Seventeen years after the National Stock Exchange of India Ltd (NSE) broke the dominance of the 137-year-old BSE Ltd and became the largest stock exchange in India, two new stock exchanges are aiming at repeating history.
MCX-SX, promoted by the Financial Technologies (India) Ltd (FTIL) group that runs India’s largest commodities bourse MCX (Multi Commodity Exchange of India Ltd) and offers front-end solutions to brokers, received conditional approval to start equity trading in July after it won a legal battle with the capital markets regulator, the Securities and Exchanges Board of India (Sebi). Also, the Delhi Stock Exchange (DSE), launched in 1947 and virtually lifeless over the past few years, is witnessing a rebirth of sorts. It is teaming up with the London Stock Exchange (LSE) to set up a trading venue in Mumbai that will run on the trading technology of LSE’s subsidiary, MilleniumIT, touted as the fastest trading platform in the world.
With four national exchanges vying for market share, analysts are unanimous that India’s exchange landscape will undergo major changes. Intense competition is likely to drive down trading costs, lead to better products and improve trading speed.
NSE dominates equities trading with 83% market share in the cash segment, and 75% share in the derivatives pie. BSE accounts for the rest.
Many analysts are, however, sceptical about the chances of all four exchanges surviving the fight. They predict a period of intense competition followed by eventual consolidation or the exit of some exchanges.
“The exchange business is a winner-takes-all game,” said Raamdeo Agrawal, joint managing director, Motilal Oswal Financial Services Ltd. “I do not know which of the four will win the game; if it is NSE or MCX-SX that will survive in the end, but one has to finish off the others to survive.”
For most of history, a single national exchange has dominated markets, in India and elsewhere, Agrawal points out.
Asian markets still have one dominant exchange but markets in the US and Europe have fragmented. Once-dominant exchanges in these economies have given way to newer bourses with faster technology, as regulations actively encouraged competition. India could head in the same direction if regulations change. Already, there are growing signs of fragmentation in other Asian markets, with new exchange groups such as Chi-X giving incumbents in Japan and Australia a run for their money.
Incidentally, it is one of Chi-X Europe’s co-founders, Hirander Misra, who is shaping DSE’s strategy in India. Misra was Chi-X’s chief operating officer when it was launched in 2007 and helped it become the second largest stock exchange in Europe behind LSE before he quit in 2010.
Misra was supposed to take over as DSE’s CEO but changes in Sebi regulations relating to executive compensation have meant that this has not been finalized yet, according to a person with direct knowledge of the matter.
Misra is currently working as an independent consultant with DSE. The exchange is expected to finalize its tie-up with LSE by September quarter and start operations by December, according to the person quoted above.
“India has already seen one instance of a new entrant edging out the incumbent with better technology and innovation, when NSE came in. BSE lost the way in between and NSE captured market share,” said Misra in a telephonic interview. NSE is the incumbent today and DSE will break its dominance, Misra said.
The MCX-FTIL group’s ambitions are equally grand, and it has already taken on the dominant equity exchange NSE as well as the regulator, Sebi, in court battles. MCX-SX forced NSE to start imposing transaction charges in the currency derivatives segment after it lodged a complaint with the anti-trust watchdog, the Competition Commission of India (CCI).
MCX-SX has roughly a similar share as NSE in the currency futures segment, though it lags behind in terms of open interest.
“As exchanges compete with each other, the market stands to gain,” said Sandeep Singal, co-head, institutional equities, Emkay Global Financial Services Ltd.
India has seen a sharp rise in electronic trades and high-frequency trading. Trades through co-located servers placed on the exchange floor to take advantage of low latency and algorithmic trading or algos—computer programmes that decide the timing, locating, price or quantity of the order—together account for nearly one-third of turnover on NSE, according to the latest data available for July.
DSE plans to woo this section by offering a faster alternative. NSE’s core technology is 20 years old and this poses problems in ensuring high-speed access when volumes go up, said Misra.
BSE and FTIL are even slower, he added.
NSE officials deny Misra’s claim. “NSE’s trading systems are comparable with the best in the world,” said Ravi Apte, its chief technology officer. “Our new trading engines have near infinite horizontal scalability and each engine can process as many as 100,000 messages a second.”
MCX-SX declined to comment for this story. BSE declined to comment on this issue.
The old exchanges can upgrade their current technology but there is a limit to which this works, Misra said. “You can upgrade a Maruti car but can’t expect it to compete with a Ferrari.”
Speed wars between exchanges will fragment the market but this can bring benefits. Increased fragmentation tends to lower the cost of trading for all investors and higher speed raises efficiency when initial speed levels in a market are low, as was the case in the US, recent research by Emiliano Pagnotta and Thomas Philippon of the New York University show.
There are other technological innovations such as improvements in front-end solutions for brokers where new exchanges can make a difference.
“There are gaps in product management systems which new exchanges can fill,” said Singal. “Trading terminals display only limited information now and for more, you have to go elsewhere.”
“There is always room for improvement with better or faster straight through processing,” said Viraj Kulkarni, head of BNP Paribas Securities Services India. “There is also a need to develop the intermediaries’ infrastructure which will help reduce costs and risks and improve speed.”
The securities transaction tax (STT) accounts for the lion’s share of trading costs. Costs will fall sharply if STT, 0.125% of the trading value, is reduced. Exchanges have been lobbying for removal of STT, and even Sebi has asked for a reduction. Such voices will only get louder once more exchanges come in.
While a large chunk of the transaction cost in India is because of STT, there is still scope for reduction in the fees exchanges charge in derivatives such as options since STT is charged only on the option premium, which is a fraction of the traded value.
BSE transaction charges are roughly 75% lower in futures and 99% lower in options compared with the competition (NSE), a BSE spokesperson said. This has earned BSE’s derivatives platform a good response in recent times, he added.
Apart from transaction fees, exchanges are likely to compete on market data fees, empanelment fees and membership fees, analysts said.
NSE has already brought down trading costs over the years, said Ravi Varanasi, head, business development, at NSE. Besides, when investors compare alternative platforms, they will tend to look at the gamut of services provided by an exchange, and not just transaction charges, he added.
“It is unlikely that new exchanges will reach out to newer participants or newer geographies,” said Rajesh Chakrabarti, professor of finance at the Hyderabad-based Indian School of Business. “There are very few untapped markets as such, and new entrants are unlikely to suddenly develop scale advantages over incumbents.”
Of the 30 million taxpayers in the country, 13 million invest through the bourse, NSE’s spokesperson said. NSE has built a network of 200,000 terminals across the country, nearly 60% of which are located in tier II and tier III towns, she added.
New entrants are likely to target the existing customer base, analysts said.
Both DSE and MCX-SX have said they will launch new products and look to offer avenues for investing in multiple asset classes although they have not revealed details yet. While some of their plans will depend on regulatory approvals, analysts say that there are several innovations that are possible even within existing regulatory constraints.
Sebi has allowed market making in derivatives and this will be useful for new entrants but BSE’s struggle to revive its derivatives platform despite incentives to market makers shows that incentives alone may not be enough. While volumes on BSE’s index options have shot up because of incentives and lower charges, the open interest to volumes ratio is less than 1%, showing the lack of long-term interest so far.
“Not all experiments will succeed but if one clicks in a big way, it will lead to a paradigm shift,” said Singal. “People were used to the 30-stock Sensex for such a long time but then NSE innovated with a basket of 50 stocks, and now Nifty is the most liquid product.”
Such big shifts can only happen with competition, Singal added.
New age regulations
Competition among exchanges can thrive only if clearing procedures in India change, analysts said. Currently, each exchange has its own clearing house, and brokers face significant costs in dealing with multiple clearing houses. This keeps liquidity concentrated on one exchange. This is also a key reason why smart order routing (SOR) has not picked up in a big way. The SOR mechanism helps investors get the best price for their transactions across exchanges by using an algorithm that routes orders to the least-cost venue.
In markets such as the US, there is a single clearing house while Europe is moving towards inter-operability of clearing houses. Regulators in the US have made SOR mandatory for brokers—and it has worked seamlessly thanks to a consolidated order flow system —allowing new exchanges to challenge incumbents. For brokers in India, SOR is still optional.
Sebi has formed a committee to examine inter-operability of clearing houses or the feasibility of a single clearing corporation. Inter-operability will be a tough ask in India, because unlike Europe, margins are collected at the client level rather than at the member’s level.
The regulatory stance on issues related to new products will be crucial. Many products related to the bond markets and interest rate futures have to be vetted by both Sebi and the Reserve Bank of India and this can often be cumbersome.
If Sebi wants to encourage fair play and competition, it must institute a principle-based approval process rather than looking into each product separately, said an exchange official on condition of anonymity. But this is easier said than done.
“While on the grounds of market efficiency, one could argue for easy approvals to product launches and a more liberal regime in general, the downside risk to Sebi’s and India’s reputation if things go wrong are simply too big to ignore,” said Chakrabarti.
Exchanges seem to be heading towards a long and messy war in India.