Competing Exchanges: The International Dimension

One of the more remarkable stories in the history of financial markets came about in the aftermath of the worldwide stock market crash of October 1987. In Japan, regulators pondered the crash and asked themselves what needed to be done in order to prevent such occurences in the future. The regulators and the economists who worked with them pondered the issues and came up with a completely incorrect diagnosis: they decided that "program trading" was to blame. Program trading enters the picture when the cash index and the futures are out of sync. When this happens, arbitrageurs use program trading to rapidly buy (or sell) all the index stocks using a computer. Japan's regulators made the arbitrage very difficult by putting restrictions upon program trading.

Today, we better understand the working of index futures markets, and know that arbitrage is essential to the functioning of any futures market. Without index arbitrage, the index futures market would be useless for hedgers since the prices of the futures would often stray away from their fair values. But this was perhaps not clearly understood at the time.

The sequence of events which followed the clampdown by Japan's regulators was most interesting. Thanks to the pervasive mispricings of the Japanese index futures without index arbitrage, the Japanese index futures market was unable to meet the needs of Japanese users.

One of the most important derivatives exchanges in the world is the Singapore International Monetary Exchange (SIMEX). SIMEX is an interesting example of strategic policymaking in Singapore: it was created in the early 1980s as part of Singapore's desire to be a center of international finance. They saw a strong derivatives exchange as an essential part of this.

SIMEX perceived the unmet demand among Japanese users of index futures. A great deal of usage of the futures on the Nikkei 225 (the Japanese index) moved off to SIMEX, where index futures on Nikkei 225 were also traded.

This was bad for Japan's financial industry, which lost fees for brokerage, transactions, research, advisory, etc. However, this was good for users in Japan, who were not locked into using their inferior domestic market: they were able to use the offshore market. This idea commonly recurs with foreign competition: when foreign airlines start operating in India, 8000 workers of Indian Airlines will be hurt and 8 million users of air travel in India will benefit.

The Nikkei 225 futures now trade in Chicago, Osaka and Singapore. But the greatest liquidity has stayed at SIMEX. Japan's regulators have since removed many of their restrictions, but a very important Nikkei 225 futures market remains in Singapore. This is partly because liquidity is hard to dislodge once it comes about, but it also owes in no small part to the elevated transaction and brokerage fees in Japan's highly rigid financial industry.

The story outlined above is one of the important battles in a burgeoning industry of exchanges competing for order flow on an international scale. We are all used to thinking about BSE and NSE competing with each other, but an important issue on the medium term concerns how they will face up to international competition. This competition consists of foreign exchanges trading on Indian instruments, and Indian exchanges trading on foreign instruments.

This competition is at its most intense in derivatives. This is because derivatives intrinsically tend to have high volumes, and also because there is a great deal of scope for designing interesting kinds of derivatives contracts (e.g. the design of the NSE-50 index) which might better meet the needs of users.

The key lessons of the Nikkei 225 story are worth reiterating:

  1. Competition amongst exchanges takes place on a global scale.
  2. When users need a product, and it is not found domestically, they will go offshore in order to find it.
  3. When alternative exchanges trade the same product, the order flow will go to the lowest cost provider (i.e., where impact cost plus brokerage is smaller).
  4. Liquidity feeds on liquidity. Once a given exchange obtains low impact cost for a given product, it is extremely hard for another exchange to take away this trading.

In India, we have seen one example of a competing offshore market. This is the GDR market, which was born as a response to poor market quality, and restrictions upon FIIs, in India. Today, with the benefit of hindsight, we know that the GDR market was not a challenge, for several reasons: (a) Indians dominate India's equity market, and the lack of convertibility meant that Indians could not send their orders to the GDR market, (b) the GDR market is self-liquidating in that there is a steady conversion of GDRs into shares, so the domestic market tends to grow over time at the expense of the GDR market, and (c) the way things worked out in India, a total transformation of trading, clearing and settlement took place on India's equity market remarkably swiftly, which eliminated the competitive advantage of trading on the GDR market. Today, the only serious advantage of the GDR market is the method through which the primary issue takes place there.

This sanguine experience might not be repeated in the future. Convertibility is on its way, derivatives markets are not self-liquidating, and the richness and sophistication of the worldwide derivatives industry far exceeds the present state of knowledge in India.

One interesting example of this is the offshore "non--deliverable forward" (NDF) market on the dollar--rupee. The NDF is basically a cash--settled forward contract. The RBI forbids many users from accessing the dollar--rupee forward market in India, hence there is a natural opportunity for offshore providers to enter into this area. In recent weeks, the liquidity on the NDF market has often been comparable to that of the dollar--rupee forward market, which suggests that this market is coming of age. The logical next step in this development is a futures market, and two exchanges (one in Chicago and the other in Dublin) are currently in the process of evaluating the launch of futures on the dollar-rupee.

The last point that we will bring up here is the competitive advantages of India's markets. One obvious advantage is that of time--zones. When it is daytime in India, which is the time when most trading takes place, there are few exchanges abroad which can compete with India (only Singapore has a large overlap in the trading day). Another strength of India's securities industry is the electronic trading which is ubiquitous in India; this is a superior technology as compared with many human--intensive foreign markets. Finally, there is the highly non-institutional and geographically dispersed nature of trading in India: in the early days of convertibility, institutional users would perhaps find it easier to cope with the paperwork and modalities of trading on foreign exchanges as compared with smaller users, who would stay wedded to Indian exchanges.

One more episode of this competition took place in early 1997. Taiwan has debated the launch of index futures for many years, and in January 1997, Taiwanese index futures started trading in Chicago and Singapore. Singapore has a timezone which is close to Taiwan, and these contracts have fared reasonably well in Singapore. However, the Taiwanese index futures have essentially not worked in Chicago.

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