United Stock Exchange of India Ltd’s (USE) business model is the first of its kind in the exchange space. It recently tied up with Bombay Stock Exchange Ltd (BSE), where the latter will provide the trading platform and clearing services for USE’s currency and interest rate derivatives products, whenever they are launched.
BSE will hold a 15% stake in USE, and is likely to get a fee for providing its trading platform, clearing services, regulatory oversight of trades and position limits and access to its distribution reach.
If BSE is going to provide all the traditional services an exchange provides, one is tempted to ask the question, “Is USE an exchange at all?” Perhaps a better way to look at it is to equate USE’s business model with those of new entrants in India’s wireless market such as Etisalat or Telenor which will soon be offering wireless services in the country without putting up any telecom tower infrastructure. These requirements will be outsourced to incumbents such as Bharti Airtel Ltd and Reliance Communications Ltd. Other critical services such as IT systems are normally outsourced as well, with service providers primarily focusing on marketing the product.
Besides, this model has been adopted in the overseas markets as well. The New York Mercantile Exchange Inc. (Nymex) had used the Chicago Mercantile Exchange’s Globex platform to offer its energy products on the electronic trading platform. Earlier, its products were traded on the floor through an open outcry system. Nymex paid CME a fee for its services, until, of course, it was acquired by the latter last year.
Note here that Nymex already had established products. The important question is, what does USE bring to the table, since BSE’s own currency futures offering has flopped? USE’s shareholders are made up of a consortium of about 12 banks and trading entities such as Jaypee Capital Services. These entities currently trade financial derivatives on various platforms. The thought process behind these entities coming together is to trade on an exchange platform where one could also gain by being a shareholder of that exchange. Put simply, if trading volumes pick up in USE’s products, these shareholders would see an increase in the value of their equity investments and/or receive dividend payments.
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While the idea sounds good, it must be noted that 12 banks and a handful of trading entities don’t make up for a large proportion of the market. Of course, for a product such as interest rate futures, banks will be the most important players. But for any product to be successful, USE needs to be able to attract other participants. This is not to say that it doesn’t have the abilities, but it isn’t right to assume that having a set of shareholders to provide the initial liquidity is sufficient for an exchange’s success.
And as experience world-over shows, even shareholders of a certain exchange trade on competing exchanges for the more important benefit of liquidity.
So if the liquidity on the National Stock Exchange (NSE) and MCX Stock Exchange (MCX-SX) turns out to be far greater than that of USE’s product, some of its shareholders would prefer to trade on the more liquid exchange. The dividend income or capital appreciation expected from their minimal investments in USE will pale in comparison with the cost of putting trades in a less liquid exchange. If the USE experiment fails, most of its shareholders will simply shift their trading to other venues and write off their relatively small investments in the firm.
From BSE’s point of view, this seems to be a neat arrangement, considering that it needed to start from scratch anyway for the currency and interest rate derivatives platforms. Like most exchanges, it would have had to look for large participants such as banks to act like market makers and provide the initial liquidity. With the USE tie-up, it gets a consortium of banks, as well as a few trading entities. Of course, its gains will be limited to its 15% stake in the firm and the fee it charges USE. But then considering that its first attempt at currency futures had flopped, this looks like a reasonable proposition.
USE’s entry will clearly increase the competitive intensity in the currency and interest rate derivatives space, which is now being fiercely fought between NSE and MCX-SX. But whether it’ll be able to capture significant share remains to be seen.
MCX-SX, FTSE tie up
Talking of competition, here are first signs of some competition in the equity space. MCX-SX, even before it has received regulatory approval for offering equity products, has entered into a cooperation agreement with FTSE, the global index services provider. FTSE will create new domestic index products for India, derivatives of which will trade on MCX-SX, when it gets approval from the Securities and Exchange Board of India.
Apart from index derivatives, these indices could be used also to list exchange-traded funds (ETFs). The market for ETFs has been underdeveloped in India and some initiative by new and existing exchanges could result in substantial growth. Global ETF fund flows in the Asia Pacific (ex-Japan) region rose from just $0.6 billion (Rs2,868 crore) in 2007 to $15.1 billion in 2008, but the Indian ETF industry, with assets under management of just $0.82 billion, hardly benefited from this.
It’s too early to say if the new exchange and the rejuvenated BSE with a new management will capture significant share from NSE. But it’s clear that the increased competition will lead to more products and better service.
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