BSE Ltd has tried a number of different techniques to attract liquidity in its equity derivatives market. It attempted to differentiate itself from rival National Stock Exchange by launching weekly options contracts, shifting the expiry of its monthly derivatives contracts to the middle of the month, and more recently launching physically settled stock derivatives contracts. It also attempted a maker-taker pricing model, to incentivize traders who put limit orders on its derivatives platform, as a means to reward them for enhancing its order book.
But all these efforts put together haven’t helped the exchange capture any share in the equity derivatives segment. BSE is now launching, in the words of chief executive officer Madhu Kannan, “its biggest ever initiative in the derivatives segment”, in the form of a market-making scheme for derivatives contracts that have the benchmark Sensex index and its 30 component stocks as the underlying asset. The scheme will incentivize broker-members who trade on BSE’s derivatives platform by paying them up to Rs 107 crore.
Graphics by Shyamal Banerjee/Mint
Derivatives account for over 90% of total turnover in the equity market. So BSE isn’t merely missing a piece of the action in the market place, but is absent from what has now become the main market. While the Rs 107-crore payout to brokers may seem like a large price to pay to attract liquidity in the derivatives market, the cost of being absent from this large market is much higher. The moot question, of course, whether BSE’s latest plan will succeed.
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There’s little doubt that brokers will take advantage of the market making scheme. The incentives are quite generous. Brokers who sign up as market-makers have typical obligations such as providing two-way continuous quotes within specified parameters for quote size and spread.
In exchange, they will be paid up to Rs 2,300 per crore worth trading in the futures segment and up to Rs 6,000 per crore worth of options premium paid and collected. These payments will be made on both the buy and sell legs of each transaction, until the daily turnover in the futures segment reaches Rs 1,000 crore and the value of premium written in the options segment touches Rs 500 crore. Besides, there is an incentive of Rs 5,000 for every Rs 1 crore of open interest (outstanding positions) held on an average over a month. The intent here is to encourage trading members tocreate medium-term positions, rather than just make intra-day trades to pocket the volume based incentives. BSE members can avail of some of these benefits without having the obligations of a market maker. In that case, the volume-based incentives will be lower, while the open-interest linked payment will be the same.
Even in this category, the payout is handsome at Rs 1,100 for every Rs 1 crore of trading in the futures segment and Rs 2,200 for every Rs 1 crore of options premium paid and collected. This column has often argued that market-making schemes in India will be successful only if the incentives are higher than the securities transaction tax (STT) traders have to bear.
In the futures segment, STT is applicable on only the sell side of the trade at the rate of Rs 1,700 for every Rs 1 crore of trading. BSE’s incentives for every squared-off trade amount to Rs 2,200 at the minimum and as high as Rs 4,600 for market-makers who put limit orders. This more than compensates for the STT, stamp duty and other applicable levies, and should hence attract market participants at least during the time the incentive scheme is operational.
BSE, therefore, should be able to attract liquidity with the help of its incentives. But note that market regulator Securities and Exchange Board of India permits such schemes to run for a maximum of six months. Will liquidity sustain when the incentives stop? This really depends on whether there is a genuine demand for derivatives based on the Sensex and for physically settled stock derivatives. If the market is content with the already liquid Nifty futures and options contracts and is comfortable with cash-settled stock derivatives, liquidity may well fizzle out when the incentives stop.
True, the initial liquidity spurred by the incentive programme will lead to arbitrage opportunities between the two exchanges and would help sustain some level of liquidity. But without genuine demand for these products, the market will never really take off. This is not to say that there isn’t genuine demand for BSE’s offerings. One of the problems the exchange was facing was to get members to make the investments required to connect to its derivatives platform and trade, because of the absence of liquidity. The market making scheme may well work as an incentive to start trading in BSE’s derivatives market.
Of course, only time will tell if BSE is able to attract genuine players and achieve its goal of creating lasting, self-sustaining liquidity in its derivatives segment. In fact, unless Sebi softens its stance on the duration of market making schemes, one may well know the fate of BSE’s derivatives segment in six-seven months’ time.
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