India has a lot to do in building liquidity in equity trading

National Stock Exchange of India (NSE) is likely to end the current year as the world’s second largest derivatives exchange, behind only Chicago Mercantile Exchange (CME), based on the number of contracts traded on its platform. Just two years ago, in 2011, it was ranked the fifth largest exchange. Five years ago, it was ranked eight. The rise in volumes on the exchange, clearly, is rather spectacular.

If the exchange continues to grow at the rate it grew this year, it will trump CME in another three years. But before getting carried away, one must note that NSE’s contracts are among the cheapest in the world. In value terms, NSE will be ranked much lower than exchanges such as Eurex, NYSE Euronext and Nasdaq OMX.

According to data collated by Futures Industry Association, 1.58 billion contracts were traded on NSE between January and August 2013, making it the second largest exchange behind CME, which had 2.17 billion contracts traded on its platform during the same period. Volumes grew by over 20% on NSE, making it the top gainer among the world’s top 10 derivatives exchanges. Volumes at the other nine exchanges in the list fell by 6.5% cumulatively.

While all this is good, clearly, policy makers can’t afford to get complacent about the state of affairs in the exchange-traded markets. First, India’s low-priced contracts make a fair comparison difficult. Additionally, while some contracts in Indian derivatives markets are very liquid, the pertinent question is if this has resulted in increased liquidity in the underlying cash markets. The equity cash market continues to be plagued by a lack of depth, with volumes falling off considerably beyond the top 100 stocks. In other words, having extremely high volumes in a few derivatives contracts, on the back of high speculation, isn’t something to be very proud about.

Interestingly, one of the reasons NSE has been able to jump up the league tables is the sharp drop in volumes on Korea Exchange. According to a Futures Industry publication, Korean authorities decided that there were just too many retail investors speculating in various ways on the direction of the stock market. To tackle this, “the Korea Exchange quintupled the index multiplier, making each contract five times as expensive to trade. That change took effect in stages starting in March of 2012 and ending in June, and the not-so-surprising effect was that volume collapsed”, the publication added.

Whether Indian policy makers choose to tackle speculation in equity derivatives markets or not, one area they definitely need to focus is in building liquidity in the underlying cash market. Ultimately, it’s the cash market that provides liquidity to equity investors, aiding in the economic purpose of capital raising.

Unfortunately, trading in India’s equity cash market has taken a hit since the time the finance ministry imposed the securities transaction tax (STT) and later disallowed using STT as a rebate against a trader’s total tax liability. In fact, one of the reasons Nifty and Sensex options are among the most popular contracts is the lower incidence of STT on these contracts. Besides, pension funds, who are large players in developed markets, are totally absent from India’s equity markets. Policy makers should push for their participation to improve the depth of the markets and reduce dependence on foreign flows.

Of course, as pointed earlier in this column—these aren’t quick fixes for building liquidity in the equity cash market, but are, nevertheless, important steps that are needed. In addition, measures such as expanding the securities lending market to stocks outside the derivatives set of stocks should be considered. After all, the need for securities lending and borrowing is more for the other stocks, since the single-stock derivatives market offers a much cost-effective way to sell stocks one doesn’t own.

Earlier this year, Securities and Exchange Board of India (Sebi) experimented with the use of periodic call auctions for illiquid securities, which was a bold move by the regulator to try and fix the problem of low liquidity in stocks of small companies. Thus far, the new form of trading hasn’t taken off; although it must be said here that these stocks weren’t traded much even earlier. It will only be fair to look at data for some more time before coming to a conclusion although Sebi will do well to revisit this at some point based on traded data. Ideally, of course, such decisions should be left to exchanges.

In sum, while overall volumes on Indian exchanges look impressive, the underlying reality about the depth of the markets is very different, and demands policy intervention.

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