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.

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.

Accepting the need for Electronic Trading

In its recent history,the Asian market has been characterized by the adoption of technology in a much more compressed time-frame as compared to its counterparts in the western world. This has been true of the industrial as well as the services sector, where it is also holds true for electronic equity trading. Asia is well poised for a rise in the share of electronic trading in the next few years. Markets such as Japan, Australia, Singapore, Hong Kong and India are seeing a lot of investment happening that is related to Direct Market Access (DMA), Smart Order Routing (SOR) and High Frequency Trading (HFT). The associated infrastructure such as market data services, co-location and so on are also being paid attention to, as is the requirement for helpful regulation. However, in some markets, the regulators are not very confident about and supportive of the needs of greater electronic trading. This is partly because of the financial crisis and rising requirements for risk management, and also due to the flash crashes that have occurred in the NYSE and OSE markets. We expect the regulatory framework to become more flexible in most markets, but there is still an important element that needs to be addressed across the board in the Asia-Pacific. That is the role of smaller brokerages and the buy-side. Unlike larger brokerages, these are still reluctant to adopt electronic trading and to make the investments required to have the same. While attitudes and capabilities do not change overnight, I believe that market investors in Asia need to be made aware of some harsh realities. To start with, the way HFT and algorithmic trading evolved in the US and European markets, there was very little time for market participants to react to and adopt such trading. The change happened so quickly that a number of brokerages and buy-side firms were unable to cope and had to operate in a more constrained fashion or even shut down. The incentive that HFT provides for those trading larger volumes means that the smaller players are at a relative disadvantage. This increases even more if they are slow to react and do not adopt electronic trading. So it is not just the speed of trading that is important to succeed, it is also the speed of thought. Hence, smaller brokerages and buy-side firms in Asia should be more positive and not be afraid of investing in DMA, SOR or HFT. The gains from these might not be apparent immediately, but if the lessons from the western markets teach us anything, it is that the quick and nimble-footed firms were the most successful during the rise of electronic trading. With the trading infrastructure in Asia changing so rapidly, there is little reason to believe things are going to be different here.