After lying vacant for months, the position of chief executive officer (CEO) of Bombay Stock Exchange (BSE) is likely to be filled soon. Could this lead to the rebirth of the 134-year-old exchange, whose market share in the equity market—both cash and derivatives—has fallen to single-digit levels?
The buzz around the selection of the new CEO gives the impression that expectations are running high. One view is that the exchange was lacking strong leadership and that a competent management will provide BSE the necessary strategic direction to regain market share. Needless to say, this view is rather simplistic. Given the weak position BSE finds itself in currently, the new management would also need large resources at its disposal to turn the exchange around.
In the exchange space, liquidity breeds liquidity. New users will naturally trade on the exchange with higher volumes in order to benefit from the bid-ask spreads. This leads to a network effect, where this addition of new users further increases the attractiveness of the larger exchange. Over time, even existing users of a smaller exchange can be expected to gravitate towards the larger one for the same benefits.
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The recent regulatory move to allow cross-margining now enables traders to save on deposits with exchanges in case of offsetting positions in the cash and derivatives segments. The savings aren’t huge simply because cash market trades have to be settled on a T+2 basis, while the derivatives position will remain open, resulting in normal margin requirements.
In other words, the margin relief is only for a period of two days. Still, some users are likely to shift cash market trades to the National Stock Exchange (NSE) to avail of these benefits in case they are already using the exchange’s derivatives segment. As one BSE member puts it, “Unless some drastic measures are taken, it would be a slow death for BSE.”
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Currently, BSE has been surviving because it has managed to hold on to a market share of about 30% in the cash market for equities. Its market share in the derivatives segment is close to nil. In the first four months of this year, its market share in the cash segment has been around 25%, indicating that the gradual decline is continuing.
So far, a bunch of brokers continue to trade loyally on the exchange’s cash segment, which has ensured that the vicious cycle of falling volumes has hasn’t culminated in zero volumes for the exchange. For the past two years, BSE has been felicitating these brokers, whom it interestingly calls volume providers.
But at current levels, the exchange is barely breaking even on its expenses. It’s only because of high financial income that the exchange has been reporting a decent profit in recent years. Stripped of this, profit before tax and exceptional items would fall to just 11% of the reported level of Rs197 crore in the financial year 2007-08. With volumes having dropped in the year ended 31 March, things are likely to have become worse on the profit front.
What are the new CEO’s options? Often, a competing trading platform is able to capture market share by attracting new users. A good example of this is the currency futures market, which has been successful simply because the more liquid over-the-counter forward market is closed for a host of participants. But this doesn’t apply in the equities market, which is open to all users already and the same restrictions (if any) apply to both NSE and BSE.
There seems to be no choice, therefore, but to target existing users of NSE. Clearly, what comes to mind are market-making schemes that provide incentives to brokers who provide two-way quotes on BSE. One broker says that given the high liquidity at NSE, these quotes should at least match the spreads available on the competing exchange.
Needless to say, this will require a large outlay in terms of commissions and market-making fees to brokers. The new CEO would, therefore, need access to a large corpus of funds and the freedom to function with some level of independence.
One of the criticisms to this approach is that BSE has already tried a number of market-making schemes, which have all failed. But then, as one exchange official points out, such schemes need to be monitored well with clearly defined outcomes. While a competent management should be able to ensure that, the BSE board would have to be gracious as far as operational freedom and access to funds go.
Of course, as pointed out earlier in this column, there is a strong case for the government to relax shareholding restrictions to accommodate further investments by strategic investors such as Deutsche Borse and Singapore Exchange Ltd. Resurrecting BSE will need deep pockets, apart from a new CEO. It would be foolhardy for policymakers to only talk of fostering competition and not do anything about it.
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Graphics by Sandeep Bhatnagar / Mint