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Recipe to make India's capital market more inclusive

Last updated on: September 6, 2012 16:55 IST

Recipe to make India's capital market more inclusive

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Aditi Roy Ghatak and Paranjoy Guha Thakurta

This is the concluding part of a three-part series, where Aditi Roy Ghatak and Paranjoy Guha Thakurta discus how share prices in India are manipulated and the future of the country's stock exchanges.

Part I: Will the advent of a 3rd exchange help India's bourses?

Part II: Equity bias just not good enough



I
s more competition what India's latest exchange for financial instruments, MCX-SX (Multi-Commodity Exchange - Stock Exchange), will be able to bring to the table and is this the key to a vibrant and more inclusive capital market? Had it just been a matter of competition between exchanges, the advent of the National Stock Exchange would have made all the difference. The NSE, however, started playing "big brother" soon after it ousted the Bombay Stock Exchange from that position.

A source close to MCX-SX says that competition always augurs well for market development: "We have this evidence of huge inclusive growth in other regulated sectors such as banking, insurance and telecommunications, which witnessed phenomenal growth, cost optimisation, product innovation and enhanced service levels after they were opened up during the 1990s. 

"The Indian exchange industry too will witness a similar change in the landscape benefitting investors and corporate across all profiles and the industry. This has been the case in Europe and the USA, where new exchanges are being established even now despite having a well-developed exchange traded market and an OTC (over the counter) market", he said.

There are other facets of the derivatives business that deserve a closer look. In the course of its many communications during the pendency of the case in the Supreme Court, MCX-SX discussed several issues of importance to the working of stock exchanges in India. Among them was why trading in IRFs (interest rate futures) was successful in the Over the Counter (OTC) market but failed on the exchange platform.

It was suggested that the market for IRFs in India was not broad based enough. Trading in currency futures that were launched on four exchanges and trading in currency derivatives succeeded but trading in IRFs, with its single-exchange launch, did not catch on.

Competition, argued the source close to MCX-SX, was the key supported by:

  • correct product design;

  • concerted awareness creation for the new product, the success of which must be critical to the exchange for it to support it passionately - such awareness would have to be around pricing of the instrument and the dynamics of both short and long term interest bearing instruments to help players act with utmost maturity;

  • introduction of competition to drive innovation and efficiency; and

  • introduction of market-makers to absorb and infuse liquidity to foster depth in that market.
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The source also suggested that the IRFs had turned out to be nothing but a notional 10-year bond bearing a coupon of seven per cent, paid semi-annually. Such an instrument was inconvenient for smaller participants. Therefore, a need was felt to make IRFs available over a broader spectrum of securities and benchmarks.

He pointed out that the International Monetary Market, a spin-off from the erstwhile Chicago Mercantile Exchange, had contracts on discount instruments like U.S. government treasury-bills and Euro-dollar futures in its short term interest rate future space apart from U.S. treasury bond contracts that are popularly traded as long-term financial futures contracts.

Reviving the IRF segment in India would involve addressing a host of issues revolving around underlying, trading hours, size of the contract, tenure of the contract, daily settlement price, deliverable grade securities, last trading day and last delivery day, freedom to exchanges to decide deliverable securities and settlement methodology, market-making and liquidity providers.

There has also been a great deal of talk about developing algorithmic trading and building a supporting infrastructure for such trading in India. However, before one rushes into such trading, it would be worthwhile to examine a July 2011 report by the International Organization of Securities Commissions (IOSCO), an international body of securities regulators. The report concluded that while "algorithms and high frequency trading (HFT) technology have been used by market participants to manage their trading and risk, their usage was also clearly a contributing factor in the flash crash event of May 6, 2010".

For the layman, algorithmic trading or automated trading - also called algo trading, black-box trading, whitebox trading, robo trading - used electronic platforms for entering trading orders with an algorithm deciding on such aspects of the order as the timing, price, or quantity of the order. In many cases it initiates the order without human intervention.

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Photographs: Lucas Jackson/Reuters

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Globally, pension funds, mutual funds and other "buy side" (investor driven) institutional traders, use algorithmic trading to divide large trades into several smaller trades to manage market impact and risk. "Sell side" traders, such as market makers and some hedge funds, provide liquidity to the market, generating and executing orders automatically.

A special class of algorithmic trading, called high-frequency trading, allows computers make elaborate decisions to initiate orders based on information that is received electronically, before human traders are capable of processing the information they observe. This has resulted in a dramatic change of the market microstructure, particularly in the way liquidity is provided.

Algorithms in the Indian stock exchanges are in a state of relative nascency in that there are some simple first generation algos, some strategy implementation algos and intelligent algos too. The concept is driven by the need for control, speed, anonymity and confidentiality, cost, unbundling, fragmentation and liquidity. Nevertheless, there are major areas of concerns over liquidity fragmentation and order proliferation, trading aberrations: feedback loop and domino scenario and data overload.

The point is that Sebi is worried about being able to manage algorithmic trading with its chairman, U.K. Sinha, saying: "We need to look at whether the regulator has the capacity to handle this (high-frequency trading). I doubt stock exchanges and Sebi have the capacity".

For some, the fears are real and well expressed while for others they represent an overcautious mind that is not good for a dynamic stock exchange. Richard Gula who develops and deploys databases on equities, futures, exchange traded funds and such other, who has built, managed and used financial databases since 1975, says: "Expect high sophisticated algo development but (this is) likely (to be) focused on a relatively small number of liquid stocks. Liquidity will define success of the effort. Regulatory issues could mushroom".

He intends to study the Brazilian futures and derivatives markets to see a possible parallel with Indian market.

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Photographs: Reuters

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Experts suggest that going ahead with algos should be preceded by an identification of the stocks' universe driving the Indian market. There should also be consultations with experienced traders to capture their knowledge and then create specific rules to drive algorithms on a macro scale. They also suggest tailormade algorithms for each stock for frequently traded stocks and built-in local anti gaming techniques. These should address the Sebi chairman's concerns around the speed at which algorithmic trading happens.

There are global experts who speak on the side of caution. Michael J Aitken, chair of capital market technologies at the University of New South Wales and chief scientist of Sydney-based Capital Markets Cooperative Research Centre, says: "We are making market design changes to try and fix up problems such as the flash crash, but we have no mechanism for working out whether the changes that we are making (that regulators are authorizing) make the markets better off or worse off. How do we know speed breakers will work? Shouldn't we have a way of evaluating the implication of this potential change before we implement it?"

The problems lie not in tweaking high frequency trades or installing dark pools or circuit breakers or any other market design change. "... rather it is the fact that regulators have no idea of how to live up to their published mandate of ensuring a fair and efficient market. Alternatively, they have no framework to facilitate evidence-based policy making".

Till such time that India comes up with a clear understanding of the way capital markets across the globe are evolving in the wake of the 'great recession' - that was brought about, among other factors, by unbridled and unregulated trading in exotic and complex financial derivative instruments such as credit swap defaults and collaterized debt obligations - from the perspectives of both the regulator and the investor, twenty-first century algorithms can be expected to remain a "no-go" or a "slow-go" area as far as Indian bourses are concerned.

The crucial question remains as to what has to be done to safeguard the interests of small hapless shareholders in the absence of any push to generate and promote shareholder activism and education, while exchanges aggressively lobby for liberalisation of rules relating to investment and trading in equities?

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Photographs: Reuters

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The source close to MCX-SX believes exchanges do not need to promote shareholder activism but must ensure transparency and good governance by becoming listed entities and provide a level playing-field for all stakeholders. This would ensure that rights of all stakeholders are protected transparently.

As India's new generation exchange, MCX-SX is emphasizing investor education and adoption of global best practices. The source adds: "We believe in the power of financial literacy and promoting research and education for creating a literate investor base".

Not to be left behind, the NSE spokesperson too talks of the impressive and intensive efforts over the years to bring more and more people into the formal financial system. Through a series of tie-ups with schools and colleges, the NSE runs several courses and short-term training programmes for the youth.

The NSE is also proud of its efforts to reach out to the retail investor. Of the country's 30 million tax-payers, 14 million are registered with the NSE because it has "made the effort to go into small towns and remote areas on the one hand and is connected with two lakh trading terminals in 2010 towns in the country", says the NSE spokesperson.

Bearing testimony to the "dramatic" increase in retail participation at the bourses, the NSE spokesperson points out: "The average trade size on the NSE has gone down by 80 per cent, from around Rs 1,12,000 in 1996-97 to Rs 19,551 in 2011-12.

Retail investors invest in small amounts compared to institutional investors. NSE's average trade size is among the lowest compared to stock exchanges across the world". Yet there should be someone worrying about the fact that in a country of a billion plus people barely half the paltry income-tax-payer base of less than 3 per cent has been attracted to equity bourses.

MCX-SX says that it is becoming the first exchange in India with a website in 11 Indian languages. It also intends making greater use of new generation media such as short messaging services (SMS) on mobile phones, wireless access protocol or WAP, Twitter etc. for price dissemination.

One could argue till the cows come home on how rights of all shareholders are never equally protected and never will be. However, recent regulatory changes that have paved the way for listing of India's stock exchanges, which is a global phenomenon in all widely competitive global markets, may expedite the process of ensuring transparency.

It is a fact that widely-held, diversified companies are best made accountable to their shareholders and the public at large by listing.

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Photographs: Reuters
Tags: NSE , MCX-SX , India , WAP

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Stock exchanges worldwide are also seeing a phase of transition phase with most of them becoming listed entities. In India as well, exchanges such as the BSE can no longer remain "closed clubs" for a privileged few.

It would seem that the reason why the BSE got overtaken by the NSE was the inability of the former to effectively deploy technology. This is also the reason why a dozen and a half stock exchanges in different parts of India became moribund over time.  Are stock exchanges natural monopolies and is the financial markets ecosystem invariably oligopolistic?

It is also pointed out by some that the USA seems to be happy with Nasdaq and NYSE. The United Kingdom too seems well served by the London Stock Exchange. How are these countries doing things differently? What are the lessons India needs to learn from the experience of other countries in this regard? 

The crucial difference is that developed economies have multiple exchanges and multiple alternate trading platforms.  In the USA, there are 15 national securities exchanges registered with the regulator, the SEC (Securities and Exchange Commission) and around 90 active alternative trading systems. Even China has four large exchanges, it is pointed out.  

Given the penetration of Indian capital markets, their skew to just one asset class (equities) and geographic concentration of volumes, MCX-SX appears confident that there is room for more exchanges to achieve the regulator's vision of "inclusive" and "sustainable" development of financial markets. There is ample potential to develop the now-moribund exchanges outside Mumbai to reach investors in India's hinterland.

It is the NSE's contention though that the retail penetration in the Indian bourses is far more widespread than it is in some of the mature as well as developing markets. "The top 10 brokerage firms on the NSE contribute about 24 per cent to the total trading activity in the cash market segment of the NSE, whereas on the New York Stock Exchange, one of the biggest stock exchanges in the world, the proportion is around  38 per cent," says the NSE spokesperson, adding: "On Bursa, Malaysia, it is about 66 per cent and on the Johannesburg Stock Exchange, it is about 66 per cent."

Nevertheless, given the size of India's population, the reach of the exchanges is pretty poor notwithstanding initiatives at investor education - that has even gone to schools. The challenge of changing the perceptions of the country's small investors, most of whom continue to look at exchanges for financial instruments as gambling casinos, not as avenues for channeling savings into productive investments, is a daunting one.

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Photographs: Punit Paranjpe/Reuters

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The NSE spokesperson says that is it a challenge that the NSE is addressing through innovative ways. "In 2007, the NSE in collaboration with the Central Board of Secondary Education launched the Financial Markets Management (FMM) course as a vocational stream at the 10+2 level.

This is the first such course run by any institution in a school in India. It is being run in 40 schools across the country, in cities like Jaipur, Allahabad, Patna, Mandi, Bhubaneshwar and Jamshedpur". There are other programmes being conducted with schools, colleges and institutes of management that should bring about a change in the not-too-distant future. Till such time, the Indian bourses continue to amaze with their stories of chicanery.

It would be worthwhile to conclude this article with the story of a once well- known company, Monotype, which sold printing equipment to the country's leading newspapers. The Monotype story is well documented in the Moneylife report that links two entities, Monotype India and Diamant Infrastructure, that have the same director and erratic price movements.

Naresh Manakchand Jain sits on the boards of both the companies but what do the companies do? Monotype reported zero sales and a string of losses in the recent past and in the not too distant past, in 2007, had been suspended by the BSE for non-compliance with the listing agreements. How the suspension was revoked in April 2012 is not clear but the document it placed before the BSE said that it had suspended its printing business.

Other violations continued: it violated the Sebi's SAST (Substantial Acquisition of Shares and Takeovers Regulations, 2011) regulations but got away with an adjudication order of Rs 1,50,000 passed in July 2011. Other irregularities continue as merrily as the company, the shares of which shot up from Rs 5.05 to Rs 211.9 (4096 per cent) between March 2011 and June 2012. No sales, no revenues, losses galore and zooming prices! One can only say "shabash Monotype!"

Diamant Infrastructure, meanwhile believes in reincarnation. It used to be Diamant Carbon & Graphite Products Ltd and then Diamant Investment and Finance Limited and is now in its Diamant Infrastructure avatar; Moneylife suspects because infrastructure is hot these days. It has been hauled up for not submitting the shareholding pattern but its prices have zoomed 4204 per cent, from Rs 1.53 to Rs 65.85 over four years (June 2007 to January 2011), before crashing 94% in just one year!

Given the scams that took place in 1992 (spearheaded by Harshad Mehta) and 2001 (led by Ketan Parekh), among others, changing the attitudes of ordinary Indians towards exchanges is going to be far easier said than done. Meanwhile, let the manipulators make merry.


Photographs: Reuters

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