Home >Opinion >Has market making given BSE a new lease of life?

Regulators and policymakers may take their own time in deciding the fate of exchanges owned by the Financial Technologies (FT) Group; but some market participants seem to have concluded that the damage is irreparable. According to a BSE Ltd spokesperson, “After the lacklustre start (of MCX Stock Exchange), (and the) failure and loss of trust in FT group operated exchanges, BSE remains the only competitor to the National Stock Exchange (NSE)."

To be sure, turnover in MCX-SX’s equity derivatives segment fell from a daily average of 1,421 crore in July, before the National Spot Exchange Ltd crisis, to 357 crore in September. But what about BSE’s own performance? The exchange has had various market-making schemes running for the past two years—this is as good a time as any to evaluate whether these schemes have helped the exchange capture share from NSE.

According to BSE, it now has a share of 20% in the equity derivatives market compared with about zero two years ago. One criticism the exchange has faced is that much of the current volumes are only because of its incentive schemes which reward market making and other firms that trade on its platform. On the face of it, it appears that there is barely any end user demand. For instance, there is still no institutional participation on the exchange.

It must be noted here that an exchange has to operate under tight circumstances—the Securities and Exchange Board of India (Sebi) has a stipulation that a market-making scheme can run only for a period of six months. So every six months, BSE shifts its incentives from BSE Sensex derivatives to contracts on the BSE 100 index. Needless to say, volumes dry up whenever incentives are withdrawn on any product, constraining the exchange’s ability to build lasting liquidity on a flagship product. As argued in this column before, the regulator must encourage transparent market-making schemes and consider some relaxation on the tenor of such schemes.

Despite all this, about 140 trading firms traded and collected incentives from the exchange in August, and, according to the exchange, liquidity on its derivatives platform is robust with as many as 30 million orders entering the system each day and 110 algorithmic trading systems connected to the exchange. It seems market making has given BSE a new lease of life.

Of course, trading seems to be concentrated among a top few market-making firms. The top five market-making firms received 60% of turnover-linked incentives in August 2013, up from 39% a year ago. The top five firms that received open interest-linked incentives accounted for 70% of such payouts. According to a large Delhi-based trading firm, this is the main reason it doesn’t trade on the exchange’s derivatives platform—the fear being that the counterparties for most of his firm’s trades could end up being just a handful of other trading firms, thereby inviting regulatory scrutiny for circular trading.

This is likely an irrational fear, considering that Sebi hasn’t acted on any trading firm engaging in market making on BSE, and also the fact that a number of other firms also trade on the exchange—40% of trading is by firms outside the top five. Even so, this is clearly an area of concern for the exchange and it must demonstrate that it can attract more end users onto its platform, including the important institutional investor constituency.

Interestingly, earlier this month, NSE announced that it will reduce transaction charges on incremental volumes for firms that increase their turnover on the exchange month-on-month. According to the BSE spokesperson, the exchange’s success in implementing an effective incentive scheme, thus creating competition, has forced NSE to cut costs. From NSE’s perspective, it doesn’t lose revenue on profit base of the reduced charges because they apply only on incremental volumes.

BSE’s incentive schemes, needless to say, have made a dent on its profitability. About two years ago, in the quarter ended September 2012, the exchange reported earnings before interest and tax of 73 crore, which amounted to 55% of its revenues. In the quarter ended June 2013, profit stood at 47 crore after deducting incentive payouts. As a percentage of revenues, profits have fallen to 35.5%. The good news is that incentive payouts have been tapering off—from as high as 13.9 crore per month in the January-March 2012 quarter to 6.6 crore in the April-June quarter. In August, the total payout stood at 4.5 crore. And trading interest continues to be alive.

The big question is if volumes will sustain if and when incentives are withdrawn. With the exchange still enjoying a 35% profit margin, it isn’t under any pressure to withdraw incentives voluntarily. Of course, there is always the risk of the regulator putting further strictures on market-making schemes. But market-making schemes are used by exchanges world over. It is best that the markets regulator focuses on keeping such schemes transparent and non-discriminatory—business decisions are best left to market participants.

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