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.

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.

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.

Indian exchanges prepare for greater competition

Indian exchanges prepare for greater competition
The Indian capital markets regulator, SEBI, is talking reforms as it recently announced a blueprint that is potentially set to increase competition among exchanges. The regulator’s stance on increasing competition and allowing foreign investment in exchanges was closely anticipated in recent months, especially among large global banks. SEBI had to address pressing concerns on attracting foreign investment (Figure indicates the drastic fall in FII inflows into India in 2011) and failing to keep pace with developments in global capital markets. The new move by SEBI has cleared the way for listing of stock exchanges. This decision comes after an expert committee headed by former Reserve Bank Governor Bimal Jalan submitted its report in 2010 on governance and ownership issues relating to market infrastructure institutions. While SEBI has broadly accepted the recommendations, it has gone ahead with the move to allow public listing of exchanges despite the committee recommending against such a move on ‘conflict of interest’ grounds. The blueprint indicates that public holding of exchanges should be at least 51%, while exchange operator, banks and insurance companies are allowed to hold up to 15%. Foreign investors are allowed to hold up to 5%. Exchange operators, however, would not be allowed to list on their own exchanges. SEBI is watching developments in global capital markets closely. The developed markets in US and Europe are far ahead in terms of maturity of market infrastructure, while India is yet to reach a stage where alternative trading venues can compete with incumbent exchanges. The NSE started in 1994 to compete with the then singly dominant exchange, BSE. But ironically the NSE has today itself become what it set out to defeat, accounting for close to 75% of equity volumes. The attention is on regional exchanges to play more aggressively. With an intention to infuse more competition, the regulator has warned that dormant exchanges that are not attracting liquidity would have to be wound up. SEBI has stipulated a minimum annual trading volume of INR 1000 crores for exchanges to continue operating and the same would be reviewed after 3 years. While we see it as a timely warning bell, it is not enough. We have to wait and see how SEBI looks to empower and encourage regional exchanges. The Delhi Stock Exchange has already woken up to the competition by following in the footsteps of LSE in upgrading its IT infrastructure by partnering with MilleniumIT, a technology player which provides ultra-low latency trading solutions. The debate in ongoing in the case of clearing houses and the regulator is expected to come out with its view soon on having a single clearing house versus introducing interoperability. Although it appears that policy challenges facing SEBI are similar to those faced by regulators in developed markets in the past, and despite indications that SEBI is trying to align with developed markets, we should be careful while concluding that the Indian regulator would eventually follow in the footsteps of US and Europe.

Net FII flows into India

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.

Delhi Stock Exchange: All suited up and (hopefully) somewhere to go

Delhi Stock Exchange: All suited up and (hopefully) somewhere to go
The news that the Delhi Stock Exchange (DSE) might buy a trading platform developed by MilleniumIT (owned by LSE) could be the sign of great things to come for the DSE, or it could be just another headline about the opportunities for growth in an emerging market. The DSE, while being one of only three national equity exchanges in India, has not been operational for some time. The efforts to revive it have been going on for a couple of years and it is expected that it would be able to re-start its operations soon. Until recently, the best candidate to provide competition in the equity market to the incumbent National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) was MCX-SX, an exchange promoted by MCX, the largest commodity exchange in India and Financial Technologies, a capital markets technology and infrastructure provider. But MCX-SX got caught up in regulations that stipulated the reduction of ownership by its promoters, something they failed to do according to the capital market regulator, SEBI, and the courts. So from being a strong candidate to take on the might of NSE, MCX-SX is still cooling its heels on the sidelines. Getting back to the DSE, the use of one of the fastest trading platforms in the world (LSE claims it is the fastest) could be a great advantage. The only problem is it is still not clear what space the exchange would be able to occupy in the Indian markets and how it would utilize such a platform. It’s a little bit like owning a Ferrari and not having a decent road to drive it on. DSE is being positioned as an ideal exchange for small and medium enterprises (SME). The issue here is that both NSE and BSE are in the process of starting their own SME exchanges, which would mean there would be tough competition for DSE. It would be critical for the exchange to ensure that there is sufficient business and liquidity in the market, otherwise the speed of the platform would matter little. LSE might have the fastest platform for an exchange, but that does not prevent it from losing ground to Chi-X in the UK market. Unlike LSE, DSE is going to compete from a standing start in the Indian market. So there are a number of issues it would need to address before the speed of its platform can have a bearing on its performance in the Indian market. But from the point of view of an average investor in the Indian market, that is not something they need to worry about. The very possibility of more competition for the incumbent exchanges is great news. When it also means that they might have access to a globally competitive platform, it is news that they can certainly savor for a while.

The Curious Case of Transaction Taxes

The Curious Case of Transaction Taxes
The issue of Financial Transaction Tax (FTT) has come to the fore in the aftermath of the financial crisis. The main motivation behind such a tax is to curb speculative flow of international financial capital. It also has the potential to generate substantial revenue which can be used to fund social development, particularly in developing countries. According to estimates by Bill and Melinda Gates foundation, FTT can raise about $50 bn from G-20 member countries, while according to other estimates FTT can raise $250 bn if a wide range of transactions are included. Implementation of such a tax would also help in monitoring of cross country flows through centralized database; this will also make evasion of such tax difficult. Such a tax to discourage speculation in short term international transactions, also known as Tobin Tax, was proposed by James Tobin in 1972. Opponents of FTT argue that this tax would increase transaction cost thereby reducing efficiency and market liquidity. Moreover, if different countries apply different tax rates, that will result in unwarranted trading volume flows from countries with higher taxes towards countries with favorable tax regime. Needless to say, implementation of such a tax is contingent on agreement reached by the major countries, namely the G20 countries. In September 2011, the European Commission (EC) backed the adoption of an EC proposal to implement FTT in all 27 member-states of the European Union (EU). This tax will be levied on all financial transactions if at least one of the parties involved in the transaction is an EU country. According to this proposal, trading on stocks and bonds will be taxed at 0.1% while derivative trading will be taxed at 0.01%. Individual EU countries may charge higher tax. If approved, this will be effective from 2014 and is estimated to raise $78 bn a year. This proposal has the backing of the two major EU nations, Germany and France, while the United Kingdom (UK) has expressed its reservation over it. British government’s position is that they would back FTT only if it is applied globally; otherwise, it fears, London, a major financial hub, will lose out to New York and Hong Kong in competitiveness. Similarly other countries like U.S., Canada and Australia have also resisted the idea of introducing FTT. Among the emerging nations, Brazil and South Africa have backed the introduction FTT, but India has expressed its reservations against it. India says this tax would be an additional burden on Indian banks which are mandated to set aside significant amount of funds to meet regulatory requirements (i.e., maintain cash reserve ratio and statutory liquidity ratio). India’s position is interesting on two counts. In 2003, India had backed a similar idea to introduce an ‘international levy’ to prevent ‘unstable capital flows’ which ‘can severely disrupt developing economies’. Such a tax was then considered to be ‘an instrument to protect weak economies from the volatility of capital … and to generate valuable developmental resources’. Secondly, in 2004, India itself introduced a similar measure, the Securities Transaction Tax (STT), in its equity and derivative market – this is a tax levied from traders, domestic and foreign, on all transactions that happen in these two market segments. The motivation behind the introduction of STT was pretty similar too, i.e., generating extra tax revenue and protecting market integrity. While it is debatable if this tax has been able to rein in speculation in the markets, it can be safely argued that this has not resulted in significant drying up of liquidity in the markets, as had been originally feared. Additional revenue generated due to this tax contributed to around $1.5bn to the government’s exchequer last year. However, the capital market regulator, the Securities and Exchange Board of India (SEBI), the exchanges, brokers and investors are in favor of abolishing STT. They believe the cost of transaction in India is high; they expect abolition of STT will positively impact the market turnover as lower or no STT would help in higher algorithm trades high frequency traders in driving up trading volumes. SEBI is currently reviewing the impact on the stock market turnover from a possible scrapping of STT and would submit its findings to the Finance Ministry who will take the final call regarding this issue. The Finance Ministry’s capital markets division is said to be in favor of reviewing the STT framework with a view of either scrapping it altogether or in a phased manner, but a final call is unlikely to be taken before the next budget. All these decisions, be it for FTT or STT, effectively come more under the purview of political agents and governments than regulators or technocrats. While the FTT issue is likely to be again discussed in next G20 meeting, decision on STT is likely to be announced by next Indian budget. Hence, their acceptance or rejection will largely depend on the political environment that is to unfold in the next few months.