Interoperability: potential game changer for Indian CCPs

Interoperability: potential game changer for Indian CCPs
India has many stock exchanges, but trading is dominated at two main exchanges – the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). BSE is among the oldest stock exchanges in the world, while NSE was established as part of India’s economic liberalization process in the early 1990s. The NSE was quick to gain market share and now accounts for around two-third of stock trading and most of derivative trading in the country. BSE was slow to react to competition in the early days, but in the last five to six years has taken steps to up its game by making major changes in its technology. Structural issues with the Indian capital market have so far limited its ability to close the gap with NSE. The Indian CCPs that clear exchange trades are owned by the respective exchanges and at present only clear trades executed at the owner exchange. National Securities Clearing Corporation Limited (NSCCL) is the CCP for NSE while Indian Clearing Corporation Limited (ICCL) is the CCP for BSE. Interoperability among CCPs at an investor level is not allowed; i.e., investors can choose which exchange would execute their trades, but cannot choose which CCP would clear them. Therefore, in spite of having multiple players in the clearing space, there is not much competition among the CCPs. The dynamics in the Indian CCP space therefore are largely driven by the competitive developments on the exchange front. The capital market regulator SEBI allowed direct market access in India in 2008 and soon afterwards allowed colocation and smart order routing (SOR). This should ideally allow investors to execute their trades at any exchange of their choice. However, most of the liquidity is concentrated at the NSE due to its dominant position. Furthermore, since almost all of derivative trading takes place at the NSE, investors tend to prefer NSE for their equity trades as well, since that allows them cross-asset margining benefits of clearing trades in different asset classes at the same CCP. Because of this, smart order routing has not picked up in India yet. Thus algo trading reached around 15% in the cash segment in NSE in 2014, but smart order routing was only around 2%. Similarly algo trading was 70% at BSE’s cash segment, but SOR was around 1%. This shows BSE (and its CCP ICCL), with its improved technology and latency capabilities, is attracting a higher share of algo trades but is still unable to capture share in smart order routing, due to unique clearing arrangements in the market. Going forward potential allowing of interoperability promises to be a significant force of change for the Indian CCPs. It would give investors the freedom to choose their CCP, and if they get better latency and pricing from ICCL, they could choose ICCL regardless of BSE’s smaller share in trading volume. SEBI is considering this and is in consultation with a range of market participants. Eventual interoperability may be a boon for BSE and ICCL, allowing it to catch up with the dominant NSE and NSCCL.

HFT on the radar of Indian and Chinese regulators

HFT on the radar of Indian and Chinese regulators
High Frequency Trading (HFT) received its share of attention in the US last year with the publication of Michael Lewis’ Flash Boys.  Recently it has received attention from somewhat unexpected quarters – regulators from India and China. India’s securities market is regulated by the Securities and Exchange Board of India (SEBI), while Reserve Bank of India (RBI) mainly deals with the country’s banks and monetary policy. However, in a recent Financial Stability report, it expressed worries about trends in algorithmic trading (a cousin of HFT) in the country. Algo trading was introduced in India around 2008 with allowing direct Market Access (DMA) in the local market; colocation was allowed subsequently in 2010 to promote its adoption. Even though it didn’t take off immediately due to overall macroeconomic condition persisting around 2008, it now represents a sizable share of around 40 per cent of cash segment trades conducted at the two major exchanges, up from around 15 per cent in 2011. More worrying for the RBI is its share in cancelled orders – of all cancelled orders, around 90 per cent comes from algo orders, and this has become a cause for concern for the RBI. To be sure, India, like many other emerging markets, has conservative regulations in all aspects of its financial services markets and promotes innovation in the markets gradually trying to contain potential risks to the maximum extent possible (for example, new algorithms need to be tested and approved by exchanges). A while ago SEBI indicated that it would come out with guidelines to curb very high order-to-trade ratio. SEBI is now considering measures to control some aspects of algo trading. One idea floating around is a lock-in proposal that prevents traders from cancelling an algo order for a given period of time. Another idea is to install a two-queue system, which allows trades by brokers with co-location and another without. China’s securities regulator is also scrutinizing high-frequency traders since its recent stock market troubles raised concerns about its financial system, though China is still at a nascent stage in its adoption of advanced trading tools and technology. Like India’s case, order cancellation seems to be their cause of concern as well. These two may be isolated incidents, but serve to underline two important themes; first is the obvious growing scrutiny on algo and high frequency trading from regulators world-wide. Equally important is the trend that while emerging markets look to emulate and adopt innovations taking place in the developed world, they are also keen to do it ‘their way’; and this is most apparent in their practices of risk management and market safeguard.

IPOs for leading Indian exchanges?

IPOs for leading Indian exchanges?
The recent discussion of the possible pressure on the Indian government to list the leading Indian bourses can be considered in many ways including as a clash of civilizational management cultures. With a history of foreign rule, Asian countries that became independent relatively recently are generally suspicious of foreign interference and see control of the large domestic institutions such as exchanges (often termed national jewels) as vital. This is an important reason for the monopolistic or duopolistic vertical exchange market structure in these countries. It makes it easier for the government and the capital market regulator to control the activity of the exchange. Ironically, in the west, after the financial crisis, the need for control and stronger regulation has become an important focus of the respective governments and leading financial regulators, for obvious reasons. Listing the Indian exchanges would make their performance not only transparent, usually a desirable trait, but also more amenable to market forces and pressures from both the domestic and the international investment community, which can sometimes run counter to the respective national interests of the exchanges in which the countries are based. The Indian government and the capital market regulator SEBI would have to take a call on whether they see listings as the best way of making these exchanges transparent. The firms that have invested in the exchanges by taking minority stakes should be in a position to sell these stakes at any point in time, and hence an IPO is not the only way for them to realize their gains on past investments. If the exchanges are indeed listed, it has to be in order to make them more efficient, transparent and globally competitive. Of the two exchanges, probably the BSE which has tried to list in the past would be the most favorable to the process since this might put it in a better competitive position vis-a-vis the leading competitor in the NSE. The NSE would probably not want to disturb the status quo, or do it in a very controlled fashion if at all. But these are internal market dynamics the regulator would not bother much about, and it would mainly focus on issues such as systemic risk management in a post-listing scenario. The final decision, while not a ‘make or break’ one some vested interests are making it to be, would still be of interest to the casual observer of India’s journey as an important emerging global capital market.

Issues with Fund performance in India

Issues with Fund performance in India
The Indian mutual fund industry has a very high number of schemes which has been another cause for concern for regulators. In 2012-13 there were a total of 1,294 schemes, while there were only 403 of them in 2004. A high number of schemes make the job of choosing a suitable scheme for retail investors difficult.  However, offering new schemes has been a marketing tool for many AMCs, and an easier route for garnering more assets. If some of them start launching new schemes frequently, others are forced to follow as they fear otherwise they would be perceived as inactive or not aggressive by investors. The regulator has been asking fund houses to rationalize so many offerings, and offer limited number of them which are truly different from each other. Some success was achieved in this regard in 2008 and 2009 when number of new schemes launched went down significantly. However, that trend was short lived and high numbers of new schemes are again being launched since then. Too many schemes make choosing suitable scheme difficult. It is also interesting to analyze how different funds have performed over the years. One way of doing this is to compare the return given by a particular fund with respect to a benchmark index. If the fund beat the benchmark on a consistent basis, say for 1/3/5 year period, it can be said to have outperformed. The argument of active management of funds and charging of fees for that purpose is justified in such cases. If, on the other hand, a fund fails to beat the benchmark index, then an investor is better served by investing in an index fund (which has lower fees being a passively managed fund) tracking the benchmark index. Since December 2009, S&P and CRISIL periodically publish a scorecard, titled “S&P CRISIL SPIVA”, comparing the performance of Indian mutual funds with appropriate benchmark indices during various time periods. Here we aggregate findings from four such reports published in December (H2) 2009, June (H1) 2011, December (H2) 2011 and June (H1) 2012, and plotted in the figure (each column in the figure indicates the proportion of funds that have failed to beat corresponding benchmark). We have selected two types of equity funds (large cap and diversified) and debt funds. We have also added a 50% (red) line for easier interpretation of what proportion of funds have outperformed; 50% being associated with the probability of two outcomes for a fair coin toss. The following observations can be made:
  • A large proportion of firms has failed to outperform the corresponding benchmark for each year and for each time period considered.
  • Debt funds have done relatively better; they have outperformed the benchmark indices more times compared to other two types of funds on a consistent basis. Except for one case (1 year, H1 2009) they are well below the 50% line.
  • The two types of equity funds on the other hand have performed poorly over time.
  • In a large majority of cases (18 out of 24) over 50% of them have failed to outperform the corresponding benchmark. Large caps have performed worse (11 out of 12 cases above the 50% line) compared to diversified funds (7 out of 12 cases). This implies if an investor was to choose a fund from each of these two categories, a toss of a fair coin on average would yield better result than seeking advice from a fund manager.
mf_performance Amidst several debates and discussion on entry load and distributor incentives, the issue of underperformance of mutual funds is often lost. However, this is one concern that should receive the most attention from all stakeholders. Unless mutual funds start offering better returns and outperforming benchmark indices on a regular basis, it will be difficult to attract investors to this industry regardless of number of schemes, geographic reach or entry load.

Entry Load Ban and its Impact in India

Entry Load Ban and its Impact in India
India’s mutual fund sector has traditionally been dominated by investments from the institutional investors, namely banks and financial institutions, non-financial corporates and foreign institutional investors. However, mutual funds are primarily vehicles for retail investments. Retail investments accounted for 51% of India’s mutual fund industry AuM in 2012-13 growing from 43% in 2008-09. While the growth in share may be due to a temporary decline in institutions’ share, retail investments has grown continuously in recent years. More importantly average holding period has gone up in recent years. The practice of charging mandatory entry load was abolished by SEBI to reduce churning, since distributors would encourage investors to prematurely terminate their investments and make new investments as that gave them more commission. Since equity funds earned the highest commission, we analyze the changes in average holding period for equity investments from retail investors. It can be seen that proportion of investments held for over 2 years has gone up, for both retail investors and HNIs. This has come largely at the cost of investments held for between 1 and 2 years. The share of investments held for less than one year has remained more or less same during this time. This is perhaps due to the fact that distributors would typically not ask investors to churn their investments within a year of investment, but afterwards. This trend therefore suggests that the abolition of entry load has indeed resulted in investors holding on to investments for longer duration, and thereby engaging less in churning. holding period We discuss this and other key issues pertaining to the Indian Mutual Fund Industry in a new report.

Evolving Business Models in India’s Mutual Fund Industry

Evolving Business Models in India’s Mutual Fund Industry
The Indian mutual fund industry has been going through turmoil in the last few years due to uncertain market conditions and regulatory changes. Many firms, predominantly foreign ones, have exited the industry since 2008. Existing asset management companies (AMCs) are exploring a number of different models to counter the challenges and stay competitive in the evolving regulatory and competitive environment. The dominant theme that is emerging in the industry is that of formation of partnerships and alliances. This can be gauged from the rising share of private sector joint venture companies that are predominantly Indian in recent times, as discussed earlier. The fusion of global best practices from international partner and local know-how of domestic players is creating good synergy. Some recent examples include partnerships between T Row Price and UTI, Schroders Plc and Axis Bank, Nomura and LIC mutual fund. Realizing the importance of scale in this industry, some firms are taking the inorganic route to grow quickly through acquisition. Along with growth of AuM in a short time, firms try to achieve other strategic objectives as well through this approach. Thus L&T’s acquisition of Fidelity’s business not only increases its asset share, it also increases composition of equity funds in its portfolio, and thereby raising the potential for fee-based revenues. Similarly Goldman Sachs acquisition of Benchmark, the earliest and leading provider of Exchange Traded Funds (ETFs) in India, allowed the firms to gain foothold into the fast growing ETF segment. Some bank sponsored mutual funds are trying to focus on distribution through parent bank branches. Though they are not opposed to third party distributors selling their products, they are not actively exploring that channel. Some international asset managers have exhibited interest to tie up with such banks to garner market share in this way. Partnership between Union Bank and KBC Asset Management is one such example. While typically 50-60% of equity funds are sold through parent branch network in case of bank sponsored mutual funds, the aim of such initiative is to sell 80-90% of the funds through parent bank’s network. However, the foreign partner needs to be careful regarding its choice of bank partners, as we have seen having large branch network does not guarantee easier access to more assets. Mutual fund business clearly has to be a strategic focus for the partner bank. Bankers in general are not very aggressive about mutual fund business, as most of their time and resources are spent on helping banking clients with normal banking services. Margins from banking services are higher than mutual funds in many cases, and therefore sales of mutual funds are often not given adequate focus. Instead of forming strategic alliances, in some cases fund houses have tie ups with banks just to distribute their products. For example, Birla Sun Life, HDFC, IDBI have such agreement with Syndicate Bank. However, this approach has achieved limited success so far. Moreover, if the bank itself is a sponsor of mutual funds, there is clearly conflict of interest, which fund managers need to keep in mind. Observing the increasing shift from transaction based to advice based model of the fund business, some firms have initiated or strengthened their portfolio management services. This is primarily targeted towards the higher end of the mass affluent segment and the HNI segment, as they are usually big ticket investors, have needs to manage a broad portfolio, and are more likely to pay fee for advice. It should be mentioned that India does not have a well-defined wealth management industry, and this initiative has a lot of overlap with the provision of wealth management services. HNI segment traditionally has turned to the international banks in the country for wealth management services which helped them with offshore investment opportunities and international best practices. However, the domestic asset managers are increasingly moving up the value chain and making inroads in the wealth management space. It needs to be said even though a number of AMCs has started offering this service, only a few of them (e.g., Kotak, ICICI) have been successful. Some Indian AMCs are now taking the next step of garnering investments from international investors by opening offices in international locations like New York, London, Singapore, Japan and the Gulf countries. Earlier they would pay high commission to foreign distributors in local markets to sell their products; now they are trying to be in charge of distribution themselves by opening offices in those locations. This way they save on paying commission, and also benefit from high margin of managing international investors’ money. While the ambition is to cater to the entire gamut of international investors, NRIs are more likely to provide early in-roads for success. Here again, some firms are looking at prospects of strategic partnership with foreign fund houses to gain quicker traction in foreign markets. Examples include UTI’s plans of launching offshore Shariah funds in the Gulf region. Some of the other leading AMCs are also planning to go international. Improving operational efficiency is an area that has not received much attention, but can be a cost saver. Indian financial firms have traditionally lagged in the adoption of technology and processes that increase efficiency of operations. However, this situation has somewhat improved in recent times with the banks and brokerages increasing their use of technology. For banks the driver has been regulations, while competition from foreign brokerages has forced domestic brokerages to adopt latest technology. Unfortunately there is no such driver for the AMCs. Firms need to give this aspect more consideration than they have given in the past.

The State of the Indian Capital Market

The State of the Indian Capital Market
There are fundamental problems in the Indian capital market structure, such as lack of liquidity and limited depth and breadth. Many listed securities on stock exchanges are not traded; among the traded securities, not many are traded actively. The market is highly concentrated; a few companies dominate trading at the exchanges. This clearly narrows the breadth of the market, giving rise to liquidity problems for many stocks. Geographic breadth is another problem for Indian markets. Around 80% to 90% of total cash trading and 70% to 80% of mutual fund ownership come from the top 10 cities, with the top two cities (Mumbai and Delhi) accounting for about 60% in each segment.. These shortcomings can be addressed by technology development, better regulations, and focus on financial inclusion. India’s capital market regulator, Securities and Exchange Board of India (SEBI), has been addressing many of these issues. Although the equity market in India is relatively well developed, the debt market is lagging by some distance. The debt market is dominated by government securities. The corporate bond market is very small for a number of reasons, including lack of market infrastructure and adequate regulatory framework, low liquidity, lack of investor interest, etc. Efforts are being made to develop the corporate bond market. Some of the measures include increasing the limit for foreign participation, reducing issuance and transaction costs for corporate bonds, applying similar mark to market accounting requirements for loan and corporate bonds to discourage banks from relying heavily on loans, and setting up a basic framework of credit default swaps on corporate bonds in the country. Some positive results have been observed in recent years, but debt market development will require long-term efforts and commitment. By contrast, India has a healthy exchange-traded derivatives market. India started off with trading in derivatives in the early 2000s, initially allowing trading in index futures (2000) and index options (2001). Options and futures on stocks were allowed in 2001. Since then the product universe has expanded, as has the investor base, resulting in higher volumes and a robust trading platform with sound risk management practices. Index futures and options and stocks futures dominate derivative contracts traded at Indian exchanges. The investor segment is broadly classified into retail and institutional segments. The retail segment brings in the volume, but its trades are essentially low value. A key concern has been this segment’s drop in participation in the secondary market and also in IPOs. This decline began with the crisis in 2008, but the lackluster performance of most IPOs has contributed to what has become an alarming drop. Foreign institutional investors (FIIs) have been a dominant contributor to Indian markets. Since economic reforms started in 1991, India has focused on attracting foreign investment flows by relaxing eligibility conditions for FIIs, relaxing investment limits, and expanding investment instruments. The intermediaries in the market include the exchanges and brokerages. India has 22 stock exchanges registered with SEBI, with over 8,000 registered brokers and over 60,000 registered subbrokers. However, most of the trading takes place at the two major pan-Indian exchanges, National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). NSE is the largest exchange in the country, with around 70% of the equity volumes, while BSE is the second largest. A lot of revamp is happening within exchanges as they turn more competitive to gain market share. Brokers, both domestic and international, are competing in a highly fragmented market. The next wave of growth will probably arise out of technological capabilities, and hence brokerages are trying to outdo each other by providing advanced trading tools like Direct Market Access (DMA) support and algorithmic trading solutions. India has been an early adopter of the various technological changes occurring in the capital markets. With electronic trading picking up along with the adoption of the internet, booming retail equity business evolved in the last 10 years. Surprisingly, due to the market boom and IPO bonanza, retail adoption of technology initially outgrew technology adoption on the institutional side, where voice brokers still played a large part. As foreign participation in the Indian markets picked up, it brought in a rigor and technological requirement essential for international competition leading to adoption of the latest technologies by domestic market participants. A key reason for the success of the Indian capital markets has been the efficiency of SEBI, the capital market regulator. Four regulators control the participants in the securities market. There have been turf wars, and the future might see a super-regulator. India has a good regulatory environment regulating the capital markets, which shielded the economy, to some extent, from larger negative impacts of the global financial crisis and helped it regain its mark quickly afterwards. The regulator has been cautious in expanding the market, and transparency and investor protection have always been high on its agenda. This has sometimes created conflicts with industries as well as among regulators, but it has taken the markets along the right path of development.

Fidelity’s exit and the Indian mutual fund industry

Fidelity’s exit and the Indian mutual fund industry
Fidelity Mutual Fund, which started its India operations in 2004, recently announced its decision to quit the Indian Mutual fund industry. L&T Finance, a subsidiary of L&T Finance Holdings Ltd., is likely to acquire Fidelity’s India business. The new entity is likely to have a 2% market share and 13th position in the industry in terms of asset base. This will be L&T’s second acquisition in this market after the acquisition of DBS Chola Mutual Fund in 2010. India’s mutual fund industry has witnessed many such exits by market participants at different points in time, but this is perhaps the most high profile case of an internationally established major player deciding to shut down its India operations. In India the mutual fund industry has been heavily dominated by the corporate segment, unlike other countries where retail investors account for most of the industry assets. Fidelity had a very high proportion of its business coming from the retail and the HNI segments. As a result equity investments accounted for bulk of Fidelity’s assets as the focus was on meeting clients’ long term financial goals. Therefore the Fidelity L&T deal has been priced much higher (5-6% of asset) as compared to other such deals in the Indian industry which are usually valued at 1-3% of assets under management. Fidelity’s decision to quit the industry comes in the backdrop of its accumulated losses, driven mainly by a high cost structure. In 2010-11, the company’s staff cost grew around 50% over previous year and was around 90% of its revenue, while staff cost accounts for only 13% for some of its competitors in the industry. This decision has once again brought to the fore issues relating to the regulation of India’s mutual fund industry and its impact on firms’ profitablity. Many argue removal of entry load and limiting payment of upfront commision to distributors (to prevent misselling of products) is hurting fund houses’ ability to sell more and grow the top line at a time when costs are rising rapidly. At the same time it needs to be said that a recent study found that ‘among 15 of 46 AMCs operating in the fund industry, which collectively manage 85-90 per cent of the entire industry’s assets und­er management,10 large AMCs registered net profit in FY11 and 12 AMCs had positive accumulation of net profits over the years till FY11’. This then raises the question if the Indian Mutual Funds industry is more favourable to the larger players and what is the critical asset base a fund house must garner to break even or become profitable, especially in the changing economic scenario. This also raises the question if the new regulations are affecting the smaller players more than the larger players. In this evolving scenario when growth has been hit, regulations are changing fast and firms are increasingly finding hard to stay competitive, some Indian fund houses are looking to partner with global players to attract global funds, investors as well as expertise. In such arrangements, the local expertise of domestic firms complement the supeerior knowledge and capabilities of global partner to create a win win strategy for all.

Recent Developments in Indian Capital Market

Recent Developments in Indian Capital Market
India’s Multi Commodity Exchange (MCX) is going for IPO starting tomorrow (22nd February). This development touches on a range of issues pertaining to the Indian capital market and regulations that Celent has been discussing for some time. First, pricing of IPOs has been a cause for concern for many market players and also the capital market regulator, Securities and Exchange Board of India (SEBI). In the past SEBI had expressed its displeasure regarding overpricing of IPOs in a number of cases and asked the underwriting banks to be more prudent regarding IPO pricing. To protect investor interest, SEBI last year proposed that underwriting banks must disclose to investors the performance and track records of their earlier issues in their prospectus and on their websites. Consequently, the merchant banks (Edelweiss, City and Morgan Stanley) involved in the MCX IPO have all publicly disclosed their track record. The past details (IPO size, listing price, comparison to movement in benchmark indices for different periods for individual IPOs) are made available in the IPO document as well as on the websites of the merchant banks. Second, this is the first IPO of the year in India and is eagerly watched, after a lackluster 2011 when companies raised less than 10bn US$ through share sales (compared to 24bn US$ in 2010). This is also interesting as MCX would the first Indian exchange to be listed. This may pave way for the other exchanges, though that is unlikely to happen in the near future. Third is the case of transaction taxes. It is learnt that the finance ministry is considering imposing a commodity transaction tax (of 0.017%) in its budget proposal for 2012-13, initially on non agricultural commodity futures. The government had proposed commodities transaction tax before, in 2009, but this was not implemented because of objections raised from some quarters. India already charges transaction tax on equity derivatives. There is also speculation that this move will be coupled with a cut in securities transaction tax – the motivation behind this being boosting the cash segment and extending the scope of taxation to other asset classes. Familiar arguments have been expressed from both supporters and opponents of this new transaction tax. Supporters argue this will raise revenues for the government and also check speculation in the commodity markets. Many have argued that speculation in commodities had significantly contributed to the rising food prices in the recent past and needs to be curtailed. Also it is argued that cut in STT will attract more investment to the cash market. Opponents argue that this move will increase cost of transaction, reduce volumes at Indian commodity exchanges, result in migration of trades to international exchanges (commodities being global assets), reduce liquidity in Indian markets, impair price discovery and increase volatility. It has also been mentioned that some vested interests may be behind such move; the argument being bigger exchanges strong in cash segment are trying to grow their business at the cost of commodity trading business. This reflects the competitive landscape of Indian exchanges that Celent has discussed in the past.