According to news reports, the Securities and Exchange Board of India (Sebi) wants stock exchanges to go through stress tests to ensure that our markets are prepared for situations such as the so-called flash crash. This is a move in the right direction and should be done sooner than later.
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On 6 May, 2010, the Dow Jones Industrial Average plunged about 900 points—or about 9%—only to recover those losses within minutes. This year there have been similar crashes in the oil, silver and natural gas futures markets. In June 2010, India had its own version of a flash crash, when shares of Reliance Industries Ltd suddenly fell by 20% because of a fat finger trade. A fat finger trade is an input error made by a trader by pressing the wrong key or the wrong sequence of keys.
Thankfully, the erroneous trade didn’t happen on the National Stock Exchange and left the Nifty index unaffected. Else, there could have been a cascading affect on the whole market, considering the large number computer-generated orders in the Nifty futures and options markets.
A stress test would help exchanges and the regulator strategize on how to tackle such situations in the future. Of course, unlike some developed markets, the Indian markets already follow real-time pre-trade risk management. So the danger of one entity running amok and putting the entire market at risk is relatively low. Even so, considering that an increasing proportion of orders are coming in electronically and at record speeds, the possibility of a contagion spreading quickly is not as remote.
Some experts suggest that the danger for the markets is no longer a flash crash akin to the one seen in the US markets. John Bates, chief technology officer at Progress Software Corp., coined a new phrase called splash crash earlier this year, referring to simultaneous crashes across different asset classes. “As asset classes outside equities—energy, commodities, forex, derivatives - become increasingly automated there will be more flash crashes. Increased interdependence of asset classes will lead to cross asset flash crashes – a domino effect where the crashes splash across asset classes, possibly wreaking havoc for market participants and regulators,” Bates writes in his blog. There is already evidence of high frequency trading strategies that span different asset classes. So the idea of a splash crash isn’t far-fetched. In any case, it’s best to be prepared.
Of course, planning a well coordinated, real-time surveillance of the markets would throw open questions on whether Sebi itself is best positioned to conduct such surveillance. After all, exchanges by themselves do not have a view of the entire market and to that extent are limited in their market surveillance ability.
This will be an added benefit of the proposed stress test and the discussion it will generate. It’s time Indian policymakers addressed these and other questions related to market integrity.
Traders avoid transaction taxes
In the past four years, the turnover in all exchange-traded derivatives markets in the country has risen by about four times. The average daily turnover across the equity, forex and commodity derivatives markets currently stands at Rs 2.3 trillion. Nearly three-fifths of this is accounted for by equity futures and options, about one-fourth by commodity derivatives and the balance by forex derivatives.
One of the starkest trends in the growth of the exchange-traded derivatives market in India is that traders have veered towards products where the outgo on transaction taxes is minimal. In early 2008, it didn’t really matter if you traded equity futures or options—securities transaction taxes (STT) on both products were similar.
But in the Union budget for 2008-09, the rules were changed and STT on options contracts fell significantly. In March 2008, just before the rules were changed, futures contracts accounted for 84% of total trading in the equity derivatives market. Now, they account for only 25% of the total market, with traders clearly preferring options to take positions on the market.
The impressive growth of the currency derivatives market, which has surprised many, is also partly because of the fact that STT is not applicable on the product. Besides, exchanges have waived fees, making it all the more attractive for traders.
And with commodity derivatives, growth was sluggish in 2008 until mid-2009, when the finance minister imposed a commodities transaction tax (CTT). But after CTT was abolished in July 2009, average daily turnover has more than doubled.
As far as the exchange-traded derivatives market is concerned, transaction taxes are either nil or negligible for about 85% of the market. The fact that only equity futures and the equity cash segment bear the full weight of STT is distortionary in nature and should be corrected.
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