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.

Issues for the Indian Pensions regulator

One of the key areas in Indian Financial Sector reform is the Pension sector reform. The PFRDA (regulatory agency for pensions in India) faces the challenge of expanding the distribution network of the newly formed “New Pension System” to cover the entire unorganized sector in the country, handle the elderly population segment which has no pension, educate citizens to take appropriate investment decisions based on their risk and return profile, as well as contribute to improving the financial literacy levels. This blog post will take a peek at the two key population segments which are at the centre of what the regulator is looking at – the elderly population segment and the unorganized labor force. India has nearly eighty million elderly people, which is 1/8th of the global elderly population. This population is growing at an annual rate of 3.8% while the overall population is growing at more than 1.8%. Unfortunately, majority of this aged population is not covered under any formal old age income scheme making them vulnerable and dependent on the earnings and transfers of the children or other family members.

The Indian labor force is more than 500 million. A special feature of this labor force is the fact that it is heavily skewed towards the unorganized sector. The organized sector employs around 11-12% of the labor force. This leads to restriction in social security access to almost 90% of the labor population. Around 11% of the labor force, the organized sector is currently under pension cover leading to a crucial social security problem in the future.

There have been a lot of half-baked solutions like the rural old age pension schemes, profession specific plans etc, that have been tried out in the past with limited results. Now is the time for the regulator to come up with a top-down policy based solution which will handle these two issues in a comprehensive manner.

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.

World Cup’s Performance Correlation with Asian Markets – Irrational exuberance?

The World Cup in South Africa is finally here and besides all the focus on the unusually bouncy new ball and the loud yellow “elephant trumpets”, the performance of the football teams in the Asia-Pacific (we include South Korea) region has also been of great interest. Above is a lighthearted look at the potential impact of the past week’s world cup results on the relevant markets from the kickoff on 11th June. Japan 1 – 0 Cameroon – Nikkei 225 up 1.92% S.Korea 2 – 0 Greece – KOSPI up 0.87% Australia 0 – 4 Germany – S&P ASX 200 Index down 0.3% So I guess all those investors would be finding even more reason to root for their national teams now =) Graphical and data source: Bloomberg

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.

HFT in Asia: Panic?

HFT or high frequency trading has been in the spotlight of late – particularly after the recent 1,000 point intra-day plunge at the NYSE. Constituting ~50% of equities volume in the US according to our estimates (see graph below), market participants in Asia were alarmed by the potential impact that HFT could have on domestic exchanges. High frequency trading still has a long ways to go in Asia, though the Japanese and Australian equities markets have seen some penetration. Largely-enabled by TSE’s new faster arrowhead system (actual latency of 2 ms which is 1000 X faster than the previous matching rates of 3-5 s), HFT should see growth in Japan especially from foreign quant funds and prop. trading firms. But will we witness the kind of dramatic plunge on the TSE as we did last month on the NYSE? Chances are low in the short-medium term as the rate of HFT in Japan is not expected to reach US levels anytime soon (ie. Significant % of volumes to effect such sensitivity to intra-day price movements and intra-day volatility) but a more important lesson which would prevent a repeat of that incident would be the need to regulate HFT with additional responsibilities on automated high-speed market makers and high-frequency trading firms (e.g mandatory quote activities and restrictions on the number of cancelled orders) and greater transparency in post-trade reporting. However, high-frequency trading does provide valuable functions in terms of liquidity provisioning and facilitates competition around latency and trading efficiency which would be hugely beneficial to Asian markets. Thoughts?

IDR – a new global investment route for the Indian investor

The Indian Depository Receipt issue by Standard Chartered Bank is coming to the Indian retail markets today (25th May). The IDR is a receipt which represents a share, or part of it in a foreign company. The company floating the issue (in this case Standard Chartered) has to appoint an Indian Depository, which will issue receipts to investors, while the original shares are held by an overseas custodian. IDRs are thus, very similar to GDRs but are rupee denominated. IDR provides an easy route for the Indian investor to have a piece of foreign investment. While the access to foreign investment has always been possible, it was a tough route to take – with the requirement of a foreign bank account and investment in a non-rupee currency denomination. IDRs solve this problem as they are rupee denominated and can be traded in the exchange. But a key point to note is that this does not protect the investor from forex fluctuations – so any exchange rate change will affect the IDR value along with changes in the underlying price change of the stock in its home market. Standard Chartered is the first foreign firm to go for an IDR and hence the interests in this issue are two-fold – for foreign firms, this will be a litmus test to understand whether Indian markets could be a good market to raise funds while from the investor perspective, we will learn whether the need for global diversification, a sign of the increasing investor maturity, is present in the Indian investor mindset. A minimum 50% of the issue is reserved for qualified institutional buyers, but this can go up if the uptake from other segments is lesser than expected. 30% is meant for retail investors and inorder to build retail confidence, the IDR is being offered to anchor investors. Only time will tell whether this will be a success in the retail segment. The issue with gaining retail interest is the higher taxation on dividend and capital gains on IDRs compared with that on Indian stocks. If these regulations are modified, we might see more and more foreign firms raising money from India in the future.

A new platform for SMEs in India

Small and Medium Enterprises (SMEs) are significant stakeholders in India’s economic development. Their contribution amounts to about one-fifth of the GDP, and they also count among the top three employment generators in the country. The Securities and Exchange Board of India (SEBI), after a careful examination of the topic about reviving the SME segment, identified the following concerns –
  1. The cost of raising capital for SMEs was high.
  2. The existing means of financing were not adequate. SMEs did not have easy access to funds from VCs/PE players.
  3. The existing compliance costs associated with raising funds were high.
In view of the above observations, it was decided that the eligibility conditions, listing requirements, corporate governance norms and disclosure standards should be suitably relaxed owing to the small sizes and low affordability of the SMEs. The need for a separate dedicated stock exchange for SMEs was therefore strongly felt. In November 2009, SEBI had announced the draft norms, and yesterday (May 19, 2010) it released guidelines for trading on the SME platform after incorporating changes based on opinions voiced by market participants and industry representatives. A post-issue upper limit of Rs. 25 crores capital at face value has been fixed for firms that intend to list in the segment. The disclosure norms have also been relaxed. The firms that intend to list in the segment will not be required to report financial numbers every quarter or even release complete annual reports. However, a statement containing the salient features of all the documents will be required, and periodical financial results may be submitted half-yearly instead of quarterly. The SEBI has the advantage of learning from the experiences of other SME platforms around the world, viz. the Alternative Investment Market (AIM) in London, the Growth Enterprises Market (GEM) in Hong Kong, and MOTHERS in Japan. The setting up of a new SME platform is a positive step, and clearly the expectations are that the SME segment in India should become more competitive.

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?