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Can anyone take on the mighty NSE? India's patchwork of exchanges looks to the future

Published in Automated Trader Magazine Issue 26 Q3 2012

Hirander Misra, chairman of Forum Trading Solutions and director of a consultancy, takes a look at the prospects for any other exchange challenging the National Stock Exchange of India. Misra, a co-founder and chief operating officer of Chi-X Europe Ltd, knows all about the battle between newcomers and incumbents. Here he offers his perspective on where the rapidly changing Indian exchange landscape could end up.

Hirander Misra

Hirander Misra

India is home to the oldest exchange in Asia, the Bombay Stock Exchange (BSE), which traces its history to the 1850s and in 1875 became an official organisation known as 'The Native Share & Stock Brokers Association'. The second oldest exchange in India is the Delhi Stock Exchange (DSE), established in 1947. These exchanges have been completely overshadowed by a relatively new entrant established in 1992 - the National Stock Exchange of India (NSE). In two decades it has amassed 80 percent market share in cash equities, with BSE accounting for 18 percent and the rest of India's regional exchanges accounting for just 2 percent.

Competitive Landscape

In Europe we are relatively new to successful competition in equity markets, given that Chi-X Europe was the first to gain tangible market share and challenge the monopolies of the national exchanges. Yet even as we stand today, a combined Bats Chi-X Europe accounts for about 35 percent of FTSE 100 volumes, with the London Stock Exchange (LSE) on around 55 percent. What has happened in India over the last 20 years with the NSE becoming dominant would be equivalent to the LSE being superseded in a big way by a new entrant, whereas data over the last 12 months suggests that we have reached a point of equilibrium in terms of European market share distribution. If anything, the LSE has gained some market share. Even in the US, when NYSE's market share was eroded, there ended up being an oligopolistic framework where there were a number of players with decent market share (NASDAQ, Bats AND Direct Edge today), rather than a single dominant force.

One theory is that once competition took hold in the West, it resulted in more innovation even from the incumbents, with lower fees and tighter spreads. That in turn led to demand for more such competition. But in India, the concern among some market participants is that the NSE has become too dominant. According to that view, NSE innovations such as order driven trading and central counterparty clearing (CCP), which once drove down costs for participants, are no longer subject to serious competition, hence the fees appear too high given the state of the technology. If you believe the NSE's critics, the so-called "child of competition" has become the incumbent.

Yet the BSE has so far failed to capitalise. Its chief executive, Madhu Kannan, recently resigned to pursue other opportunities. During his tenure participants said there were improvements, but he failed to reverse the BSE's slump in market share, which in cash equities dropped from about 25 percent market share to the recent 18 percent level. The BSE, with a 6 percent market share, has started to challenge the NSE's monopoly on equity derivatives, but this has come at the cost of paying market makers as part of a liquidity incentive scheme. While moving to offer colocation and attract more algorithmic trading, the BSE has not addressed the core issue of its Bolt system being outdated, which ultimately inhibits this type of order flow. It has also had limited success in attracting foreign trading firms to drive liquidity, even if this is via their prime brokers.

So, can anyone actually challenge the NSE or are traders in India, for all intents and purposes, in the thrall of a near-monopoly? Given that there are 15 regional exchanges, there are plenty of candidates, yet they never really embraced electronic markets and as a result liquidity moved away from the exchange floor and then away from quote-driven trading. So is it a surprise that collectively they have 2 percent market share?

This was the case with the DSE, which has not had its own trading activity for nearly a decade, despite having the second largest number of company listings after the BSE at more than 3000 - about double that of NSE. Many of these exchanges have set up an execution broker that facilitates the trading of their members on the NSE and BSE through direct membership of these exchanges.

Could all that be set to change with more competition about to embrace the Indian market? DSE late last year signed a deal with MillenniumIT, the LSE subsidiary, to provide it with trading, clearing and surveillance technology covering equities, futures and options and FX. This is the same system that runs the LSE's own equity markets at an average round trip latency of about 100 microseconds at high throughput, bringing India in line technologically with leading edge Western exchanges.

Technology of this nature will help facilitate more trading and act as the enabler for tighter spreads and a deeper liquidity pool. The market is awaiting more news on DSE's plans. It also now looks likely that MCX-SX, the FX products exchange, will get approval at some stage this year to trade equities and futures and options, albeit on the Financial Technologies platform, which is outdated and slow with throughput limits, as can be seen from the comparative table.

DMA, SOR and Algos

A large part of trading in India is still very much manual and terminal based. Since the market opened up to DMA in 2008 that has been steadily increasing, but not as fast as it should have been. "One Touch DMA", where a broker still has to press a button, remains more prevalent as not all clients are comfortable signing up to DMA, and would rather a broker handled their orders before final routing to the exchanges.

The Deli Stock Exchange

The Deli Stock Exchange

In September 2010, the Securities and Exchange Board of India (SEBI) approved Smart Order Routing (SOR). SOR still has some issues that are limiting take-up from a market structure standpoint. For instance, there is no defined best execution requirement from regulators, as in the US and in Europe. Also, there is no opportunity to cross net trades between two exchanges, and the stocks traded at a particular exchange need to be settled and cleared at the same exchange, adding to the frictional costs of trading. Nonetheless, such teething trouble was also witnessed in Europe with SOR in the first few years after MiFID went live in November 2007, and will be overcome as experience of SOR increases and other market structure changes are driven through by SEBI.

The exchanges until now have been the bottlenecks. System improvements at the exchange level will partly address that. But the key developments will come from competition as was the case in Europe. In that case, Chi-X Europe launched just as MiFID regulations were kicking in, forcing incumbent exchanges to innovate.

Key Market Structure Developments

There are obstacles. One impediment to market development is the State Transaction Tax (STT). Introduced in the 2004 budget, the rate has come down to 0.025 percent for day trades for the seller only, and 0.125 percent tax on both buyers and sellers for delivery-based trades. That is down from 0.15 percent levied initially.

Prior to April 2008, STT was allowed as a rebate against tax liability under Section 88E of the Income Tax Act, which was discontinued. This change in the STT regime resulted in jobbers and arbitrageurs (who generated more than 30 percent of volumes on exchanges) losing their business. The STT regime and high stamp duty charges on share market transactions are the main reasons for the high cost of trading in India. The financial sector is lobbying to eradicate the tax.

Bombay Stock Exchange

Bombay Stock Exchange

At a meeting in April, SEBI decided that national exchanges and clearing houses could have IPOs. This is a major landmark, as the exchanges themselves had been lobbying for just such a ruling. Nonetheless, SEBI has a few strings attached. The companies will not be allowed to list on themselves and their regulatory teams must set up dual reporting lines to a CEO and an independent committee to ensure there are no conflicts of interest. Also, individual investors can only hold typically 5 percent. SEBI is also closely watching developments around clearing interoperability in Europe as well as consulting with key market structure experts from that region.

But it's not all about birth - there's a certain amount of death in the air as well.

At that meeting SEBI also defined the process of "de-recognition and exit of stock exchanges". There are 15 regional exchanges in India, and SEBI effectively told them to ensure that they were well capitalised and that they re-launched their trading and met minimum prescribed criteria, or shut down within two years. It might sound severe, but it ties in with the government's strategy to develop a much wider level of ownership of equities in the retail sphere, given that only about 1 percent of the Indian population trade equities.

The government wants this to increase to 10 percent over the next five years, so there is naturally going to be some consolidation. Those that emerge successfully may be in a position, individually or collectively, to mount a serious challenge to the dominance of the NSE.

Déjà vu?

So could it be déjà vu yet again, with competition leading to a shift in liquidity in India? After all, we all know it can be done. Most new venues fail but a small number succeed. I for one have proof of that pudding. So let the exchange battle commence!