Mumbai as an international financial centre: Implications for the securities industry

BSensex, June--July 2007

The Mumbai - International Financial Centre (MIFC) committee, chaired by Percy Mistry, has done an in-depth exploration of the idea of the Indian financial sector being part of a global competitive landscape in finance (link).

In India, we are used to the idea that markets like steel or cars are global - where Indian firms have to either compete with the best in the world or exit the business. But the notion of global competition in finance is as new in India as the idea of global competition in manufacturing was in 1990. Today, Indian financial firms are not part of global finance, and the prevailing ethos of the government is one of protectionism and export pessimism. Arguments continue to emanate from the status quo about why Indian finance should be kept cutoff from global competition, or about why Indian financial firms will be unable to export even when trade barriers are brought down. Reforms in Indian financial and monetary economics are at roughly the level of the Indian real economy as of 1990.

An open and competitive financial industry is, however, the inevitable destination for India, given the contradictions and difficulties that the present closed-economy framework is running into. In a few years, every financial firm in India will be deeply engaged with global competition, global suppliers and global customers, just as is the case with manufacturing firms today.

In this context, a key question that the securities industry needs to ask itself is: What is the role for Indian exchanges and securities firms, in the world of globalised finance?

Start from the customer

With convertibility, Indian customers will have a wealth of choices on assets and trading platforms. For securities firms with retail customers, this means that their offerings will need to expand to connect up to all assets and all exchanges worldwide.

Today, in a closed economy setting, the bulk of financial assets of a household are held with one depository and one depository participant. Customers today are able to enjoy getting one single account balance statement at one URL on the Internet. In a world with globally diversified portfolios, assets will be spread all across the world. This will yield tremendous benefits to households through reduced risk. But at the same time, this will increase complexity of decision making, recordkeeping, tax planning, etc.

Implications for customer-facing financial firms

Financial firms need to gear up for this world by offering aggregation services, where multiple depository accounts and other repositories of assets are converted into a single account balance statement which is visible to the Indian household in realtime. Further, Indian households will need considerable help in achieving adequate global diversification in terms of advice and guidance on product selection. Rational portfolio choice suggests that roughly 75% of the financial assets of the typical household living in any country should be placed outside that country (link). An ideal mechanism for achieving this is a set of index funds for the top 20 countries of the world. Customer-facing financial firms in India will need to setup the relationships with global index fund providers, exchange memberships, depository connectivity, and advisory capability so as to be able to deliver seamless product offerings to the Indian household.

Going beyond the portfolio of financial assets to trading objectives, Indian households will have access to the world's best exchanges when it comes to international underlyings such as currencies, equity indexes or international commodities. When households have globally diversified portfolios, there will be a natural interest in correspondingly sophisticated risk management. The typical household may want to eliminate Euro risk by shorting Euro-Rupee futures, block losses on the rupee-dollar exchange rate by purchasing put options, and block losses on overseas index funds by purchasing put options on indexes. Further, households and firms with exposures and interest in international commodities will have an interest in the offerings of global commodity derivatives exchanges.

The picture so far has clear implications for Indian customer-facing financial firms. The imperative for them consists of establishing processes and skilled employees who are able to support and guide the global diversification of client portfolios and spot/derivatives trading outside the country by Indian households. The opportunities in this are here and now, with each Indian citizen being already able to transfer $100,000 per year outside the country. In the years to come, the removal of capital controls will only strengthen the avenues for households, and thus increase the payoffs for such a business strategy on the part of Indian financial firms.

Implications for exchanges

The next step consists of thinking about exchanges. The natural venues for trading G-7 currencies, overseas indexes and international commodities are overseas. The natural venues for trading in rupee-related derivatives, and other Indian underlyings, are in India. The questions faced by Indian exchanges are two-fold. First, how can exchanges in India continue to be the centres of liquidity on Indian underlyings, and particularly rupee-related currency derivatives? Second, is there a role for Indian exchanges to compete in international underlyings?

For some financial products, the very information that feeds into speculative price discovery is dispersed all across India. In this case, distribution spread all over India becomes relatively important, and exchanges in India have a natural advantage by virtue of having that distribution. This kind of logic appears to hold with equities and agricultural commodities. While competitive situations like the Singapore exchange trading Nifty futures will arise, the threat posed here is relatively weak. Indian exchanges can easily have significant liquidity here, and have amplified activity by tapping into global order flow.

Trading in interest rates and currencies, in contrast, is about macroeconomics. Trading in interest rates and currencies is based on examining macroeconomic data, and does not require a complex information set that is dispersed all across the country. Hence, the entry barrier introduced by distribution is absent. In these two areas, there will be a bigger battle for Indian financial markets to continue to be relevant. The competitive landscape disfavours Indian markets through the hostile stance of public policy in India towards the development of these markets. Already, roughly $1 billion of daily turnover is taking place outside the country on Indian interest rates and currencies. Until fundamental reforms take place in the regulatory framework, it is likely that these markets will continue to shift outside the country.

The hardest challenge is found with underlyings that have nothing to do with India, such as crude oil. Is there a role for Indian exchanges in these markets? While this sounds daunting, it is no more difficult than (say) producing steel or cars in India for the export market. The window of opportunity may lie in low IT costs that are made possible through economies of scale coupled with Indian software genius. Along the way, a full removal of taxation of transactions is also required.

NSE and BSE are the 3rd and 5th biggest exchanges in the world by number of transactions. This lends economies of scale and makes possible low-cost transaction processing. In addition, NSE and BSE should be able to harness Indian software genius to arrive at remarkably low cost solutions when compared with the other three biggest exchanges of the world. Put together, this may make possible a per-transaction tariff at NSE and BSE which is low by world standards. The window of opportunity in attacking international underlyings lies in achieving per-transaction tariffs which are significantly lower than the lowest values seen outside India.

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