Beyond HFT

Last week I attended the Tokyo Financial Information Summit, put on by Interactive Media. The event was interesting from a number of perspectives. This event focuses on the capital markets; attendees are usually domestic sell side and buy side firms and vendors, including global firms active in Japan. This year there was good representation from around Asia ex-Japan as well; possibly attracted by the new volatility in Japan’s stock market. The new activity in the market was set off by the government’s Abenomics policies aimed at reinvigorating the Japanese economy. But I suspect the fact that Japan’s stock market is traded on an increasingly low latency and fragmented market structure gives some extra juice to the engine. Speaking of high frequency trading, Celent’s presentation at the event pointed out that HFT volumes have fallen from their peak (at the time of the financial crisis) and that HFT revenues have fallen drastically from this peak. In response to this trend, as well as the severe cost pressures in the post-GFC period, cutting-edge firms seeking to maintain profitable trading operations are removing themselves from the low latency arms race. Instead, firms are seeking to maximize the potential of their existing low-latency infrastructures by investing in real-time analytics and other new capabilities to support smarter trading. HFT is not dead, but firms are moving beyond pure horsepower to more nuanced strategies. Interestingly, this theme was echoed by the buy and sell side participants in a panel at the event moderated by my colleague, Celent Senior Analyst Eiichiro Yanagawa. Even though HFT levels in Japan, at around 25 – 35% of trading, have probably not reached their peak, firms are already pulling out of the ultra-low latency arms race–or deciding not to enter it in the first place. The message was that for many firms it is not advisable to enter a race where they are already outgunned. Instead they should focus on smarter trading that may leverage the exchanges’ low latency environment, but rely on the specific capabilities and strategies of a firm and its traders. Looking at this discussion in a global context, it seems interesting and not a little ironic that just as regulators are preparing to strike against HFT, the industry has in some sense already started to move beyond it.

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 Competition and Market Impact: Currency Derivatives in India

Rivalry among Indian capital market players, including exchanges and regulators, is not new. It was again observed in the currency derivative space recently. Trading in currency derivatives in India began in August, 2009. The National Stock Exchange (NSE) of India was the first player to offer this facility to investors. Two more players, MCX-SX and United Stock Exchange (USE) later entered into this space. Initially NSE was not charging any fees for trading in currency derivative. There were arguments both for and against such policy. NSE’s stand was that such a move was intended to benefit all players (exchange, members and investors) and thereby develop this new market. However, such a stance taken by the first mover and dominant player in the market meant other players were also not able to charge transaction fees in this market. This led MCX-SX to lodge a complaint against NSE to the Competition Commission of India (CCI). In its order, CCI found NSE guilty of abusing its dominant market position. Subsequently NSE introduced transaction charge in the currency derivative segment starting from 22nd August, 2011. According to NSE, while they are challenging the CCI order, they are ‘implementing its direction to levy charges out of respect for the commission’. As a result, transaction charges are being imposed for the first time in the three-year history of this market segment. The NSE would levy transaction charges of up to Rs 1.15 per 100,000 Rs of turnover in the currency future segment. On currency option contracts, members will pay a transaction fee between Rs 30 and Rs 40 on every 100,000 Rs of premium payable. Also, it would levy an advance transaction charge of Rs 50,000 per member per annum and would charge an admission fee of Rs 100,000 from its existing members and Rs 500,000 from others – this would be set off against actual transaction charges payable by the member in the respective financial year. Subsequently, MCX-SX said that it would also levy charges for currency derivative transactions. The third exchange, USE is still considering on levying charges, and hence is the only exchange left which does not impose charges on currency derivatives. Absence of levies and fees was a big contributor to the growth of currency derivative trading in last few years. Besides no transaction charge, this segment is also not charged Securities Transaction Tax (STT), a tax charged on all other transactions. Therefore trading in currency derivatives used to be a much cheaper option and arbitrageurs were attracted to this segment. With the introduction of transaction charges, costs are going to increase and the volumes are likely to be impacted. The results observed so far are very much in accordance with that. Trading volumes at both NSE and MCX-SX, the two exchanges which introduced transaction charges, fell significantly since August 22, while trading volume at USE actually grew marginally. Compared to the period 1st January, 2011- 18th August, 2011, it can be seen from the figure, average daily trading volumes fell by 20% NSE and by 17% at MCX-SX since 22nd August, while it grew by 7% at USE. Similar trend has been seen in case of trading value as well. It must be mentioned here that trading volume in currency options at NSE actually grew by 8% after introduction of transaction charges. This probably indicates the introduction of charges was a deterrent for arbitrage players who are more active in the future segment.

Equities Trading at Indian Exchanges: Competition Can Wait

MCX-SX, which offers trading in currency futures, had requested to the Securities and Exchange Board of India (SEBI), the capital market regulator, for approval to launch trading in equities, equity derivatives, interest rate futures and other instruments. It was thought that this move would add a new dimension to India’s exchange landscape which is dominated by the two main exchanges, the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). The recently started United Stock Exchange, which commenced its operations in the currency futures segment on 20th September, 2010, recorded on its very first day a turnover more than that of the combined turnover at NSE and MCX, the country’s existing currency trading exchanges. It was anticipated equities trading at MCX, if approved, would also throw up similar competition to the country’s two existing exchanges. In September 2008, MCX-SX was conditionally recognized as stock exchange trading in currency futures by SEBI for a year; recognition was extended in August 2009 for one more year to give MCX more time to comply with requirements. In April, 2010 MCX-SX sought permission seeking approval for trading in segments permitted to BSE and NSE. In July, 2010, MCX-SX filed petition before the Bombay High Court seeking intervention over the delay in approving its application by SEBI; in August 2010, the Bombay High Court asked SEBI to take a final decision on the matter by September 30. On 23rd September, 2010, SEBI rejected the application stating it ‘was not satisfied that it would be in the interest of trade and also in public interest to allow the application’. SEBI’s rejection, as mentioned in its order, was based on a number of issues. Under MIMPS (Manner of Increasing and Maintaining Public Shareholding in Recognized Stock Exchanges Regulations), no person resident in India shall at anytime, directly or indirectly, either individually or together with persons acting in concert, hold more than five per cent of the equity share capital in a recognized stock exchange. A select class of financial institutions, however, can own up to a maximum of 15% each.
  • MCX-SX is promoted by Multi-Commodity Exchange of India Ltd (MCX) and Financial Technologies India Ltd (FTIL). When MCX-SX was formed, its promoters MCX and FTIL owned 51% and 49%, respectively, which, after divestment, came down to 37% and 33.9%. The promoters in April, 2010 undertook a further financial restructuring to comply with regulations, by reducing their respective shares to 5% each. However, it also issued warrants to MCX and FTIL, which allows the promoters to gradually sell the warrants under favorable market conditions. Under this arrangement, according to SEBI, MCX and FTIL have together now a holding of 71.90% in the shares and warrants issued by the company.
SEBI listed ‘excessive concentration of economic interest in the stock exchange in the hands of the two promoters’ and ‘not being fully compliant with shareholding regulations‘ as reasons for rejection.
  • MCX-SX had submitted that the two promoters did not share a common management, but it (SEBI) found the two entities are operating under a common management. According to SEBI, therefore the share holding of FTIL together with that of MCX (5% each) exceeds the permissible limit of 5% limit of ownership in a stock exchange.
  • SEBI stated that ‘the promoters of MCX-SX and their associates had arrangements with three shareholders of MCX-SX where sale of shares between the parties were based on offers to buy back the shares at or within specified time in the future’. It found such arrangements illegal.
  • In its order SEBI said ‘MCX-SX has been dishonest in its disclosures to SEBI on material information and has failed to fulfil its disclosure and fiduciary responsibilities’ and also it ‘has failed to adhere to fair and reasonable standards of honesty that should be expected of a Stock Exchange’.
MCX-SX may appeal to the Securities Appellate Tribunal (SAT) against the decision, or go for a writ petition in the high court.