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June 30, 2000

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Devangshu Datta

Merger of exchanges

In 1999, the global equity market traded more than $ 31 trillion according to Standard & Poor's. That's a record and it's been an incredible decade for stocks. As late as 1993, the quantum of trading was barely $ 5 trillion. So there has been a six-fold expansion in volume in the last six years at a compounded growth rate of better than 35 per cent.

Of that, $ 31 trillion, just about $ 3 trillion was contributed by emerging markets equity trading. That too is a record, but it's only 9 per cent of total turnover. Which should put all the foreign institutional investments into perspective. The big firangi institutional investor sees a given emerging market as perhaps one out of ten options where ten percent of total corpus might be parked.

However, the emerging market churn appears to be far higher than in developed markets. Churn or velocity of trading is usually defined as a percentage of total market capitalisation. When it comes to churn, the emerging markets are toppers. Nine out of the top ten sorted according to churn are emerging markets.

South Korea had a good year leading the list with 347 per cent of its market cap being traded last year. That means the average share changed hands approximately 3.5 times. Taiwan is also a very high churn market with 286 per cent churn. Then its China, Greece, the US and Turkey, with the US being the only developed country to feature amongst the top ten. All these countries saw churn rates of over 100 per cent.

India is ninth on this list. Singapore is eleventh and Hong Kong is fourteenth. Japan and Britain are at number 12 and 13. Indian bourses traded approximately 86 per cent of market cap last year. In general, this was of course a great year for stocks and that would definitely have boosted turnover. But the 1990s were in general a great decade for stocks and turnover rose strongly through the decade as we have already seen.

One could, in fact, call it a global equity phenomenon. It's difficult to overestimate the contribution of infotech to this equity cult. First of all, IT shares led the charge. The Nasdaq has outperformed the Dow Jones and S&P 500 handsomely. Infotech and new economy stocks have outperformed every other sector by a factor of four to one. A lot of the new volume and even more of the new market cap was generated by stocks that didn't even exist in 1990. The decade also saw the emergence of the next generation of brand names - again driven by the new economy with AOL, Yahoo and Amazon in the forefront. In India too, Zee, Infosys and Satyam among others have become premium brands.

Infotech has also contributed enormously to easing access to the market and that in turn has led to a huge expansion in equity trading volumes. V-SAT terminals, screens, relational databases, Internet-based trading systems have all contributed to transparency and access for non-institutional players. As a result, the ancillary costs of trading have dropped sharply. Commissions on average are down to a tenth of real 1990-levels in the US markets and India too. Plus, new equity markets such as China, Russia and Hungary have opened up and promptly gone stratospheric.

The new trend is mergers. These are not only local as in the Inter-Connected Stock Exchange (ICSE) initiative in India, they are also occurring cross-border. After the currency integration of the EU, the Paris bourse took an initiative to create a new euro exchange by merging with Brussels and Amsterdam exchanges. The London Stock Exchange is also merging with the Frankfurt Deutsche Borsche.

These mergers make sense at several levels since new technology is rendering geographical barriers irrelevant. The mergers will open up access to new markets for all the traders of their respective nations provided there is full convertibility. That is a good fallout.

The hard issues would be regulatory in nature and mainly revolving around technical issues. For example, can the Deutsche Borsche's Xetra order matching be integrated with London's quote-driven SETs? The new iX, as the international exchange will be called, may also be seriously looking at a merger with Nasdaq. In which case, there will presumably be further thought to be devoted to a seamless trading system.

There would also be soft issues involved in the interfacing of different trading cultures and methods. Sometimes as in the case of the New York Stock Exchange (NYSE), it is the hangover of old systems that is holding the stock exchanges back. Wall Street still uses specialists and despite espousing new technology, the system is an extension of the old open outcry system.

Specialists concentrate on one share, they are allowed to take forward positions to maintain liquidity and ensure that bids and offers on the system are matched. It works well enough, because the depth and liquidity on the world's biggest exchange is sufficient. In fact, price impact in cases of large trades tends to be the lowest on the NYSE.

But there are several problems with this. The first problem is that the system isn't infinitely scaleable if the number of listings increases. The NYSE will run out of specialists long before it runs out new stocks asking for listing. In case of a merger with a screen-based Nasdaq style system, there will be a serious conflict of cultures.

The third problem is that it leads to asymmetrical information distribution. Only the exchange specialists have access to NYSE data regarding market depth and liquidity. These are the pending orders at prices above and below market. The information is priceless and it enables specialists to generate healthy returns. The exchange is also woefully bad at marketing its data. It garners revenues of $ 130 million from data which is probably sold on by various data providers for revenues in excess of $ 10 billion.

Going by the global trend, one would imagine that a merger between Indian exchanges would be easy and inevitable. The BSE and NSE have roughly equal footprints and similar trading systems. With ALBM versus badla and Sensex futures versus Nifty futures, even the derivative products are similar and roughly equivalent. The ICSE would bring a niche competence of access to some illiquid stocks that are only listed on smaller exchanges although it doesn't increase geographical footprint. There is obviously no currency risk. So one would expect such a merger to occur sooner rather than later.

Actually, the problems with an integration of Indian exchanges revolve around vested interests. The primary problem would be the loss of arbitrage opportunity. At least half of trading volumes here are generated due to arbitrage considerations. Chuck in rolling settlements, unify the pay-in/pay-out dates and those volumes will disappear. So will the easy money that is associated.

Devangshu Datta

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