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

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

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.

Exchange initiatives in Asia

In a recent post we discussed that OTC derivative market reform process is giving rise to new opportunities for several market participants. We identified provision of collateral management services as one such opportunity. It comes as no surprise that the Singapore exchange and Clearstream are partnering to offer precisely such service. This development also highlights another trend that has been observed for some time now – that of partnership and alliances in the exchange landscape, particularly in Asia. Even though the Singapore Exchange (SGX) failed in its bid to take over the Australian Stock Exchange, it has been very active in forging partnerships and alliances with other exchanges, both in the region and globally. Recently it bought a controlling stake in the clearing house LCH.Clearnet. It also partnered with the London Stock Exchange to provide investors in each country the opportunity to invest in the most actively traded stocks on the other’s exchange. It has similar partnership for cross trading of certain products with other exchanges like the National Stock Exchange of India. The exchange has increased the trading hours to accommodate such collaborative initiatives with other exchanges. Besides partnering with other exchanges, it is also adding new services to expand vertically. The exchange started offering clearing services for commodity derivatives through its AsiaClear offering a few years ago. In addition to providing CCP services as mandated for OTC derivatives under the proposed reforms, the SGX is collaborating with the Korea Exchange to develop the latters’ OTC clearing capabilities. Going beyond traditional partnerships with other exchanges, the SGX partnered with Chi-X to offer a dark-pool platform to the investors in the region. Even though that initiative did not meet with much success in terms of attracting volume, it displayed the exchange’s intention to explore newer opportunities. The SGX is one of the four exchanges to join the ASEAN trading link, an initiative  that offers a common link to investors in the seven ASEAN bloc countries to trade in other member countries. In addition it is looking for organic growth by adding product base and improving distribution services (e.g., developing Chinese Yuan capabilities). Not to be left far behind, the Hong Kong Exchange has acquired the London Metal Exchange. Regulators in Malaysia have allowed CME to buy a 25% stake in the Bursa Malaysia’s derivative business and revamp its technology. In Japan the Osaka Securities Exchange merged with the Tokyo Stock Exchange to make it the third largest exchange by market capitalisation. These developments show that the exchanges in Asia have been very active in forging new partnerships and broaden their suite of offerings. The trend is expected to continue in the future.

OTC Market Reforms in Asia: Presenting New Opportunities

In another blog we discussed the issues that will have serious implications for different market participants in the OTC derivative market reform process in Asia.  Here we look at its impact on different market participants. The move towards central clearing is likely to create more demand for clearing services. Currently a small number of brokers offer clearing service in this space, and they may not be able to handle the sudden rise in demand. Some of the major international clearing firms are in the process of scaling up their operations in the region. Even though the volumes in the OTC segment are low at present, the growth prospects of the Asian economies in general, and niche areas (e.g., NDF clearing) make the region strategically important for many of these firms. However, some participants are wary about the costs of having to join many clearing houses and the issue of assuming unlimited liability in case of default. International banks have significant share in the OTC derivatives space in Asia; if these issues are not sorted out, some western banks may withdraw from some markets, or even the whole region, which would likely have an adverse impact on liquidity. Regulations mandating central clearing will create business opportunities for centralized clearing. In some markets like Singapore, the incumbent exchanges are taking a leading role in this regard. It will be interesting to see if new players will be able to enter and succeed in this business. Low volumes in the Asian markets, proliferation of CCPs and competition from international ones may result in each CCP specializing in specific niches along product lines or local currency instruments. The business models of new CCPs will come under heavy scrutiny from regulators, breaking trends from the past. As large number of OTC trades move to the CCPs, the concentration risk at some of them would be significant and national regulators would want to make sure those risks are adequately managed on a continuous basis. As CCPs replace bilateral trading, and market participants face the choice of executing trades at different CCPs, they will also need tools for managing and optimizing the use of collateral. This represents an opportunity for some market players who specialize in providing collateral management solutions. Needless to say, the kind of solutions needed and offered in this space will depend largely on the maturity of specific markets and market participants. Thus, while Credit Support Annexes (CSAs) may be sufficient for emerging countries of the region, advanced services (like collateral transformation, outsourcing of collateral management) would gain traction in the leading countries like Australia, Hong Kong and Singapore. Reporting banks would come under greater regulatory scrutiny and will have to run stress tests and ensure capital requirements on an ongoing basis.

China’s road towards Currency Internationalization

China is the world’s second biggest economy, largest exporter and second largest importer. Yet China’s currency, the Renminbi (RMB), accounts for less than 1% of global FX turnover. The Chinese authorities have been making concerted efforts since late 2008 to internationalize the Renminbi by trying to increase its use in international trade and investments. Their efforts are paying off as RMB settled trade has grown since late 2010 and accounts for 8-10% of all international trades at present. The following highlights some major successes of their efforts: •    From October 2010 to June 2012 value of RMB payments grew by 17 times. Currently 91 countries are processing renminbi payments. •    Hong Kong is the dominant offshore centre for RMB trading accounting for around 80% of all renminbi payments; share of Singapore, Taiwan are also significant. UK is positioning itself as a major offshore trading centre for renminbi. •    RMB is among world’s top ten currencies traded. Three FX markets exist for RMB: onshore CNY market which is tightly controlled, offshore CNH market in Hong Kong which is relatively free, and USD denominated non-deliverable forward market. The currency sometimes trades at different rates in the CNY and CNH markets and many firms, especially large ones with subsidiaries outside borders, use it to conduct exchange rate arbitrage in these two markets. Given that China’s currency is not fully liberalized, this arbitrage sometimes is not settled by market forces and it creates pressure on the currency, as was evident late last year. Some therefore argue that significant proportion of RMB settlement comes from speculation in the two markets while imports are still invoiced and mostly settled in US dollar. Bank of China Hong Kong (BOCHK) and Bank of China, Macau, are the only two entities approved to clear offshore RMB transactions. Other banks can engage in offshore RMB business through agreement with BOCHK, or through relationship with other banks which have existing agreement with BOCHK. This presents an opportunity for many regional and international banks to tap into this burgeoning market of RMB clearing and trade related services. Moreover, two of the world’s biggest exchanges, the Hong Kong Exchange (HKEx) and the CME Group, recently announced plans to launch offshore yuan futures in Hong Kong by the end of 2012. This is likely to facilitate exporters and importers hedge their currency risks, especially now that the currency is showing some volatility. The forwards market at present is very efficient with tailor made contracts; therefore some think currency futures may not gain traction immediately among traders. However, along with importers and exporters who use currency futures and forwards to hedge exposure, this will also attract asset managers and other financial institutions as the contracts will be standardized and tradable at the exchanges. The outcome of these initiatives remains to be seen, but these moves are likely to further strengthen China’s efforts towards Renminbi internationalization. It must be mentioned that in spite of these developments, there are challenges with China’s efforts to internationalize the RMB. At a broad level, RMB is mostly used to settle imports, but not exports. Even in imports, invoicing is often done in US dollars while settlement happens in RMB. It is argued many Chinese corporations use the different currency markets (CNH-CNY) to engage in speculative activities and not that much for pure trade purposes. This effectively allows for interest rate speculation between the two markets as well. Many of these problems are intertwined as China has traditionally had very strict capital control, and the internationalization of renminbi is taking place before fully liberalizing its interest rate, exchange rate or capital account. Therefore how China attempts to internationalize its currency and manages its key rates at the same time will be closely watched.

OTC Derivatives in Asia

Over-the-counter (OTC) derivatives have come under scrutiny since the Global Financial Crisis (GFC) of 2008. The global OTC derivative market is primarily dominated by the US and Europe, with Asia accounting for less than 10% of notional outstanding. The Asian financial market, unlike its western counterparts, is not a homogeneous entity. Rather, the countries in the region are divided along jurisdictional lines with limited regional integration. Thus Asia not only consists of a large number of countries with each at different level of economic development, they also have different regulatory and monetary regimes. This has resulted in a number of highly localized markets with the exception of a few, notably Hong Kong and Singapore. In two new reports Celent discusses the development in the OTC markets in 11 Asian countries, divided into two groups. The first report looks at the advanced economies and includes Australia, Hong Kong, Japan, New Zealand, and Singapore. The second report covers the emerging economies of China, India, Indonesia, Malaysia, South Korea and Taiwan. It is interesting to note that the emerging countries account for only 9% of total OTC turnover in these countries, even though there share is much higher on other economic and financial indicators.blog

Tokyo Roundtable 2013: The Capital Markets Revolution in Japan and Asia

Tokyo, home to Asia’s largest capital markets, is also wonderful in May, and was a perfect location for two recent Celent roundtables.

The first was Exchange Panel: Drivers of Innovation and a Market in Transition. We invited Executives from five major global exchanges; CME Group, JPX Group, Korea Exchange, NYSE Euronext, and Singapore Exchange Limited. Representatives from both Asian and global exchanges discussed changing equities derivatives market structures, business models, challenges, and opportunities in Japan’s and Asia’s capital markets.

Though similar at first glance, the exchanges from the East and West presented a marked contrast. Asian exchanges insisted that competition, diversity, and deregulation are the keys to growth. Exchanges based in Europe and the United States said they found the diversity and competition excessive; they would prefer order and market discipline. All exchanges stressed the importance of innovation and collaboration, and all agreed the distinction between investment and speculation is important.

Such differences between East and West reflect the history of the global exchange business. Differences in time and distance are shrinking as networks grow, but, ironically, the advent of global capital markets has led investors to recognize the importance of individual trading venues.

For the second roundtable, The Capital Markets Revolution in Japan and Asia, we invited the top players. From online securities companies, Monex, Inc., from buy-side, Nissay Asset Management Corporation, and from sell-side, Nomura Securities Co., Ltd. This session focused on the emerging low latency landscape and the opportunities and challenges in the region’s equities and derivatives markets. In Japan and Asia, since the introduction of arrowhead, the latency has been lowered enough and the attention has shifted to its execution quality. Technologies such as Big Data and transaction cost analysis (TCA) are the focus of their challenges.

Finally, in response to questions from audience of the venue, we asked the panelist to comment on high frequency trading (HFT). There were two comments; one was “the opportunity to get everyone used to HFT is here”, and another “HFT is welcome in Japan”.

The market environment has changed drastically. Conversion of monetary policy, “Abenomics,” and the “three arrows” were a volcanic combination. Magma flowed, but all indicators began to rise.

FIG 1:Tokyo Equities Market last six months

Tokyo Roundtable 2013_GraphSource: NIKKEI, Celent
 
These discussions will continue in New York in June. Celent will continue to explore the market trends of tomorrow. We are looking forward to meeting you again.
 
 
 

CCP adoption in South Korea

In 2009, the G20 agreed to set up CCP (central counterparty) settlement by the end of 2012. However, as of early December 2012, adoption of CCP settlement for OTC derivatives has not been passed by South Korea’s National Assembly. In other words, South Korea yet to keep its commitment to the G20 agreement which says that G20 countries should set up a CCP by the end of 2012. The adoption of CCP settlement is crucial to improving the transparency and stability of the OTC derivatives market. In order to prevent another KIKO incident in the future, the role of CCP is essential in South Korea. This would also help support Korea’s global credit standing.