The BSE Ltd has played party-pooper and ended the blast trading members were having in the Sensex options market. In the preceding two weeks, average daily volumes on index options market had skyrocketed to Rs 36,786 crore, thanks largely to a new market-making scheme BSE introduced effective 1 February.
It soon became evident that much of this unusually high volume of trade wasn’t genuine, and some trading members were trying to garner a higher share of the incentive the exchange was doling out. It’s good to see that the bourse hasn’t been carried away by the artificially high volumes, and has taken remedial measures effective this Monday. As a result, volumes in the index options segment dropped drastically to Rs 2,702 crore, or less than 8% of the average daily volume in the preceding two weeks.
By Shyamal Banerjee/Mint
Earlier, a large part of the trades were in far out-of-the-money put options, where traders carried little or no risk of being impacted by movements in market prices. In any case, they didn’t leave positions open for too long, which is evident from the low open interest position on the exchange. The high volumes only benefited a handful of brokers, who were trying to garner a higher share of the incentives given under the market making scheme. While BSE has put a limit on the total amount of volume-based incentives it will disburse each day, the payout is on a pro rata basis. As a result, a broker with a higher share of the volumes will get a higher share of the incentives. To be sure, just 10 trading members accounted for 99.6% of the index options volumes last Friday, while the top five among them cornered 75% of the volumes in the segment.
By generating inconsequential trades between themselves, these handful of trading members were the only ones benefiting from the market making scheme introduced for Sensex options. BSE has done well to tweak the incentive scheme and restrict the payouts to at-the-money options and just a few in-the-money and out-of-the-money options. Trades in far out-of-the-money options will no longer be incentivized. Trading on Monday was far more sane.
Of course, trading is still concentrated among six-seven brokers. But they’re at least now trading in the contracts that matter—strike prices that are close to prevailing market prices.
This is the third or fourth time BSE has tweaked its market making schemes. It had started with a first-come-first-served model, which was exploited by some street-savvy brokers, who generated the required volumes almost as soon as the day’s trading commenced. As a result, there was almost zero liquidity for most of the trading time. BSE then said that it will pay incentives in roughly 2-hour slots, but again on a first-come-first-served basis. The result was that the street-savvy lot tuned themselves and their systems to the new requirement, and generated trades as soon as these three time slots began.
So from having a one large chink of trading in the initial hours, there were now three chunks of trading each day. As before, there was practically no trading in other parts of the day. BSE then wised up and said that the incentives will be paid on a per-minute basis, to ensure that there is trading throughout the day. But again, armed with fast software trading systems, some trading members generated volumes in the first few seconds of each of these one-minute slots. BSE struck the final blow to this form of trading when it said that incentives will be given on a pro rata basis and not on a first-come-first-served basis.
Now, when traders enter into a trade, they can’t say for sure, what amount of incentives they will earn. To some extent, this will help when BSE has to eventually transition to a structure were no incentives are paid for attracting trades. After all, the markets regulator Securities and Exchange Board of India has a six-month time limit for each market-making scheme and the incentives will have to be stopped at some point.
Looking at the various changes BSE has had to make with its incentive schemes, one gets the impression that it has been on a learning curve and that the broking community is always a few steps ahead. Be that as it may, the positive fallout of all this is that trading has finally commenced on its derivatives platform, after years of no activity. Exchanges across the world resort to market-making schemes to kick-start trading and pull liquidity from other venues.
Thus far, it does look like only a few brokers are trading to rake in the incentives. This begs the question if they will continue to trade when the incentives stop. Of course, only time will tell. But now that trading has commenced and at least some brokers have gotten used to BSE’s systems, some level of activity is likely to continue. Besides, Sensex products offer new trading opportunities such as arbitrage with the more popular Nifty derivatives products. Additionally, even when the incentives cease, BSE’s trading fees are far lower than those of the National Stock Exchange, and if it can retain some level of liquidity, this could attract some traders. The challenge for the exchange, of course, is to attract trades that are not driven by the need to earn incentives.
If BSE succeeds in doing this, the entire marketplace will benefit from increased competition in the equity derivatives market.
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