About Muralidhar Dasar

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.

High Speed Analytics using FPGA

Field Programmable Gate Array (FPGA) technology has been receiving a lot of attention in the high frequency trading community in recent months. It is essentially a hardware related technology pioneered by scientists in the semiconductor/electronics industry. FPGA, as its name suggests, consists of programmable logical gate arrays, which can be used to implement desired logical functions on a piece of semiconductor chip. The beauty of this technology is that the desired logical functions are implemented at the hardware level itself, unlike conventional software based methods where analytical functions are implemented by software processes queuing up and waiting for a slice of the processor’s time. The hardware based method is much faster, and especially at a time when high frequency trading institutions are looking for latency advantages in the order of milliseconds, the technology provides significant competitive advantage. We are therefore witnessing a great deal of interest, and not surprisingly HFT institutions are investing resources on FPGA related technology R&D. However, the market for FPGA based analytics for HFT applications is still at a nascent stage. While the advantages of FPGA to HFT institutions such as ultra-low latency and reliability are appealing, the downside to this technology viz. time and cost of fabricating, limited ability to handle complex logical operations will prove to be bottlenecks. As mentioned, the technology is borrowed from the semiconductor/electronics industry where significant advancements have already been made in dealing with technology-related bottlenecks, leaving out factors such as cost constraints and difficult regulatory environment as major factors that will decide the future of this technology.

Navigating through tumultuous WM landscape in India

The Indian wealth management market is dominated by domestic wealth management providers in the mass affluent segment, while international firms and private banks are strong players in the high and ultra-high net worth segment. Insurance providers are dominant players in the mass market. Brokerages and retail banks have started separate wealth management businesses and they are gaining strong ground in high affluent segments. Another characteristic of the Indian wealth management market is the large share of the business captured by unorganized players. The size of this business is estimated to be about twice the size of the business of organized players. The unorganized segment mainly comprises of private financial advisors and chartered accountants who provide personalized financial advisory such as tax and investment advisory. Increased penetration of the organized players is slowly drawing the clients away from the unorganized players. However, the picture is not all hunky dory for wealth management providers, as the industry is beset with several challenges. Rising competition and resulting downward pressure on advisory fees, along with a large chunk of ‘invisible’ wealth are some of the reasons why private banks and wealth management providers are not able to monetize the opportunity easily. By ‘invisible’ wealth, we refer to wealth that is hidden away in tax havens and black money which has become a topic for heated public debate in the country today. Also, not to forget the negative investor sentiment caused by a series of scams and the slide in equity markets, which has made the challenge greater. Lack of product variety is also a matter of concern. Alternative investment vehicles such as hedge funds and private equity provide limited options for investment, and regulatory constraints on overseas investments have resulted in poor product variety comprising mostly of vanilla products. The Indian market is still nascent for exotic investments such as art and luxury goods. Also, the affinity of wealthy individuals towards investments in gold and real estate which do not require the specialized services of a wealth manager further contributes to target segment shrinkage. There is a gradual shift to advisory based feel model from transaction based fee models, with regulators stepping in protect investor interests. While it seeks to remedy conflict-of-interest between wealth managers and their clients, it also exerts downward pressure on fees. We might eventually see smaller players being forced out of the business. Large players would have to stay invested for sufficient length of time before returns start trickling in. Therefore, large banks and brokerages which have high reach and who can monetize the potential for cross-selling banking/mutual fund products would be placed at an advantage in capturing this market.

Observations on HFT

High frequency trading (HFT) has been in news recently, especially after the US stock market crash, also called ‘Flash Crash’ of May 6, 2010 which created sudden panic in the market for a few minutes. Many have blamed high frequency traders and rogue algorithms for suddenly pulling out liquidity, reacting to uncertainty in the market. “Quote-stuffing”, a phenomenon where traders place large rapid-fire orders and cancel them immediately, was highly criticized as a major factor. The debate over the impact of high frequency trading on market stability has invited the attention of the regulators, who are currently assessing the impact of HFT on the market microstructure and gathering opinions of industry participants. Academic research investigating the role of HFT has not clearly reached a conclusion on whether HFT is good or bad for the markets, and there are arguments on either sides of the table. Those in favour of HFT say that it adds liquidity to the market, reduces spread and helps in ironing out price inefficiencies. Those taking the counterview say that HFT reduces book depth, it is unfair to market participants who cannot invest heavily in sophisticated technology, and it contributes to increased volatility. Notwithstanding the arguments over curtailing the freedom of HFT traders and asking for mandatory reporting among other measures, HFT as a trading paradigm has evolved during the last five years, with adoption rates constantly going up. Celent estimates that about 55% of all equities volumes are driven by HFT in US, the number is around 35% in Europe and around 5% in Asia, as shown in Figure. The rise of HFT in US and Europe was driven by regulations such as RegATS and RegNMS in US, and MiFID in Europe which spurred greater innovation in technology. Asia is now being touted as the next growth driver for HFT. Asia has taken to the adoption of HFT rather slowly, much of which can be attributed to the regulatory environment. Japan is an exception, however. Celent estimates that the percentage of equities volumes driven by HFT in Japan is around 30%. The reason is increased fragmentation in the Japanese equities market, coupled with adoption of sophisticated technology. Tokyo Stock Exchange’s adoption of high-speed Arrowhead trading system is a case in point. Japan is an interesting case, because the increase in HFT adoption coincides with increasing spreads and increasing volatility. However, this should not be understood as an insight about how HFT will unfold in the rest of Asia. The market for HFT in US is maturing, and Europe is also headed in that direction, which is why investors could look towards Asia and emerging markets for future growth opportunities. Added to this is also the concern about over-regulation in the Western markets. By maturity, we mean the increased standardization in HFT techniques and reduced diversity in trading strategies to capture unique trading opportunities. Trading firms and even trading venues are dealing with this by adopting sophisticated technology which may be cost intensive, such as upgrading hardware and software for achieving the least latency, for instance. This battle to achieve near-zero latency is not a feasible method for winning the market because of the costs involved. Therefore, the strategy for winning the market in the matured Western markets is moving towards “effective trading strategy generation”, and development of proprietary trading strategies which can be implemented with the existing trading and connectivity infrastructure. Japan and Australia are leading the trend in APAC, followed by Singapore, Hong Kong and Taiwan. China and India are important markets for HFT in Asia, but success will depend on how trading firms find their ways in dealing with the regulatory environment in both countries. Last year, China toughened its regulatory stance on speculation on futures exchanges. The exchanges have increased monitoring of “quote-stuffing”, which was mentioned earlier, and keeping a close watch on investors trading between their own accounts. In India, there have been some healthy signs for HFT. Both the BSE and the NSE have installed new co-location centers, and regulators have allowed ‘smart order routing’ paving the way for increased automated trading. Celent estimates that the percentage of cash equities volumes driven by HFT in India is around 5%. Another encouraging sign is the setting up of a cloud model which offers shared IT infrastructure by NSE. This is a boon to smaller players who do not have the capability to invest in private infrastructure. Instead, they can now plug into the infrastructure provided by NSE and get onto the HFT highway by paying a fee for the services availed. Overall, the signs for growth of HFT in India are positive. There is an interesting pattern that is emerging in relation to cross-asset correlations between asset classes over the last five years. Cross-asset correlations, especially in the developed markets have increased at an alarming rate. What this effectively means is that, portfolio diversification and other hedging techniques are way less effective today in protecting from unexpected price movements, than they were five years ago. There is a peculiar relationship between the increase in multi-asset trading and high frequency trading with increase in cross-asset correlations, which is being investigated. Consequently, alpha generating opportunities in the developed markets have dwindled. Despite the heterogeneity in Asian markets and the several challenges such as regulation, cost of borrowing and liquidity, there is more reason for investors to look towards Asia for future growth opportunities in HFT.

Private Equity in India: Poised for growth

The year 2010 was a good one for PE in India. India posted the highest growth rate in PE deal value among all major economies in Asia-Pacific, clocking 111% growth, ahead of China’s 56% growth. The deal activity in India doubled to about US$7.4 billion, compared to US$3.5 billion in 2009. The past decade saw enormous growth in PE investments, which increased from US$1.2 billion in 2000 to US$7.4 billion in 2010, registering a CAGR of 20% during this period. However, the credit crisis of 2008 threatened to stall the growth in deal activity, because the crisis had a clear impact on PE activity in India. Deal values dropped considerably starting Q4, 2008. The lull lasted five quarters before the deal values were restored to pre-crisis levels in Q1 2010. The total deal value in Q1 2011 has shot up to US$3.3 billion from US$1.4 billion in the previous quarter, a 142% rise. With the economy poised to grow at around 9%, and the IMF providing a close growth forecast figure of 8.3% for 2011, investors are upbeat about growth prospects. The year 2011 has clearly begun well, and the deal activity is expected to continue into the next quarters. According to industry estimates, there is US$20 billion of committed, unused capital yet to be deployed in the Indian market, which already makes supply constraint a non-obstacle. The PE landscape in India is highly dynamic, and more often than not, it systematically responds to macroeconomic cues, domestic and global, and indicators such as interest rate and inflation. It is interesting to note that in spite of its dynamic nature, there is a striking characteristic that continues to persist. The average deal size has mostly flickered around US$25 million since 2004. The quarter-on-quarter figures since Q3, 2008, as shown in the Figure, do not show much variation in average deal size. It suggests a mindset that a majority of PE deals target minority positions. Tighter regulation on buying large positions in publicly listed companies could be one factor that is keeping the average deal size low.

Infrastructure was the star sector for PE investments in 2010. The aggregate deal value in infrastructure stood at US$2.3 billion, accounting for 32% of the announced deal value. The power sector is emerging as an attractive segment within infrastructure, with PE funds looking to capitalize on the demand-supply gap. India is currently power starved; industry estimates suggest that the energy availability of 750,000 million units (MU) fell significantly short of the demand of 830,000 MU during 2010. PE firms are chasing investment opportunities as India expands its power generation capacity. Infrastructure is followed by telecommunications, where the aggregate deal value stood at US$823 million. A close third position was taken by the financial services sector, which registered an aggregate deal value of US$820 million. In terms of volumes, technology sector saw the largest number of PE deals. Q4 2010 was particularly favourable to the technology sector, with the total deal value more than trebling when compared to Q4 2009. Technology is expected to continue leading PE deal volumes in 2011 as well. There are several challenges facing the PE industry. The regulatory challenge is foremost, followed by political pressures (especially in infrastructure sector) and volatile macroeconomic factors such as high inflation. The current regulation is particularly unfavourable for picking up large equity (over 15%) in publicly listed companies. Moreover, private equity is not treated as a separate asset class, which makes its treatment under securities and tax laws complex. Lack of meaningful exits was criticized as an impediment, but 2010 has proved it wrong. PE exits in 2010 stood at US$5.3 billion, and the exit volume registered at record high of 120 exits during the year. Strategic sales emerged as an important exit mode, with 26 deals choosing this route. The strong record of exits should boost investor confidence and fuel the next round of growth in 2011. The Indian PE industry is maturing. The attitude of promoters towards PE/VCs is changing, and there is greater recognition of the value that PE/VCs bring to the business. Although obstacles such as divergence on valuation expectations between promoters and investors, a tough regulatory environment, and inflation concerns remain, the fundamentals are intact. The PE industry is set for aggressive growth in 2011.

Increasing banking penetration in India

The RBI recently brought out a discussion paper on giving out new banking licences to business houses and non-banking financial companies (NBFCs) to increase competition in the sector, and also expand the reach of banking services across the country. The estimated banking penetration in India is about 45% among middle and high income groups and less than 5% among low income segment. Expanding the reach of banking services is crucial to tap the country’s savings and investments. Microfinance institutions have been partly effective in tapping rural savings, 41% of which are held as cash according to NCAER estimates. The RBI therefore has a clear mandate in awarding new banking licences, however, more deliberation is required on a few issues before the RBI actually implements it. The issues that are being debated widely in this context are – minimum capital requirement, shareholding of promoters and foreigners, permitting industrial and business houses, and NBFCs to start banking arms. RBI’s stance on disfavoring groups with real estate interests was a bold assertion. It highlighted the view that linkages with the real-estate sector, given its sensitivity and any subversion of the Chinese walls between the bank and real-estate business would have implications for the financial stability of the bank. On minimum capital requirements, we hold the view that the RBI should set it in the range of 300 to 700 crores and gradually increase it to 1000 to 1500 crores over a period of five years, in order to encourage only serious players to apply for licences. We recount here that the RBI, in 2001, had set a minimum capital requirement for banks at Rs 200 crore, which was to be increased to Rs 300 crore in 2004. We also expect the minimum capital requirement for other banks to go up once the announcement for the new banks is made. In addition to technical details, we hope that the debate also includes innovation in banking models and leveraging technology for better penetration of banking services, especially transaction banking at a time when mobile phones have seen high penetration in rural areas. If the business is able to generate wider employment opportunities and is also able to gain access to a wider customer base, then it’s a win-win situation for both the business and the people.

Financial inclusion in India and micro-insurance, the new buzz word

‘Greater financial inclusion’ figures prominently on the economic development agenda set by the Indian government in recent times. The much-talked-about UID project which aims to provide unique identity numbers to all Indian citizens, and links the number up with a compulsory bank account is indeed a bold step towards realizing that goal. The recent buzz word, however, in discussions on financial inclusion seems to be micro-insurance. The Finance Minister, in his recent address at the Global Insurance Summit, stressed on the need for popularizing micro-insurance in semi-urban and rural areas of the country. The attention on micro-insurance seems to have come at a right time, when the success of several government sponsored welfare schemes for the rural poor in India like the National Rural Employment Guarantee Scheme (NREGS) depends quite a lot on the ability of the financial system to mitigate the risks arising out of unforeseeable natural calamities and other disasters. In this context, the increasing efforts of insurance companies in tapping semi-urban and rural markets are an encouraging sign. Insuring the vast rural population against losses from disasters is indeed a big challenge for the Indian insurance industry, when at the same time it is important to ensure that premiums remain affordable. IRDA, the Indian insurance regulator, has in a recent exposure draft on a standard insurance product suggested that the premiums will be decided by the regulator and insurers might not get any leeway in this regard. The regulator’s goal of promoting financial inclusion is laudable, but greater freedom to insurance companies to design products and price them might be more desirable. The regulator has also proposed that insurers will have to mandatorily offer the standard product. The draft also talks about placing restrictions on selling other products with higher premium and lower benefits. Overall, it could be surmised that the regulator is concerned about insurance agents pushing expensive endowment products to the poor, which is a very valid concern. It would be interesting to monitor developments in this area for the next few months, as IRDA is also considering a proposal to allow cross-selling of micro-insurance products which would essentially provide insurance companies access to the large network of public sector banks for selling their products. The banks would benefit too as it would enable them to enlarge their portfolio of products.

Introducing CDS in India

The Reserve Bank of India (RBI) recently put out a draft report on introducing credit default swaps as OTC derivatives product for corporate bonds in India. Two attempts to introduce the product were already made earlier in 2003 and 2007. The timing of the latest proposal indicates that perhaps the central bank was waiting for the financial crisis to subside and also buy that extra time to learn lessons from the crisis. However, RBI has not incorporated some key lessons from the crisis. The following are a few glaring shortcomings in the proposal – 1) At a time when the world is moving towards centralized clearing systems, issues such as opacity and counterparty risk associated with OTC markets seem to have been overlooked, at least for now. What is more worrisome is that the proposal is not even keen on establishing a trade reporting platform. While it envisages the establishment of a trade reporting platform in the future, the proposal gives a green signal to begin CDS trading without setting up a trade repository. 2) The proposal says that the market is essentially a dealers market. Users are only allowed to buy CDS from dealers alone. However, what is very surprising is that it does not allow CDS buyers to unwind the protection by entering into another offsetting contract. If buyers desire to unwind, they have to terminate the position with the original counterparty, thereby allowing excessive and unfair control to the sellers. 3) The trade reporting format provided in the proposal does not include price data, which makes it even more unfriendly to the buyers. Opacity in prices even on post-trade basis, along with transparency issues arising out of the OTC nature of the market loads the dice heavily against CDS buyers. One would just hope now that the CDS market does not suffer in the same manner in which interest rate futures market did, especially given that India certainly needs a mature CDS market to manage systemic risks prudentially.

25% Public Float in India : Is the timing right ?

The Securities Contracts (Regulation) Rules (SCRR), 1957 was recently amended to incorporate a minimum 25% public float for all listed companies – private and public. The amendment also applies to listed statutory corporations. Public float is defined as that part of a listed company’s shares that are not held by the promoter. The proposal to push for a 25% public float had been around for some time now, and it has finally seen the light of the day, with the proposal turning into a law with a strong push from the Finance Ministry. There is little doubt about the objectives of the amended law – greater public float creates deeper public markets, making the markets more efficient, thereby reducing the cost of raising funds. However, the crucial question that is being asked now is about the timing of the amendment, and about the time-frame given to companies to comply with the new law. While equity markets all around the world still appear shaky and offer no compelling signs of recovery from the financial crisis, it appears that the amendment is a tad hasty. It is not very convincing that the next 2-3 years is the best time to dilute shareholding, especially given the volatility and the subdued valuations. The criticism is equally about the short time-frame (2-3 years on average) given to the companies to comply. This compliance is estimated to raise money in excess of Rs. 1.6 trillion. Companies might be unable to put the forcefully raised money to any better use. The premise that ‘greater public float results in greater liquidity’ also appears shaky. Higher public float might discourage many companies which are more comfortable with smaller divestment from listing. Also, listed companies which do not want to divest at the moment, might rather prefer to delist than comply with the new law. This might in fact result in lower liquidity. While the objectives of the amendment are noble, and definitely in the right direction towards creating more mature equity markets, the government should have waited for more convincing signs of global economic recovery before making the law.

Regulating Microfinance Institutions in India : A complex task

The Indian microfinance industry comprises of numerous microfinance providers who are spread all across the country. The starting point of complexity in regulating the industry lies in the diverse nature of institutional forms they are registered as, viz. – NBFC-MFIs, cooperative societies, non-profit organization, trusts, all subject to different laws. The Draft Micro Financial Sector (Development and Regulation) Bill was tabled in the Parliament in 2007, but it failed to become an Act. Since then, there has been no clear consensus on whether MFIs should have their own legislation, or be subjected to the same norms as banks and NBFCs. The Finance Ministry and Nabard are again renewing efforts to put a clear regulatory structure in place. Recent reports about MFIs offering loans without adequate background checks on borrowers’ repaying ability, the amorphous ways of fixing the interest rates have raised questions about corporate governance in the industry, thereby alerting the regulators. Recently it was suggested that the RBI regulate the MFIs by capping the interest rates that are charged, or by applying NBFC norms. It is a complex task, since there is no clear way of knowing what the right interest rate to charge is, given the country’s large geographical expanse and the great diversity among borrowers’ credit profiles. Moreover, any attempt to regulate the MFIs has to tread a fine balance, since a large part of the rural populace is already a part of the system, and therefore has a direct bearing on rural economic activity. An appropriate way of bringing structure to the microfinance industry at this juncture might be to just lay down prudential norms for the industry for an interim period, and mandate all microfinance institutions regardless of their institutional forms to report to one single authority (RBI or Nabard). Greater information sharing might be the simple answer to improving corporate governance at MFIs.