITAL MARKET ACCESS TO SMEs IN INDIA

Mr. Ayan Banerjee1

Abstract The Over The Counter Exchange of India (OTCEI) was setup with the astute vision of providing

equity market access to SMEs in India. However, it failed to stand the tests of time. OTCEI was hailed to be ahead of its times yet it was eventually a failure in financial institution building. Years after OTCEI was setup, the original motivation for setting up such a platform still holds good. With abounding enablers for the success of the idea, the design merits attention.

The paper reinforces the significance of SMEs, the need to setup capital market access for SMEs and delves particularly into the case for equity market access. A solution is sought to reinvent the equity market access for SMEs. OTCEI is revisited; lessons are also drawn from similar successful international experiments- in particular, AIM and NASDAQ. Keen attention to the required market microstructure has been paid, policy issues have been looked into and an overall strategy for resurrecting the equity market platform for SMEs in India has been formulated. Key Words: Capital Markets, Small and Medium Enterprises, Stock Exchange, Market Micro Structure,

Venture Capital & Private Equity 1 INTRODUCTION

1.1 If India is to attain its aspiration of double-digit growth rates and a reduced poverty ratio, greater focus on the well being of the Small and Medium Enterprises (SME) sector becomes a necessity. There is no universal definition of SMEs; generally, in India industries that have capital investments upto Rs 5 Crore will be classified as small-scale and those enterprises that have investments up to Rs. 100 Crores as medium scale.

2 SMALL AND MEDIUM ENTERPRISE FINANCE

2.1 Innovation is the means by which the entrepreneur either creates new wealth producing resources or endows existing resources with enhanced potential for creating wealth. (Drucker, 1985) Innovation has always been the hallmark of SMEs. The prime progression in the economic force of changes is the introduction of innovation culture (Schumpeter, 1927). Since the innovation process is a recursive heuristic cycle, problems at some stage of development necessitate the need for reevaluation of the earlier stage of the innovation process – leading to learning. Innovation is an ongoing effort and the success of the economy (just as is those of any business enterprises) is dependent on its ability to continuously provide innovation. Oxford Analytica (2005) highlighted the constraints facing high growth companies and SMEs in Europe in accessing equity finance, which in turn inhibits their growth and expansion, thereby impairing innovation and job creation. Studies conducted by US Department of Commerce, revealed that since World War II, 50% of all innovations and 95% of radical innovations, have – unsurprisingly – come from new and smaller firms (Pavitt, 1990). The US SME sector provides 67% employment and 61% of manufacturing sector output. More than 99% of all enterprises in the world are SMEs! In India too, SMEs play a vital role in the growth of the economy. Small industries have around 40% share in industrial output, producing over 8000 value-added products. They contribute

1 Capital Market Space, London, Email: ayan.a.banerjee@gmail.com The author would like to express his deepest gratitude to Prof G. Sethu (Indian Institute of Capital Markets), Prof. Vijay Marisetty (Monash University), Mr. Amol Agarwal (Investment Banker, IDBI Caps), Mr. Madhav Mehta (Sr. Analyst, AOC Partners), Mr. Abhijeet Bhandari (Consultant, Headstrong), Mr. Amithanand Bhavani (Assistant Manager, Indian Bank), Mr. A. Manickavelu (MD–Officiating, OTCEI), Mr. Ajeet Prasad (MD-CEO, ASREC), Mr. Mahesh Thakkar (ED, ALFS), Mr. Martin Graham (Director, AIM), Mr. Terry Smith (CEO, Collins Stewart), Mr. Ravi Mohan (MD, S&P Crisil) for being extremely helpful in guiding and canalising the path at various stages towards the completion of the research effort. There are also others who have provided considerable facilitation but whose contributions are not being acknowledged in this laconic note. My heartfelt indebtness goes out to all of them.

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Electronic copy of this paper is available at: http://ssrn.com/abstract=962033

nearly 35% in direct export and 45% in the overall export from the country. The SME is the second biggest employment-providing sector (after agriculture), providing direct work to around 30 million people and contribute around 90% to the Gross Domestic Product (GDP)i. However SMEs in India, which constitute more than 80% of total number of industrial enterprises and form the backbone of industrial development, suffer from the problems of sub-optimal scale of operation and technological obsolescence. Indian SMEs are facing stiff competition from their global counterparts due to liberalization, change in manufacturing strategies and uncertain market scenario. The non-availability of “institutional” finance on affordable and easy terms is hindering access to new technologies (Kacker, 2005).

2.2 SMEs can access capital through seven channels (Exhibit 1). The non-availability of finance on

affordable terms is hindering their growth. Theoretically, seven modes of finance can be employed- but all have some degree of problem associated with them in providing capital to SMEs. Banks are invariably restrictive in lending to SMEs. Early stage ventures often have a low equity base and lack a visibility in cash flow, which can sustain debt finance. Further, the loans are collateralized, high cost and often are bundled with a delay in receivables. The high informational asymmetry makes it difficult for the debt finance to thrive. With the banks increasingly being in the public eye, there is an increased element of risk averseness (Exhibit 2). The course of debt financing from a development finance institution has not been a runaway success. Bond finance as an option is as good as negligible even for a large corporate in India, let alone being workable for an SME. The MFI sector is growing but not rapidly enough and certainly not large enough to provide the required capital. The same may be said of the VC industry, which has shown noteworthy evolution – thanks in large part to regulations and India’s promise of growth but has to attain greater significance for India to achieve breakaway growth. A large part of the capital required by SMEs still comes from lending by NBFCs and through informal finance – wherein the cost of borrowing is significantly high. Thus, the situation is complicated by the fact that the preferred mode of finance is self – largely due to associated high interest ratesii.

3 As is evident, the resolution of capital raising problems for SMEs will enrich the Indian economy and

also provide greater employment.

Exhibit 1: Access To Finance Exhibit 2: Debt Financing to Startups

Surplus Units Deficit Units

Banking Finance

Equity Finance

Informal Finance

Bond Finance

Non Banking finance

MFI VC/PE Funding

Regulatory Framework

ACCESS TO FINANCE THROUGH 7 CHANNELS

Assets/Business Not Risky Risky

A

vaila

ble

Prom

oter

’s C

apita

l

N

ot

Ava

ilabl

e

Debt available

Uncertainty in availability of debt Debt unavailable

2

4 ADVOCATING ENHANCED CAPITAL MARKETS FOR SMEs IN INDIA

4.1 Diversification: A financial system that is built on the two pillars of banking and securities markets is stronger than a system that is built solely on banking credit since the better-functioning system is that which would diversify its sources of finance, turning variously to banks and markets as conditions dictateiii. It is not possible to say unequivocally which of the two systems is better for economic growth. The growth rate depends, inter alia, on the efficiency of financial and legal institutions in the country (Chakraborty and Ray, 2003). The capital market (in which banks are important participants) can and should compete head-on with banks in the supply of debt finance to businesses including those to SMEs. From a regulatory viewpoint, it is essential that the competition between the banks and capital markets take place on a level playing field. (The Economist, “A survey of global equity markets”, May 2001)

4.2 The role of the State in the advancement of the financial sector is much debated. However, there is

extensive agreement about the role of the State in producing ‘financial regulation’. Beyond that, whether the State can play a role in designing markets and to what extent the State should do so, is still up in the air. Financial market systems in developed and emerging markets have been known to be vulnerable to capture by vested interests (Rajan and Zingales, 2003). Inefficient ways of organizing the markets (such as floor trading or telephone markets) are associated with rents captured by the insiders who dominate these markets. One should, ideally, take a unified approach to the problems of development. Recent and growing literature emphasizes that one takes a levelheaded approach to market failure and the potential for government intervention. It is not that markets are intrinsically bad or intrinsically good: the point is to understand the conditions under which they fail or function at an inefficient level and to determine if appropriate policies grounded in an understanding of these conditions can fix such efficiencies. These conditions can be best understood by serious appreciation of subjects that are at the forefront of economic theory and rationale. Thus, there is much need for State intervention to help financial market systems march towards a competitive outcome – with no entry barriers or rents accruing to participants with concentrated market power. Though these problems can be induced by faulty state intervention as well, sanguinity in the administrative machinery propels us to repose faith in State intervention. A review of India’s performance in developing its financial system presents us with an understanding of the impact of State guided financial sector development, with stories of both success and failure (Thomas, 2005). And the failures, which are nothing less than learning opportunities, should be made stepping-stones to success.

4.3 Better allocation of capital and risk (Dudley and Hubbard, 2004): Further development of the capital

market in India will generate two major sets of economic benefits. 4.3.1 Improved capital allocation: Because the prices of equity (and corporate debt, which is unfortunately

a virtual nonentity in India) respond immediately to shifts in demand and supply, changes in the outlook for an industry (and/or company) are quickly embodied in current asset prices. The signal created by such a price change encourages (i.e., by higher prices) or discourages (i.e., by lower prices) capital inflows into the industry (and/or company). Businesses with high returns attract additional capital quickly and easily. When returns decline, prices fall signaling investors to cut the flow of new capital. The ability of companies in their early stages of development to raise funds in the capital markets is also beneficial because it allows these companies to grow very quickly. This growth in turn speeds up the dissemination of new technologies throughout the economy. Furthermore, by raising the returns available from pursuing new ideas, technologies, or ways of doing business, the capital markets facilitate entrepreneurial activities. While it is true that several ventures are too risky for equity market activities and deserve the attention of venture capital, yet there are a large number of cases where a thriving equity market would have been the perfect setup for raising capital.

4.3.2 Efficient Risk Distribution: The development of the capital markets has helped distribute risk more

efficiently. Part of the efficient allocation of capital is the transfer of risk to those best able to bear it — either because they are less risk averse or because the new risk is uncorrelated or even negatively correlated with other risks in their portfolio. This ability to transfer risk facilitates greater risk-

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taking, but this increased risk-taking does not destabilize the economy. The development of the derivatives market has played a particularly important role in this risk-transfer process. Thus the capital markets ensure that capital flows to its best uses and that riskier activities with higher payoffs are funded.

4.4 Better economic performance: The improved allocation of capital and risk sharing facilitated by capital

markets has led to superior economic performance (Dudley and Hubbard, 2004). As the capital markets have become more developed in the UK and the US, the economic performance of these countries has improved. They provide examples and empirical evidence of the superior economic performance in five major respects: (a) Higher productivity growth (b) Higher real-wage growth (c) Greater employment opportunities (d) Greater macroeconomic stability and (e) Greater homeownership.

5 THE CASE FOR EQUITY MARKET ACCESS FOR SMEs IN INDIA

5.1 As countries grow richer, financial markets play an increasingly important role relative to banksiv. India, as an emerging (not just developing) economy must provide the platform for a more enhanced equity market. The steps taken now by India will be forward looking with an eye on its future.

5.2 Wider share ownership: is profoundly importantv; it spreads wealth and it is important to have growth

that is inclusive. Additionally, it changes attitudes towards economic freedom, by aligning employees’ interests more closely with those of companies, so reducing opposition to lower business taxes or measures to make markets for goods and labour work better. A third aspect of a growth in equity culture through this platform for SMEs is greater shareholder activismvi. More than any one technological breakthrough, this cultural change promises to raise productivity and economic growth. Indeed, it may even be a necessary condition for the rapid adoption of new technologies. A thriving equity market provides the much necessary option to young entrepreneurial firms to raise money. And it reduces the dependence of companies on credit. (The Economist,“Waking up to equity risk”, Mar 8 2001)

5.3 Vibrant Venture Capital (VC): Contrary to perception, stock markets and venture capital are not quite

substituting recourses. There is greater vitality of venture capital in stock market centered systems (Black and Gilson, 1998). The Report of the Committee On Technology Innovation And Venture Capital (2006) outlines that our ‘underdeveloped equity market for the listing of early stage firms limits the transition into and from early stage investments (venture capital funds)’. The underdeveloped equity culture has made it difficult for companies to graduate from venture capital/startups to a scale of operations that would make them internationally competitive. With the formation of this platform, an added incentive for greater venture capital participation would be a reduction in their lock-in period. Thus, if the companies could be listed, the VC can pump the now unchained capital into other new ventures providing opportunities to more entrepreneurs inviting innovation. A fiscal policy could be devised to account for their holding period and listing in either this platform or BSE/NSE or a strategic sale or promoters’ buyback.

5.4 Mergers and Acquisitions (M&A): India's corporate sector is highly fragmented. Thus, the individual production capacities, as compared to those of companies globally are low and thus there is scope for mergers and acquisitions. Yet, in spite of the possibilities, the level of M&A activity seen against global trends remains low, a significant reason is that most Indian companies have highly leveraged balance sheets i.e. are low on equity and high on debt. Unless there is a ‘balance’ between debt and equity, it would be difficult for M&A activity to increase. Though there have been a few big-ticket M&A deals in India and several smaller ones too in the past, cash has remained the consideration of choice. In more developed markets either stocks or a blend of stocks and cash is more popular during M&A eventsvii.

5.5 Widening investment options: From the investors’ perspective, the existence of a platform for SMEs

allows them to invest init allows mutual fund to bring in more innovation into their products vide SEBI Circular “EXECUTIVE DIRECTOR INVESTMENT MANAGEMENT SEBI/IMD/CIR No. 5/70559/06 June 30, 2006” securities with a different risk-return-liquidity profile from existing products in the equity asset class. Interestingly, as a case in point, (Board, Dufour, Sutcliffe and Well, 2005) show that

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there is no significant risk (stock price volatility) differential between the Alternative Investment Management (AIM) and the Official List of the LSE. Thus fears of a high-risk market may be allayed.

5.6 When companies are in the growth phase, they tend to get leveraged. Beyond a certain point, banks are

reluctant to provide further credit. Equity capital is required to bring strength to the leveraged balance sheet. At this point either the promoter will have to self provide for injecting in the requisite levels of equity or would have to do without the capital, which in turn would kill the impetus of growth. Having the option of equity financing through the equity market, allows the firm not only to raise long-term capital but also to get further credit due to additional equity cushion now being available.

5.7 Improved economic policymaking: Capital markets act as long-term discounting mechanisms that provide nearly instantaneous feedback to policymakersviii. When bad policies are formulated, equity and bond risk premia tend to rise and stocks and bonds go down in value. These price signals raise a red flag to lawmakers about the wisdom of pursuing the policies in question. Since the capital markets anticipate future developments, they reduce (political) incentives to do things that provide short-term gains but that bring long-term costs that will ultimately hurt economic performance. The importance of the capital markets in disciplining policymakers has presumably also increased because of the emergence of the investor class.

6 MARKET MICROSTRUCTURAL DESIGN ISSUES

6.1 Having convinced ourselves of the need to provide equity market access to SMEs in India, the next measure is to contemplate how this may best be done. Appraisal in the market microstructure design includes issues, tradeoffs and balance on several parameters: competition, internalization, regulation, transparency etc. Each of these parameters is a controlling concept and would require intense contemplation. The leverage they provide in forming the market design can be especially high as they are relevant across a broad range of important market design and regulatory questions.

6.2 Competition across platforms vs. competition for executing against an individual order: A pivotal

precept in economic studies is the emphasis of the constructive consequences of market competition and mitigating market impediments to competition. Yet, in the trading context the core issue concerns what type of competition is most significant and should be promoted. Should our market institutions focus upon enhancing competition at the "high frequency" order-by-order level (BSE/NSE) or competition among platforms with alternative designs or pricing? This would be at the heart of much of the debate on inter-market competition and fragmentation. This is a recurring theme in all discourses on market microstructure. The stance would determine whether or not the issue in question would find any interest among implementers.

6.3 The Benefits and Costs of Internalization: An issue to reckon with is: ‘to what extent is internalization

desirable and when it should be encouraged?’ When buyers and sellers are not contemporaneous, intermediaries (such as market makers and specialists) play a crucial role. When there are matched arrivals of buyers and sellers the investors find it useful to trade directly with one another and indeed, under such conditions market intermediaries should not undercut the trading dynamics. In various contexts intermediaries are able to match the prevailing quote and obtained a desired execution. But this limits the ability of customer orders to interact directly, which may widen market spreads. (Biais, Glosten and Spatt, 2005) which can be anti-competitive in market equilibrium. Consequently, in the market microstructure context, spreads are artificially high. Yet, the empirical consequences of internalization are much more nuanced. (Battalio, 1997) and (Battalio, Green and Jennings 1997). NASDAQ has designed many policy innovations to reduce the extent of internalization of orders and increase the interaction of customers in the marketplace. Benefits to the investors arise from both tighter spreads and a reduced need to trade against intermediaries. Measuring the extent to which customer orders interacts as compared to when an intermediary executes the customer order and assessing the resulting size of the spreads is important to the evaluation of many policy interventions. Among the range of issues for which attention to internalization is relevant have been the order-handling rules, payment for order flow, inter-positioning by the specialist, auto-quoting and the ability of the specialist

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to stop the market, market fragmentation, market data revenues, dealerization of the market, price improvement programs (such as the structure currently being used on the Boston Options Exchange.) Many of the same concepts and principles apply to an important range of market structure questions.

6.4 Market transparency: An important theme with applicability to a variety of market design issues is the

importance of transparency of the markets in which the instruments trade. Transparency relates to how orders are exposed to the market and indirectly, the role of rents captured by the various players in these markets. There is a feeling among financial economists that both pre-trade and post-trade transparencies are relevant to the competitiveness of a trading platform. Pre-trade transparency relates to whether quotes and potentially even the order book are available to investors at the time of the trade, while post-trade reporting refers to the rapidity of reporting of the trade after the fact. By increasing the investor's knowledge about market conditions, the competitiveness of the underlying trading market can ultimately be enhanced by post- and even pre-trade transparency. For instance, the absence of trade reporting gives dealers considerable market power because it limits the investor's understanding of the size of the spread and the state of the market. The usual argument against transparency is that dealers need time to work orders; if this argument were correct it would suggest that the spreads and price impact of large orders would be substantially greater than for small orders. The contention that the results reflect market power rather than the costs of working large orders seems greatly enhanced by empirical evidence in various market contexts. While we lack direct evidence about the optimal transparency regime, competition and transparency have proved important in other market microstructure contexts. Spatt, Biais and Glosten (2005) offer an argument as to why transparency may be optimal by enhancing risk sharing. While the conventional argument is that trade disclosure can make it harder to supply liquidity to large traders because the market maker is in a difficult position in trying unwind his inventory after a large and difficult order (Naik, Neuberger and Viswanathan, 1999) argue that in a transparent system the market maker would not need to scale back the size of the trade (the informational content of the trade would already be reflected in the marketplace), thereby enhancing risk sharing. A similar outlook also arises in Vayanos (1999). The empirical evidence in Gemmill (1996) for the London Stock Exchange is consistent with the view that transparency does not reduce liquidity.

7 BUILDING THE PLATFORM: LEARNING FROM GLOBAL EXPERIENCE

7.1 Promoter: A critical decision that must be made who should promote the new platform? Should the same stakeholders, the Financial Institutions who are the very same as that of NSE, continue? Or should a consortium of capital market players – Venture Capitalists, Mutual Funds, Investment Banks, Broking Houses etc., who will have some stake in getting the venture off its feet, promote it? What about private players? Further, should it be corporatized? And be listed? Should the two main stock exchanges have stake in it or be one of the promoters? Or should the new platform just be an extension of one of the main markets as AIM is that of LSE? These are a few questions, which have to be delved into and extensively contemplated. It is very important to have the interest of the promoters in any venture. One of the important reasons that is often cited for the failure of OTCEI was the apathy of the promoters. This must change for a desire of a different outcome.

7.2 Regulation: Regulation sets the rules for competition among market centers. Well-placed regulations can

instrument innovation. While too much regulation will stifle innovation and growth, inadequately regulation will result in price manipulation leading to serious market dishevels and eventual failure. Pushing for transparency of prices and quotes enhances competition but it limits the flexibility and speed with which markets could act. The ‘balance’ will have to be discovered.

7.3 For instance, the Securities Exchange Commission (SEC) rules on Alternative Trading Systems (ATS)

distinguish them from exchanges. ATS are electronic trading systems and other proprietary trading systems that do not carry out all the functions of an exchange. ATS are regulated as broker dealers with additional requirements depending on their size. An exchange has self-regulatory obligations, has requirements as to governance and board structure, and must participate in market linkages. An excellent example of this is the "order-handling rules," adopted in the aftermath of concerns about monopolization

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by Nasdaq market makers, which was strikingly pointed out to policy makers by the important academic work of Christie and Schultz (1994) and Christie, Harris and Schultz (1994).

7.4 The AIM prides itself in ‘light but careful regulation’ and ascribes its success to this seemingly simple

idea. Skepticism of a compromise of regulatory potency is reasonable for fears of price rigging and manipulation. However, the regulations and rules applicable should recognize that all market centers are not equal. Thus, OTCEI and BSE/NSE cannot and should not have the same level of regulation. The AIM, which is specifically tailored to growing businesses, is a sub-market of the LSE. AIM combines the benefits of a public quotation with a flexible regulatory approach and allows smaller companies to float shares with a more flexible regulatory system than that which is applicable to the main market (Table 1). Launched only in 1995, AIM has raised almost £25 billion for more than 2,200 companies. Flexibility is provided by less regulation and no requirements for capitalization or number of shares issued. Thus, some companies have since moved on to join the Main Market, although in the last few years, significantly more companies transferred from the Main Market to AIM (AIM has significant tax advantages for investors, as well as less regulatory burden and hence reduced cost of compliance for the companies themselves). In 2005, 40 companies moved directly from the Main Market to AIM, while only 2 companies moved from AIM to the Main Market.

7.5 Table 1 highlights the main differences in the admission criteria for the Main Market and AIM.

Incidentally, OTCEI Initial Public Offering (IPO) norms, were not fitting for SMEs- they were far too stringent and demanding. As a result, new IPO issues were an impediment in attracting trading interest.

Table 1: Architectural Differentiation of AIM From The LSE Main Market Main Market AIM

• Minimum 25% shares in public hands • Normally 3 year trading record required • Prior shareholder approval required for

substantial acquisitions and disposals • Substantial regulation on acquisitions • Sponsors needed for certain transactions • Minimum market capitalization • No tax benefits • Pre-vetting of admission documents by the

UKLA

• No minimum shares to be in public hands • No trading record requirement • No prior shareholder approval for

transactions (except to reverse takeovers) • Currency for and easier rules on acquisition • Nominated adviser required at all times • No minimum market capitalization • Eligibility for a range of tax benefits • Admission documents not pre-vetted by

Exchange nor by the UKLA in most circumstances. The UKLA will only vet an AIM admission document where it is also a Prospectus under the Prospectus Directive

7.6 It is important to look at the building the investor base – both institutional and retail. The vision is to

distance away from financial markets as games among a small group of players and move towards a more Walrasian vision of a market of numerous, smaller players to change the focus from strategic behaviour to prices. This warrants the reduction in informational asymmetry. When dealing with what is in effect a public stock-issue, one needs that to be effectively marketed if it is to have a realistic chance of success. It is a simple fact that when an investor receives a prospectus from their broker or other adviser, if they have seen coverage of the firm in the press they are more likely to consider the offer. Thus, as pointed out by (Barber and Odean, 2003) attention leads to interest in investing. A professional and specialist financial Public Relations (PR) firm should help the firm to develop a media strategy for the public offer, incorporating the major publications to:

1. Ensure major publications list the up-coming offer 2. Gain editorial coverage surrounding the offer so that the investor community (both

private and institutional) becomes more familiar with the firm and the proposition that is coming to market

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The press release for the public issue should also be approved by the lawyers/ auditors/ investment bankers handling the verification of information (due diligence) for the prospectus – as it is effectively a part of the public offer. When a company becomes public the entire process of investor and media relations has to become professional and need to retain a PR firm to assist and manage that process to maintain effective relations with the market.

7.7 Analysts (full house brokers, investment bankers, independent researchers, rating agents etc.) will play a

crucial role in providing investors with their perspective of various investments in securities. The market needs a free flow of information to maintain transparency and fair price of securities issued. The relationship between issuers and analysts cannot be completely regulated. Issues to reckon with include

7.7.1 Lack in motivation due to reduced revenue generation 7.7.2 Researchers access to management 7.7.3 Review of sell-side analyst reports by corporate issuers 7.7.4 Research that is solicited, paid or sponsored by the issuer 7.7.5 Analysts’ conduct in preparing and publishing research reports and making investment

recommendations

Thus, the Exchange can take up an exchange sponsored Research scheme. (As is provided by Standard and Poor’s in Malaysia Bursa, Singapore SGX.) This will ensure that there is basic coverage of the company listed. The participation of the company can be either voluntary or compulsory. The cost can be shared between the company and the exchange (For instance, in Malaysia: 50% costs are borne by the company; in Singapore: 80%).

BOX 1: UK’s Junior Markets Ofex is an independent market catering for smaller issues in the UK. The market is less liquid (sales of shares are infrequent and made amongst a relatively small number of buyers) compared to AIM. There are no minimum trading, capitalization, public ownership, or other requirements other than the basic public limited company requirements. There is a 'sponsor' company and a firm of external auditors and lawyers whom together will undertake an independent audit of the accounts and produce a report and prospectus on the company. AIM and TechMark are divisions of LSE. They have the same rules but TechMark is for technology-based companies. There are actually no rules on trading period, public ownership, or capitalization. The process is similar to Ofex but requires two sets of lawyers and a corporate broker. The process is slightly more involved than Ofex but not substantially different. AIM and Techmark suit companies with a clear intention and prospect of progressing onto the main London Stock Exchange market. Both processes also engage a financial PR firm to ensure the issue is well publicized and achieves its minimum subscription. Each company applying to join AIM must appoint a nominated adviser, popularly known as a ‘nomad’. Nomads are responsible, amongst other duties, for warranting that a company is appropriate for AIM. Once admitted to AIM, a company has ongoing disclosure requirements and must retain a nominated adviser.

7.8 For firms with little known history, corporate governance assumes greater significance. The management

will play a greater role in investment decision of investors. Corporate governance practices may be incorporated in listing rules. The costs and benefits of reporting, compliance and enforcement of each practice must be carefully evaluated.

7.9 Investors are the single most important partakers from the demand side that would decide the success of

the platform. With tax exemption from capital gains, investment in this platform can be made to appeal to investors.

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7.10 The complete company filings, analyst reports and other news may be uploaded on the website of the Exchange. The exchange should be able to directly procure the report(s) from the Registrar of companies (ROC). With media and PR support, already dissemination of information is taking place. The firms should be freed from additional printing costs.

8 BACK TO THE FUTURE: LESSONS FROM OTCEIix

8.1 The Over The Counter Exchange of India (OTCEI) - setup in 1992 - as an idea was outstanding but it lacked proper implementation giving many critics the chance to label it ‘quixotic’. There is no denying that there were shortcomings then, but none that can’t be overcome today. The time has come to revisit OTCEI. We endeavor to develop the idea that OTCEI was and present a case for a dealer market in India. In any effort of designing such a structure, the comparison and the learning from the previous experiment- OTCEI, which is widely believed to be ahead of its times, will become inevitable. We will look into OTCEI’s deficiencies, where it went wrong and why it failed. And then conclude, based on the current market scenario, it is time to take a look at the idea again. We will also draw instances from the success of LSE’s junior markets (Ofex, Techmark and particularly AIM) and NASDAQ while unmistakably bearing in mind that the entire apparatus may not be applicable to the Indian setup en masse.

8.2 A critical part of launching any new product or idea is the timing. During the period of infancy of

OTCEI, the Indian stock market went into a bearish phase. This adversely affected the investor’s interest in the equity market and the impact was particularly harsh on OTCEI. Liquidity began to dry up. Had OTCEI been established, it would have absorbed the shocks of the bearish sentiments, as did the other exchange and as expected of a stock exchange.

8.3 Another reason is, possibly, the lacunae in the marketing effort. Surely, there were attempts to market

OTCEI and there was some system in place, one predictably faces the question ‘how much is enough?’ It’s not just about the money being spent on the activity but also the effectiveness of the exercise. (It may be a worthwhile exercise to study and compare the advertising and marketing costs of OTCEI to that spend by AIM and NASDAQ during their initial stages)

8.4 A problem with the supply side of OTCEI was that most of the companies started failing in their

businesses and the losses mounted. This led to a further deterioration in the relationship with the market. It is important that such companies have access to advice and counseling from management consultants. This will ensure better health of the companies listed. Subsequent section 6.10 discusses how management consultants may be made the most of and how to make it appeal to them.

8.5 The Market Microstructure: We reckon that the most significant reason attributable to the OTCEI

breakdown was its microstructural design. The market microstructural design should be congruent with the objective of the exchange. While one must appreciate the many constraints under which OTCEI was operating and its endeavor to be a platform with enhanced efficiency, promoting transparency and increasing integrity, the trading costs were high; in part due to a few off beam policies and in part due to ineffective appliance of others that eventually led to its misfortune. For instance, OTCEI was the first exchange with an online depository, which operated in the absence of any legal laws on depository and was fraught with many legal and operational issues. Various remedial measures were taken to improve the functioning of OTCEI across different time periods (1997-2002) but have been unable to revivify OTCEI. Exhibit 3 summarizes an assessment of the OTCEI market microstructure. Table 2 compares the OTCEI (1992) and the recommended platform for trading equity of SMEs and other low liquidity scrips.

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EXHIBIT 3: ANALYSIS OF OTCEI MARKET MICROSTRUCTURE

O T C E I: M A R K E T M IC R O S T R U C T U R E

• P ro m o te r’s In te re st• Institu tio na l p a rtic ip a tio n• L end ing secu ritie s/ca sh• E nou gh no . o f com pan ie s• M arg in system s• S u itab le IP O N orm s

Sh o u ld ’ve H ad Sh o u ld n 't h ave H ad

Did

n't H

ave

Had

• M arke t m aking• Q uo te d riven• C o n tinu o u s• N o n-In term ed ia ted• R ing le ss & sc reen -b ased

• M ax. b id -a sk spread 10 %• N o n du a l list in g• Q u asi-D epo sito ry• M u ltip le ne tw o rk ing system s, techno lo g y

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Table 2: Comparison of OTCEI (1992) and the recommended platform on market microstructural grounds

Attributes Recommended SME Platform (OTCEI*)

OTCEI (1992)

Intermediated Non-Intermediated

Non-intermediated (electronic matching)

Call Market Vs Continuous Markets Continuous Continuous

Auction Market vs. Dealer Market Dealer Market Dealer Market

Order Matching Automated Automated

Transparency High High

Anonymity High High

Market, Limit orders Both Both Consolidation vs Fragmentation Fragmentation Fragmentation

Competition among dealers High - Competition between compulsory, additional & voluntary market makers

Competition between compulsory, additional & voluntary market makers

Mutualization Demutualised Demutualised

Quote/ Order driven Order driven Quote driven Trader anonymity Yes Yes Cap on bid-ask spread No Yes Spot/carry forward Carry forward option Spot Borrowing/Lending Securities Yes No Borrowing/Lending Cash Yes No Settlement (Account Period/ Rolling) Rolling1 Rolling Settlement Period T+2/T+3 T+3 Demat/Paper Demat Demat Listing Parallel (with low liquidity

scrips form BSE/NSE) Unique

Presence National (additionally with the RSEs)

National

8.6 Initially, there were 115 companies listed on OTCEI. The question to be asked is ‘is that enough? Why not more?’ If one counts the total number of SMEs in India that would have met the listing criteria and might have been interested had there been greater awareness, 115 materializes as insignificant! SEBI Disclosure and Investor Protection (DIP) guidelines replaced OTCEI IPO norms, which were not suitable for small and medium companies. As a result, new IPO issues were hurdled and the Exchange could not attract trading interest.

8.7 At this juncture, it is imperative one looks at the entire equity market structure in India. We have two

major stock exchanges- BSE and NSE- which are both vibrant and are competitive. But their efficiency is essentially in the scrips, which have high liquidity. There are still a large number of shares (NSE’s - India’s Securities Markets Review 2003, 2004, 2005) that are not actively traded in the BSE and NSE platforms.x In fact, India has the second largest number of listed companies in the world. (Exhibit 4)

Though the Dave Committee on OTCEI recommended relaxation of maximum size of the issue that may be listed on OTCEI, relaxation in the listing criteria and shift from rolling (T+3) settlement to five-day accounting period settlement (that was being followed by other exchanges)

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EXHIBIT 4: LISTED COMPANIES IN INDIA VIS-À-VIS THE WORLD

8.8 The remaining stock exchanges- 22 regional stock exchanges and OTCEI- have hardly any activity.

Taking a cue from the policy of Priority Sector Lending (PSL) as applicable to commercial banks, the government will have to create a ‘system’ replete with a structure that provides an impetus to the ailing equity market for SMEs in India.

8.9 It is suggested that those companies who do not meet minimum liquidity/trading criteria listed on either

BSE/NSE be given the option of either (a) de-listing themselves or (b) parallel list themselves on the “OTCEI” platform as well, which is expected to provide liquidity since there will be market makers. (O’Hara, Market Microstructure Theory) Thus, the OTCEI platform will have access to a much larger number of stocks, depending on the criteria used, which would bring about greater survivability to market makers in the OTCEI platformxi.

8.10 The, objective is to bring down the (effective) cost of equity to the enterprise. Similar to the PSL for

banks, capital market participants (MFs, broking houses, investment banks etc) should be made instrumental in the efficient functioning of the platform (Exhibit 5). There are three ways by which the participation of the market players can be achieved.

8.10.1 Firstly, the administration could pass a regulation saying that a certain amount of their portfolio

must come from projects relating to this segment. Thus, if the directive comes from the government at a policy level, then the Mutual Fund Asset Management Company, for instance, can no more excuse itself from not investing in this low liquidity platform claiming to be ‘answerable’ to trustees and investors. Besides, it gives the AMC the opportunity to come out with new and innovative products. Investment in these companies could bring in astronomical amounts of returns for investors as well. Investment banks too must be directed that they will have to maintain a certain part of their portfolio in the services of these clients at softer rates. Rating agencies and brokerage houses must have a certain number of reports covering this segment.

8.10.2 However, by passing a directive, the cost of monitoring may become significant. The Reserve Bank

of India (RBI) has issued several guidelines for banks on SME sector lending but many of them are

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not being steadfastly adhered to. So a situation should be created in which market participants indeed want to do (out of their own interest) what the policy would like them to do (in the larger interest)! The interest of the participants in question can be generated only by incentivising them. So in return for bearing some part of the cost (that would have otherwise at market rates been incurred by the SME), the pro bono publico efforts of providing inexpensive services to their SME clients could be rewarded by fiscal incentives. By changing (raising and exempting) the tax structure, the Government can succeed in providing incentives to various capital market players directing the flow of effort/funds. Thus, a second option is to provide fiscal benefits and exemptions to the participants for the particular projects.

8.10.3 A third option is to empanel and register players who are interested in providing their services to

companies in this bracket. They could be handed out the fiscal and other benefits regularly subject to conditions being fulfilledxii.

EXHIBIT 5: CAPITAL MARKET PLAYERS TO PLAY A MOMENTOUS ROLE

Company

Audit/Tax/Law Consultants

Management Consultants

Investment Bankers

Securities Supply Support System

Market Maker

Media Rating AgenciesPublic RelationsAnalysts

Information Disseminators

OTCEI

RetailInvestors

Demand

InstitutionalInvestors

VC

9 WHY NOW? WHAT HAS CHANGED BETWEEN THEN AND NOW? 9.1 More intense motivation of the Government – policies: Recent governments have shown undying

interest in the welfare of SMEs. Several key initiatives have taken by RBI, however, these have largely been in the bank financing. Thus, among the many issues that appeal to the policy formulators, OTCEI should distinctly stand as one of them.

9.2 More equity culture, stronger capital markets: The equity markets and the capital markets in general,

have become more robust. Capital market regulations in India are among the best in the world. The Securities Exchange Board of India (SEBI) has tightened the screws on loose ends. The recent boom in the stock market has spurred widespread interest among investors in the capital markets. Investors have been embracing higher risk associated with equity for higher returns. As the investor base keeps widening, it becomes inexorable to provide investors with a greater choice set of investments. Thus, the creation and conservation of OTCEI as a platform for SMEs becomes inevitable.

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9.3 Learning From Failure: Borrowing from the cliché, ‘failures are the steeping stones to success’ it must be recognized that the failure has helped us discover where our previous follies essentially lay. Thus wiser, we are better equipped to vitalize OTCEI this time around.

9.4 Involvement of market participants: For the successful application of the design, it is important to take

into confidence everyone associated with it. The involvement of all market participants will create a more robust system and a conducive environment for SMEs to raise capital.

9.5 Technology Improvement: While OTCEI had the latest technology available to itself when it was

launched, subsequent dwindling activity and eventual failure prevented it from keeping abreast of the latest technology due to lack of funds. Thus, with time, it fell behind. However, the rebirth in the form of a new avatar calls for reinvestment in new technology, which itself has improved by leaps and bounds in the last decade or so.

9.6 Marketing and branding: The previous experiment left many (brokers, companies, investors etc.) with

burnt fingers who are bound to be once bitten twice shy. A level of comfort will have to be provided to those in terms of effort of resurrecting this platform before one can expect them to facilitate and the process and be part of the success. Thus, marketing and branding exercise of the platform itself will have to be taken on a war footing. Additional efforts will have to be taken to attract new investors.

10 IN LIEU OF A CONCLUSION

10.1 Ever since there has been an attempt to revive OTCEI and find an effective role of the Regional Stock Exchanges (RSE) in the larger scheme of things (Report of the Committee to Study The Future of Regional Stock Exchanges – Post Demutualisation, 2006), OTCEI has been treated as equivalent to a Regional Stock Exchange. Ironically, OTCEI was India’s first national stock exchange! The infrastructure of regional stock exchanges can be combined with that of OTCEI. The original reason why OTCEI was formed still holds good – and this is the best time to get it implemented. Stopgap arrangements of trading in permitted securities must be replaced with revival efforts of making OTCEI a platform for trading in securities of SMEs and low liquidity scrips.

10.2 In fact OTCEI, with the aid of the RSEs, which are groping to find a role in the rapidly developing

securities market, can form the scaffold for creating opportunities for other products which require a dealer platform – corporate bond (which when successful can eventually include bond market for SMEs), and even foreign exchange. As pointed earlier, we should take a unified approach to the problems of development. Thus, the efforts of reviving OTCEI is not just an equity program for SMEs but goes far into making India a strong capital market center and a global power to reckon with.

10.3 While it is acknowledged that the fiscal benefits meted out to various parties and the initial investments

into the project will be a cost to the economy, it is deemed that in the net it will be a benefit since a successful equity platform for SMEs, will help SMEs to prosper which in turn will result in wealth creation and employment for the nation. The only constraint to the solution being offered is in the implementation of the project.

10.4 There is little literature and data that is available on the topic in the Indian context, hopefully, with the

establishment of the new database that the SME Centre, Indian Institute of Foreign Trade is currently compiling, research on this topic will become more forthcoming. One of the purposes of this paper is to spur further academic research on dimensions that would be especially important for policy-making.

10.5 "Unlike some of the older fields of economics, the focus in finance has not been on issues of public

policy. We have emphasized positive economics rather than normative economics, striving for solid empirical research built on foundations of simple, but powerful organizing theories. Now that our field has officially come of age, as it were, perhaps my colleagues in finance can be persuaded to take their

14

noses out of their databases from time to time and to bring the insights of our field, and especially the public policy insights, to the attention of a wider audience."

Merton Miller's Nobel Prize lecture

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ENDNOTES

i India Global Summit on SMEs, Conference Proceedings, Emerging Challenges and Opportunities, 23-24 Nov. 2004,New Delhi ii NSS Report No. 459: “Informal Sector in India, 1999-2000-Salient Features” iii A comparison of bank-based and market-based financial systems with respect to their ability to smooth the negative consequences of a macroeconomic shock reveals that the market-based system provides better arrangements to speed up the recovery, but concentrates the burden of the shock in one period. In contrast, the bank-based system allows for both quick recovery and postponing and smoothing the negative consequences of the shock over several periods. (Vinogradov, 2005) iv Conference on “Does Financial Structure Matter?” took place on February 10-11, 2000 in Washington DC. Researchers: Thorsten Beck, Asli Demirguc-Kunt. (Refer Demirguc-Kunt and Levine, 2001) v It is plausible to find many promoters indisposed to part early with power so careful consideration must be made with regards to the rights of the investors in the platform. Thus, the rights and obligations of the parties concerned cannot be the same as those applicable to the main market (BSE/NSE). vi For instance, recently continental Europe’s new shareholders put pressure on managers to improve their performance reflecting an angle of corporate governance previously undiscovered. vii Author assessment based on analysis of data from CMIE Prowess, CMIE M&A, CMIE Economic Intelligence Unit, Thomson Mergers and Acquisition, Bloomberg and Compustat viii Global examples highlight this linkage between the capital markets and improved policymaking: 1. Bank of England was given independence in setting monetary policy (1992). 2. Independence of the Federal Reserve from US administration pressure. 3. The U.S. Budget Enforcement Act of 1990. ix It may be borne in mind that the new platform being suggested need not be or even be called “OTCEI.” It could either be a completely new entity, or be a subsidiary of one of the two exchanges, or be a revived OTCEI in a new avatar. The reference to OTCEI in the context of the “new” structure is used merely for convenience of reference and is not suggestive of anything else. x This is despite the fact that many of them have some intrinsic value. A ‘Committee on Market Making’ under the Chairmanship of Mr. G.P. Gupta (Chairman, IDBI) was set up by SEBI to study the various facets of market making, including the merits and demerits of the two trading systems: the order-driven system and the quote-driven system. The committee was of the view that shares could be classified into two categories viz. liquid and illiquid. Since it does not make sense to have an order-driven setup for illiquid shares, market-making facility should be provided to them. The Committee stressed the obligation of market makers to offer continuous two-way quotes and indicated that this would force them to carry an inventory of stocks preventing the market from drying up. xi The profits of the market maker will be the sum of the profits from each security’s bid-ask-spread (BAS). This has an interesting reference to OTCEI where through the regulation BAS was bounded (1%-10%), which dampened the profitability of the compulsory market makers and thus their interest to make the market. xii The discussion of fiscal incentives is an exercise in itself. The same is being left for a more opportune occasion by more competent authorities.