Interoperability: Potential Game Changer for Indian CCPs

India has many stock exchanges, but trading is dominated at two main exchanges – the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). BSE is among the oldest stock exchanges in the world, while NSE was established as part of India’s economic liberalization process in the early 1990s. The NSE was quick to gain market share and now accounts for around two-third of stock trading and most of derivative trading in the country. BSE was slow to react to competition in the early days, but in the last five to six years has taken steps to up its game by making major changes in its technology. Structural issues with the Indian capital market have so far limited its ability to close the gap with NSE. The Indian CCPs that clear exchange trades are owned by the respective exchanges and at present only clear trades executed at the owner exchange. National Securities Clearing Corporation Limited (NSCCL) is the CCP for NSE while Indian Clearing Corporation Limited (ICCL) is the CCP for BSE. Interoperability among CCPs at an investor level is not allowed; i.e., investors can choose which exchange would execute their trades, but cannot choose which CCP would clear them. Therefore, in spite of having multiple players in the clearing space, there is not much competition among the CCPs. The dynamics in the Indian CCP space therefore are largely driven by the competitive developments on the exchange front. The capital market regulator SEBI allowed direct market access in India in 2008 and soon afterwards allowed colocation and smart order routing (SOR). This should ideally allow investors to execute their trades at any exchange of their choice. However, most of the liquidity is concentrated at the NSE due to its dominant position. Furthermore, since almost all of derivative trading takes place at the NSE, investors tend to prefer NSE for their equity trades as well, since that allows them cross-asset margining benefits of clearing trades in different asset classes at the same CCP. Because of this, smart order routing has not picked up in India yet. Thus algo trading reached around 15% in the cash segment in NSE in 2014, but smart order routing was only around 2%. Similarly algo trading was 70% at BSE’s cash segment, but SOR was around 1%. This shows BSE (and its CCP ICCL), with its improved technology and latency capabilities, is attracting a higher share of algo trades but is still unable to capture share in smart order routing, due to unique clearing arrangements in the market. Going forward potential allowing of interoperability promises to be a significant force of change for the Indian CCPs. It would give investors the freedom to choose their CCP, and if they get better latency and pricing from ICCL, they could choose ICCL regardless of BSE’s smaller share in trading volume. SEBI is considering this and is in consultation with a range of market participants. Eventual interoperability may be a boon for BSE and ICCL, allowing it to catch up with the dominant NSE and NSCCL.

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.

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.

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.