About Anshuman Jaswal

Dr. Anshuman Jaswal is a Senior Analyst in Celent’s Securities & Investments practice. He has written more than 100 reports on a variety of topics in the capital markets including derivatives, electronic trading, market infrastructure and regulation, and commodity markets.

The Financial Crisis Turns Five

We like to think that we learn from our mistakes, and the financial crisis was no exception. But we seem to be making the same (or similar) errors, jeopardizing the security of our financial system. The large fines imposed on JPMorgan for the London Whale episode underline this. Furthermore, new risks are surfacing that are different from the risks seen in 2007-2008 – but just as worrying. The recent instance of Goldman Sachs sending wrong orders for options to a number of leading American exchanges, along with the Flash Freeze at Nasdaq, not to mention the earlier Flash Crash and Knight Capital episodes, show that in the future it might be exchange-traded products that make the system vulnerable. At a time like this, moving OTC derivatives to swap execution facilities and central counterparty clearing to make them more similar to exchange-traded products seems like a dangerous venture. We are centralizing risk without knowing whether we are capable of handling the concentration of OTC trading and clearing. So have we learned anything? It’s highly debatable. My Banking colleague Gareth Lodge puts it differently. The Chinese leader Zhou Enlai was once asked, by Richard Nixon, what impact the French Revolution had. “Too soon to tell,” was his response. Gareth (and Zhou Enlai) may be right. Maybe the crisis is still teaching us, or just celebrating its fifth birthday and continuing to grow in more subtle ways.

Putting the best foot forward, by choice

The recent City Day organized by SunGard in Mumbai provided interesting insights into India’s equity trading industry. Mr. Damodaran, ex-head of SEBI, the capital market regulator put India’s liberalization and globalization into perspective by pointing out that often in its recent history India has been forced to take actions that are seen to be desirable in hindsight. In 1990-91, it was the precarious forex reserves situation that forced India to open up its economy. Moving on two decades down the line, one hopes that electronic trading in the form of Direct Market Access (DMA), Smart Order Routing (SOR) and algorithmic trading would be something that our capital markets adopt out of choice and because they see the merit in doing so, as opposed to either being forced to do it, or even worse, not doing it at all and facing the possibility of extinction once the global broker-dealers enter the market in a big way. A trend that usually follows the widespread adoption of electronic trading is the concentration of trading, especially in one financial center across a region. In Europe, London happened to be the center that benefited most from the introduction of these technologies. Similarly, markets such as Japan, Korea, Taiwan, Singapore and Hong Kong are adopting high frequency trading in a big way. India cannot afford to be left behind in this context. The same goes for the leading brokerages in the Indian markets. It takes a trading desk between six months to a year to fine-tune its electronic trading capabilities. The longer the delay in getting the buy-in to do so, the lower the chance of success and indeed survival. The buy-side also has to be decisive and quick in its approach. Moving on to some of the other presentations in the event, there were useful inputs given into the issues that are cropping up in terms of the infrastructure for electronic trading. While NSE has a fast matching engine, the rest of the infrastructure has a long way to go. As pointed out, in Indian centers outside Mumbai the contrast between Indian and international capabilities is even more stark and communication networks have been found lacking. Data quality is also something that brokers, especially the smaller ones are struggling with. In this scenario, it is important that India opens up its markets to globally renowned vendors, while at the same time encouraging its local IT firms to also compete in the market. The Indian market is large enough for a number of firms to participate and be able to meet the various requirements for electronic trading.

Accepting the need for Electronic Trading

In its recent history,the Asian market has been characterized by the adoption of technology in a much more compressed time-frame as compared to its counterparts in the western world. This has been true of the industrial as well as the services sector, where it is also holds true for electronic equity trading. Asia is well poised for a rise in the share of electronic trading in the next few years. Markets such as Japan, Australia, Singapore, Hong Kong and India are seeing a lot of investment happening that is related to Direct Market Access (DMA), Smart Order Routing (SOR) and High Frequency Trading (HFT). The associated infrastructure such as market data services, co-location and so on are also being paid attention to, as is the requirement for helpful regulation. However, in some markets, the regulators are not very confident about and supportive of the needs of greater electronic trading. This is partly because of the financial crisis and rising requirements for risk management, and also due to the flash crashes that have occurred in the NYSE and OSE markets. We expect the regulatory framework to become more flexible in most markets, but there is still an important element that needs to be addressed across the board in the Asia-Pacific. That is the role of smaller brokerages and the buy-side. Unlike larger brokerages, these are still reluctant to adopt electronic trading and to make the investments required to have the same. While attitudes and capabilities do not change overnight, I believe that market investors in Asia need to be made aware of some harsh realities. To start with, the way HFT and algorithmic trading evolved in the US and European markets, there was very little time for market participants to react to and adopt such trading. The change happened so quickly that a number of brokerages and buy-side firms were unable to cope and had to operate in a more constrained fashion or even shut down. The incentive that HFT provides for those trading larger volumes means that the smaller players are at a relative disadvantage. This increases even more if they are slow to react and do not adopt electronic trading. So it is not just the speed of trading that is important to succeed, it is also the speed of thought. Hence, smaller brokerages and buy-side firms in Asia should be more positive and not be afraid of investing in DMA, SOR or HFT. The gains from these might not be apparent immediately, but if the lessons from the western markets teach us anything, it is that the quick and nimble-footed firms were the most successful during the rise of electronic trading. With the trading infrastructure in Asia changing so rapidly, there is little reason to believe things are going to be different here.

Mobile trading and Smart Order Routing approved in India

The Indian capital market regulator, Securities and Exchange Board of India (SEBI), has finally approved two different but equally important means of access to the stock markets. Both mobile trading and smart order routing have been approved by SEBI. Mobile trading was being eagerly expected in the retail markets. India has a mobile phone user base of 645 million people, compared to only around 11 million demat account holders. As mobile connectivity is available to a far greater proportion of the population as compared to internet connectivity, industry participants believe that it could lead to a boom in stock market participation. While the brokerages that wish to provide this facility would have to ensure that they provide secure access, encryption and security, we believe that the infrastructure provision would not be the difficult element if mobile trading has to succeed in India. Globally, mobile trading is successful in markets such as Korea where people are very comfortable in using this medium. But in many other leading markets, mobile trading has not really taken off as people do not feel comfortable accessing the amount of information required to come to a decision about buying and selling a stock. So in the end successful adoption will come down to a trade-off between how comfortable mobile trading is as a medium of access and how important it is for the target investor to access the market through his/her mobile. Even though internet connectivity is not available to many Indians, physical access to brokerages still exists in most far flung Indian towns but we still have only 11 million stock market investors. Hence, the Indian brokerages have to ensure they put in sufficient effort to target the latent demand for stock trading in the population. If this does not happen, we could end up with a situation that exists in western markets where only a small proportion of the investors are interested in using mobile trading. While Smart Order Routing (SOR) is a different technology targeting a different segment of the market, a similar word of caution would be in order. The brokerages that want to provide the facility have to comply with a number of regulations. They will have to apply to the respective stock exchanges (mainly NSE and BSE). The exchanges have to communicate their decision to brokers within 30 days. Brokers will also have to submit a third-party system audit of its smart order routing system and software, beside providing an undertaking that the new system will route orders in a neutral manner. They have to provide an alternative mode of trading system in case of failure, besides maintaining logs to facilitate an audit trail. Furthermore, the broker server that would route orders will have to be located in India. So there is a lot of infrastructure that has to be put in place before brokerages can begin to offer the service. Besides, there is still a lack of comfort with the use of the technology in the leading exchange, NSE. Its position as the market leader could possibly be threatened, especially once MCX-SX, the exchange promoted by Financial Technologies, comes online. While SORs could help increase liquidity and encourage algorithmic trading the inability, at times, of the exchanges to cope with high volumes during peak hours could be a barrier to their widespread adoption. As in the case of mobile trading, there are a number of factors beyond the technology itself that will be at play in the next few months and years. So while we are certainly looking forward to the desired success of both mobile trading and smart order routing in India, a lot of effort would be required on part of the brokerages, and also the exchanges, to make this happen. With the large size of the stock markets and the mobile subscriber base, it is easy to think that both these technologies will succeed, but that is not something we can take for granted.

Electronic and cross-border trading in Asia

I recently participated as a moderator in two panel discussions on the South East Asian markets in the SunGard City Day held in Singapore on 14th July, the topics being electronic trading and cross-border trading respectively. An important point that came out of the discussions was that Asia-Pacific cannot be seen as one market, unlike the European Union. It comprises of various national markets at different stages of development. Japan, Australia, Singapore and Hong Kong are the leading markets in the region. By comparison, markets such as Indonesia, Malaysia and China are lagging behind. The difference can be seen in terms of infrastructure, e.g., the differences in the latency of the exchanges, as well as the number of products that can be traded on them. In the leading markets, the circumstances are becoming more conducive to high-frequency trading and the operation of alternative trading systems, including dark pools. Co-location services are being provided by the exchanges and the regulators are reducing the barriers on off-exchange transactions, such as the limits on the size of transactions and the time limit within which a transaction has to be reported. A crucial factor in the adoption of greater electronic and algorithmic trading will be the willingness of the buy-side to develop the infrastructure for the same. An interesting example that was quoted in the event was that a buy-side trading desk took three months just to fine-tune the latency of their connectivity to the exchange. What this highlights is the fact that while many in the local sell-side and increasingly the buy-side are convinced of the need to have algorithmic trading, it will take time to put the necessary systems in place. Also, the local players are not sure about whether they can afford the level of investment (and the time taken) required to create the trading infrastructure. Hence, the barriers to adoption of technology are more practical than theoretical, unlike earlier. In fact, most of the panelists stressed that there has been a sea-change in the mindset of the domestic market participants in the last 2-3 years and they are much more open to having algorithmic trading and dark pools now. It is further expected that once ADR/GDRs can be traded in these exchanges, the level of algorithmic trading will go up, with the greater presence of exchange-traded funds also playing a similar role. However, the level of off-exchange trading in the next 3-4 years is expected to go up to 5% at the most, up from the current 1% but much below the 30% levels seen in Europe. Cross-border trading in the ASEAN region has picked up in the last few years. Regulation has also paved the way for this, e.g., in Malaysia, regulation has recently allowed up to 30% of the NAV of a firm to be used in trading assets abroad. Even before the recent ASEAN linkage between six countries was announced, cross-border trading was a prevalent phenomenon. The linkage is expected to increase the level of electronic trading and also make it cheaper and more efficient. The next step should be to develop the post-trading infrastructure and linkages between the central securities depositories.

Front-running needs to be eradicated

‘Front-running’, the practice of traders or brokers benefiting from stock market transactions by leaking information of the trades to some of the other market participants in advance, has long been suspected in the Indian stock markets. I have had discussions with the domestic buy side in which they have taken me through the various stages of an equity transaction and pointed out the pre-trade, trade and post-trade stages in which there can be leakage of information that can be profited from. What is worse, the players who suffer from the practice just shrug their shoulders and describe it as something they can do little about. Similarly, when I have spoken of Indian brokerages that have become more capable technologically being used by foreign buy side firms, the same issue has turned up. The latter is wary of the possibility of insider trading or front-running damaging their profitability. Against this back drop, the ban on a trader of HDFC Mutual Fund by the capital market regulator, SEBI, on the basis of 38 instances of wrong doing over 24 trading days between April and July 2007 when the three investors colluding with the trader bought or sold shares before HDFC AMC’s trades were executed, is a welcome development. While it could be merely an initial move in cleansing the markets of an undesirable practice, it shows the capability and the willingness of the regulator to punish participants that undertake front-running. For the traders or brokerages that engage in such actions, it is crucial to understand the damage they are doing to the reputation of their firms and indeed the market as a whole by engaging in such practices. Firms that are very well capable of competing on an equal footing in the markets are being handicapped by the existence and indeed the mere talk of front-running. Such unfair practices are self-defeating and needed to be weeded out. The regulator is to be complimented on taking such an action and we hope that future transgressions would be similarly caught and punished. Furthermore, both buy side and sell side firms need to ensure that they have sufficient checks and balances in place to help the regulator eradicate the practice. Similarly, whistle-blowing needs to be encouraged, not just by individuals, but also firms that believe that their brokers or traders have let them down.

Positive changes in pre-IPO equity placement rules in India

Liquidity, depth and transparency are some of the main aspects that need to be enhanced in the Indian equity markets. The majority of the trading happens in the shares of the top companies and the attempts to encourage the stocks of small and medium enterprises to become an active part of the secondary trading have generally not been successful. Similarly, transparency has been another aspect that needs to be addressed. In a move that is expected to improve both liquidity and transparency, the Indian Finance Ministry has decided that any equity placement prior to an Initial Public Offer (IPO) will be categorized as part of promoter shareholding for the purpose of calculating minimum public float. This change will be part of a proposed amendment to the Securities Contracts (Regulation) Rules, 1957, that would prescribe a minimum public float of 25 per cent for initial and continuous listing, in all companies regardless of their size or ownership status. Also, the rules would be equally applicable across all sectors, thereby removing existing waivers for the public sector undertakings (PSUs) and companies in the sectors of information technology (IT), media, entertainment and telecommunication. Encouraging greater public ownership in all companies through such a change is a very positive move indeed. It will lead to greater accountability and transparency in the long run. The depth of trading in the shares of the companies that are affected by the new rules is expected to improve and the overall health of the capital markets will also benefit. There are some implications of the rules in terms of greater accountability for the investors whose equity is considered to be a part of promoters’ holding. While this means that these investors, mainly institutional, would have to take more precautions and be aware of the legal ramifications, on the whole it is desirable as also sheds some light on the role of institutional investors and high net worth individuals in the decision-making processes of companies. Hence, while this new change is expected to ruffle some feathers initially, it is a welcome step in improving the quality of trading and enhancing transparency in the Indian markets.

SEBI succeeds in curbing ULIP threat to Mutual Funds

The Securities and Exchange Board of India (SEBI), India’s capital market regulator has succeeded in achieving its underlying objective in the recent row with the insurance regulator, Insurance Regulatory and Development Authority (IRDA). The removal of the front-load commissions for mutual funds by SEBI in mid-2009 had led to an environment in which the mutual funds were at a disadvantage against the insurance companies’ unit linked insurance plans (ULIPs), which had a large investment component. For ULIPs, the commissions for the agents continued to be high, at times more than 40% for the initial installments. As a result, there was mis-selling (over-selling and resorting to unfair practices) on part of the insurance agents. By raising the issue of its role in the regulation of the investment component of the ULIPs, SEBI ensured that the IRDA was forced to take action to prevent SEBI from encroaching into its domain of insurance regulation. In the end, IRDA had to increase the insurance component of ULIPs and also to create disincentives for people who were investing in ULIPs for a period of less than five years. Also, the commission structure of ULIPs had to become more transparent to prevent mis-selling. The two main beneficiaries of this action have been the mutual funds that have regained their pre-eminence as a tool for investment, and the consumers who are enjoying more transparency in ULIPs than earlier, albeit at the cost of fewer choices, as the ULIPs are no longer directly competing with mutual funds. There are some important issues that have been raised by this entire episode. The main one is that there needs to be a redressal mechanism through which the regulators can solve problems with each other. The ULIP episode has been a highly long-drawn public affair that caused a lot of confusion for the investors and companies alike. The insurance companies’ revenues due to ULIPs will also suffer as there would be less investment in them now. Furthermore, the episode does not reflect well on the reputations of the regulators or the Ministry of Finance. There were contradictory signals coming from the ministry as the Finance Minister referred the matter to the courts, but the his Minister for State supported the IRDA’s case in a written reply to the Upper House. The early stage of development of financial regulation in India means that there will be more turf wars. The government is possibly trying to create the infrastructure for their quick resolution through the creation of the Financial Stability and Development Council (FSDC). Whether it is through the FSDC or some other means, it is important to lay down clear guidelines to be followed. Otherwise the Indian financial markets would more and more resemble the Wild West, entertaining for sure, but too chaotic to make sense of. This issue has been dealt with in greater detail in a recent Celent report: Capital Market Regulation in India: Turf Wars Inevitable?