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The average daily turnover of the National Stock Exchange’s (NSE) equity cash and derivatives markets in India stood at a massive 1.33 trillion in the first five months of the current calendar year. But this impressive turnover figure masks the fact that India’s equity markets lack depth, and that they are getting increasingly shallow.

Already, trading of some key Indian financial assets is dominated by overseas venues. Unless policymakers chart a course correction, Indian trading venues will lose out further, and eventually Indian companies will struggle to raise capital onshore.

About two-thirds of the above-mentioned turnover comes from trading in Nifty options contracts. Growth in options trading is a sign of a maturing market, but in India, there has been a disproportionate increase in the share of options trading, thanks to lower transaction taxes applicable in this segment. Turnover in almost all other segments of equity trading have been declining.

Shyamlal Banerjee/Mint

The last time there was a major exodus of Nifty futures positions to SGX was when policymakers imposed a curb on participatory notes in 2007. The policy mistake this time around is the uncertainty about the general anti-avoidance rules (GAAR). A large number of foreign institutional investors have shifted or closed their positions, and one related casualty is the Nifty futures contract, where the domestic exchange has lost its leadership. Soon, SGX is expected to launch Nifty options, and it can be expected to capture share in that segment as well.

These problems aren’t restricted to derivatives contracts. Trading in Infosys Ltd shares in now dominated by the Nasdaq, which has a 60% share, followed by NSE (35% share) and BSE Ltd (with a mere 5% share). Consider here that only 13.5% of Infosys shares are held as depository receipts and are traded on the Nasdaq. The rest are listed and traded on Indian exchanges. Using the turnover by market capitalization ratio, therefore, the Nasdaq is far ahead.

Note that the above-mentioned two contracts are among India’s top traded contracts. It is well-known that beyond the top few contracts, liquidity dries off in the Indian markets. But now, even the top contracts are getting increasingly shallow. Some of the mini flash crashes seen in recent times, such as the one on Nifty futures earlier this year and the one on Reliance Industries Ltd’s shares two years ago, are at least partly owing to shallow order books that couldn’t absorb large sell orders.

What are the policy imperatives to arrest the decline of Indian trading venues? Policymakers need to be consistent about policies related to taxation, especially when it comes to foreign institutional investors (FIIs). There is ample evidence now that GAAR and the uncertainty surrounding it has driven away many FIIs.

But it’s important to note that recent policy mistakes aren’t limited to foreign investors. Even domestic investors are fleeing exchange-traded equity products. Anecdotal evidence suggests that dabba trading, or off-exchange trading, has increased considerably in recent times. This is due to multiple factors such as an increase in compliance costs, higher margin-related costs, as well as to avoid securities transaction tax. For the same reason, many retail and wealthy investors find succor in the commodity futures market, where none of these constraints apply.

Apart from peeving foreign institutional investors and domestic retail investors, policymakers have managed to curtail the participation of domestic institutions as well because of regulatory changes for mutual funds and insurance companies. While none’s arguing for a return to the days of massive commission dole-outs to insurance sellers, it is evident that a correction in policy is due.

More importantly, it is crucial that at least part of India’s pension funds find their way into equity markets. This will not only help subscribers of pension funds beat inflation, but also help the markets get a deep and steady source of funds. In developed markets, pension funds are invariably an important part of the markets.

India’s labour ministry is known to have reservations about exposing the pension savings of its subscribers to volatile markets. But since these investments are made for the long-term, volatility shouldn’t be a concern. Besides, if the labour ministry wants to protect low-income groups from exposure to a market they don’t understand, they can allow equity exposure to subscribers who meet a minimum threshold either with respect to the outstanding balance or their annual contribution. There is no need to protect high income groups from the risk of investing in equities.

As pointed out earlier, policy course corrections are necessary because the equity market plays an important role in the economy by enabling companies to raise funds. Large companies may be able to raise equity funds abroad, but for smaller firms, a weak domestic equity market will result in unbearably high cost of funds.

Your comments are welcome at inthemoney@livemint.com

Also read:Previous stories by Mobis Philipose-

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