Industry lobby group Confederation of Indian Industry (CII) held its third capital markets summit in Mumbai last week around the theme of deepening them. The conference included the industry’s pet topics on how to develop the corporate bond market and increase liquidity in equity cash markets. Both issues have been discussed for years now, with little to show for results.
So what ails India’s equity cash market? Liquidity is concentrated in top 100 stocks or so; beyond the top 200, stocks are quite illiquid. Smaller firms are typically illiquid in most markets, including developed ones. But in India, the proportion of liquid stocks to the total number of traded stocks appears to be lower. Some market experts say this can be remedied by increasing participation of Indian households in equities. The proportion of household wealth invested in equities is low compared with developed markets.
Anup Bagchi, chief executive officer of ICICI Securities Ltd, made an interesting point in this regard at the summit. The total number of demat accounts in the country total nearly 17 million, while the number of tax assesses are around 35 million. He also quoted number of car and two-wheeler owners to make the point that the scope for increasing the direct participation of Indian household into equities isn’t high. The better solution, according to him, will be to increase participation through the indirect route, where households, which aren’t sophisticated enough to invest directly, are encouraged to invest through mutual funds. Besides, pension funds, which hold a large proportion of financial wealth in the country, should be encouraged to invest a part of it in equities.
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Needless to say, it is a tall order for pension funds to generate 8-9% annual return, especially during times when interest rates are low. The obvious answer is that they invest a part of their corpus in equities. The markets will evidently benefit, both in increased liquidity as well as in having the stability of more large domestic institutional investors. In developed markets, pension funds are large players in the equity cash market.
Having said that, the entry of pension funds will not solve the problem of concentration of liquidity. Market participants will not suddenly start trading more stocks actively just because pension funds will be buying some of those shares. In any case, the current policy framework for pension funds permits investments only in the top traded stocks. Some experts said at the summit that the cost of trading is high and that the securities transaction tax (STT) should be revisited, since it works against liquidity.
While there is little doubt that statutory taxes such as STT and stamp duty are high and must be eliminated or reduced, this again will not solve the problem, which has existed for years before STT was introduced by the finance ministry. The problem has been there from the times the market was primarily made of retail investors and has continued even with the increase in institutional participation and the entry of foreign investors. The problem was there even before futures and options were introduced. So the argument that this problem arose because of migration of liquidity to the derivatives market also doesn’t hold. One speaker at the summit talked of the need to allow margin-funded trading. But again, it’s unlikely that it will solve this structural problem in the Indian markets. In any case, from a trader’s perspective, leveraged trading is more cost effective in the derivatives market.
This is not to say that there should be no policy response to the problem. Apart from addressing some of the lacunae in the markets, such as reducing the cost of trading and pushing pension funds to invest in equities, policymakers can also increase the scope of the securities lending market as well as the derivatives market.
The securities lending segment hasn’t taken off, mainly because of the product design, but also because only stocks that are eligible for derivatives trading are permitted in the segment. The need for securities lending and borrowing is more for the other stocks, since the single-stock derivatives market offers a much cost-effective way to trade stocks one doesn’t own. Again, this will not work like a magic potion.
Another factor that will help in increasing liquidity is an increase in the use of technology to generate orders. Already, electronic trading has aided in the increase in the liquidity of the index options market across various strike prices and maturities. By extension, technology can help trading desks send orders for a far larger number of securities compared with, say, what a manual trading desk can do.
In addition, exchanges must be given more freedom in designing products. This will give them flexibility in adapting to the need of the hour. For some illiquid stocks, there may be a case to have a periodic call auction, rather than a continuous market. We will only know when exchanges are given the freedom to take a trial-and-error approach.
In sum, building liquidity beyond the top few stocks could well be a long-drawn affair and one shouldn’t expect quick fixes.
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Graphics by Sandeep Bhatnagar/Mint
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