One of the reasons the Bombay Stock Exchange (BSE) hasn’t provided effective competition to the National Stock Exchange (NSE) was its inability to engage market-makers. While the exchange has used market-makers in the past, it wasn’t doing so in the past few years after an audit committee found loopholes in the implementation of a market-making scheme sanctioned by the previous management.
Ever since the new management took over, it has been knocking at the door of the regulator, the Securities and Exchange Board of India (Sebi), to approve its market-making schemes.
Market-maker firms offer both buy and sell quotes in securities, and provide liquidity to the market, while at the same time profiting from the difference in the bid-ask prices. Exchanges also incentivize market-maker firms with a view to building liquidity in their markets.
Sebi has now issued a circular allowing stock exchanges to offer incentives to brokers for providing liquidity in illiquid contracts in the equity derivatives segment. The move is welcome as the exchange can now incentivize brokers for offering two-way quotes in its derivatives segment. If the market-making scheme is designed and monitored well, it can attract liquidity to BSE’s nearly inactive derivatives market.
But there’s still one major obstacle that can make any market-making scheme ineffective. In order to incentivize its market-makers effectively, the exchange would have to rebate them statutory charges such as the securities transaction tax (STT), and then some more. Otherwise, it will be a loss-making proposition for market-makers, and the scheme would never take off.
It’s important to note here that rebating statutory charges would entail huge costs. In the futures segment, STT is charged at the rate of Rs17 per Rs1 lakh only on the sell leg. Compare this with NSE’s exchange fees of Rs1.75 per Rs1 lakh on both legs of the transactions. The STT charges are five times the fee charged by exchanges.
In overseas markets, capturing share from competing exchanges would require providing rebates that are proportional to exchange fees, which along with brokerage charges, form the bulk of trading costs. In India, however, the biggest cost is statutory charges and for exchanges to effectively compete by engaging market-makers, they pose a monumental hurdle.
So while the approval from Sebi is a victory for BSE, it would also need the blessings of the finance ministry. The imposition of STT falls fully under the purview of the finance ministry. Interestingly, reports suggest the finance ministry is interested in supporting competition among exchanges.
It would do well to prove its pro-competition stance by scrapping STT, which is a barrier not only to effective competition in the exchange space, but also to effective financial intermediation.
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