New Directions in the Markets

The capital markets have seen momentous changes since 1993. What are the important new aspects of the capital markets that the investor should know and pay attention to?


While stock market liquidity is much improved in India today as compared with previous years, it remains important for investors to be aware of the costs of trading and how to avoid them.

The word liquidity is used often and misunderstood often. The simplest way to measure liquidity is to look at the difference between buy and sell prices. If a share quotes at 10/11, i.e. that buyers pay Rs.11 while sellers get Rs.10, then it is quite illiquid. These quotes mean that when you buy the shares at Rs.11, you are immediately one rupee poorer, because the sale value of the shares is only Rs.10. This difference of one rupee is called the "bid--ask spread".

The spread is very important to traders. When you think that a price is going to go up, you buy at Rs.11. Whether you are right or wrong in your forecast, you will lose the spread. Many traders work hard to find the brokerage company which charges the least brokerage. They should pay even more attention to the spread, because it is generally bigger than the brokerage fees!

With floor--based trading, it was impossible for the investor to know the true spread and this was the basis of much malpractice. Today, with computerised trading, the investor can go to the NSE or BSE screen and see the quotes for himself.

Good liquidity is now found on the bigger stocks of the country. On NSE, the spread for stocks like Reliance and State Bank is often as small as five or ten paisa (much less than was ever observed in the earlier days, even when badla was available). In general, we say that liquidity is "good" when the spread is less than 0.5% of the price. Such liquidity is good for both long--term investors and traders, but the competition in trading is very heavy in such stocks. When the spread is small, lakhs of traders using NSE terminals around the country are competing to be first in catching news about prospects of companies. This makes profitable trading extremely difficult.

Inferior liquidity is present in most stocks of the country. However, these are the stocks where competition in trading is less, with greater opportunities for identifying undervalued or overvalued stocks. In such stocks, both traders and investors are advised to place "limit orders" insisting on a good price. For example, if a stock has quotes of 10/11, then the buyer (who would normally pay 11) should put a limit order at Rs.10.90, and the seller (who would normally get 10) should put a limit order at Rs.10.10. This will take a little more time to execute, and might sometimes fail to execute, but such methods will significantly improve the prices obtained when buying or selling. Traders can also earn profits from doing "market making", e.g. placing limit orders at 10.10/10.90. This earns a revenue of 80 paisa on each cycle of buying and then selling (or selling and then buying).


The most significant development in the markets of the last two years is the depository (NSDL) which has been started by IDBI, UTI, NSE and SBI. Especially for investors who are not in Bombay, the costs suffered through dealing with registrars, having certificates and dividend checks stolen, courier charges, etc. are enormous.

The depository is a great advance for the stock market. The depository does to shares what banks do to currency notes. When one person needs to give Rs.10,000 to another, he can give currency notes, or he can deposit the currency notes in a bank and write a cheque. In exactly the same manner, instead of one person giving shares to another, he would deposit the shares at the depository and then write a "cheque" enabling transfer of securities. The transfer takes place within one day, the buyer never loses dividends or bonus shares through delays in transfer, and the buyer never gets fake certificates.

For many investors who have been avoiding the stock market owing to the extremely painful paperwork and bad experiences with fake certificates, the depository is a reason to return to equity investment.

The shares of more than 90 companies are available for trading through the depository, and 5,000 investors have converted Rs.9,000 crore of securities from physical shares into electronic holdings. Every investor in the country should now go to the nearest depository participant and open his account.


The most important change expected in the next one year in the capital markets will be the launch of derivatives trading.

Futures and options are tools which are used all over the world for both hedging (reducing risk) and trading (taking positions based on forecasts). They have been found to be safe and effective instruments.

People often compare derivatives against badla. This comparion is not accurate. Badla is merely a method for borrowing shares or money. Derivatives on the index allow for hedging (reducing risk) of any portfolio, and for trading. Derivatives will help investors do better planning when they expect that they will receive or have to pay money in the future.

Derivatives will enable fascinating arbitrage strategies. Today, arbitrage of a simple nature takes place: traders buy on the NSE and sell on the BSE. With index futures, arbitrage will take place between the present and the future -- for example, a trader may choose to buy the index in the present (on the cash market) while selling the index in the future (on the futures market).

The risk of equity investment will come down once derivatives are available. This will help the investment culture in the country. Derivatives will also make taking positions on the index possible, which is currently not available.

The End of "Free" Speculation

In the earlier days, in India, markets offered methods for "free" trading, where a person could take positions, even very large positions, without any connection to the kind of losses that he could bear.

This style of functioning led to everyone getting hurt from time to time. Traders who made losses which were bigger than their capacity to pay for them, which led to payments crises, which led to delays and losses for everyone on the market. In the modern world, the solution adopted uses the "clearing corporation". The clearing corporation makes itself to be the legal counterparty to every buyer or seller on the market. Hence if the buyer goes bankrupt, the seller still sees his position go through without any delays or problems. Hence the payments problems faced by the entire market are now eliminated.

Many people would still like to go back to the old world, where they could just take positions and not face any constraints in doing so. We have to become very clear that the days of "free" trading are over. Markets which allow free trading will not survive, and wise regulators will not allow such markets to exist. The new way of functioning is twofold: (1) before taking a position, the trader will have to pay up a deposit, which is called "initial margin", and (2) the trader will have to pay up all losses made on an open position on a day to day basis. The initial margin that is currently used on many cash markets in India as of today is actually on the low side, and is likely to rise in the future as the understanding of these problems improves. The upcoming derivatives markets will also require payment of initial margin.

This discipline is used on all well--functioning markets in the world. It ensures that payments crises do not develop on the market. It reduces the potential for market manipulation. Without this discipline, the smooth functioning despite massive volumes of a market like NSE would not be possible.

We should understand that the days of "free" trading are over and the days of paying initial margin before taking a position are here. The organisation of markets in India is increasingly going to reflect this reality.

Trading in Corporate Bonds

Many people buy corporate bonds to hold till maturity. One new feature in the country is the increasing interest in trading corporate bonds.

When interest rates go up, bond prices go down. When bad news appears for a company, which increases the risk of failure in servicing the bond, bond prices go down. Traders work on forecasting interest rates and on watching the level of distress of a company and trade in corporate bonds. Some bonds, like the TISCO SPN are already highly active in secondary market trading.

Prior to the liberalisation, interest rates were fixed by the RBI, and few large bond issues took place. Hence the traditional focus amongst traders is in equity. However, today interest rates are mostly market determined, and fluctuate every day. Large bond issues are taking place on a regular basis. The total volume of bonds which are currently available for trading is around Rs.75,000 crore.

This has two consequences, for investors and for traders. For investors, corporate bonds can increasingly be viewed as liquid, as part of the portfolio which can be liquidated when money is needed -- the investor is not forced to hold the bond till maturity. For traders, corporate bonds are now something to trade on, in addition to the traditional interest in trading on equity.

Index Funds

Investors in mutual funds have generally noticed that mutual funds do badly. Most mutual funds, in all countries, deliver inferior returns to the market index after their risk is taken into account.

Hence a new concept called the "index fund" has come up. In the index fund, the fund manager makes no attempt to outperform the index. He simply buys and holds all the shares in the index, in correct proportions. Wherever index funds have come, they have done better than 80% of the mutual funds which are competing against them.

This approach has several benefits. The fund manager does not waste money on doing research. He does not waste money on trying to trade actively. The investor is not worried about the kinds of stocks that the manager is putting into the portfolio, about the kind of brokerage firms which the fund manager is using, etc. The investor buys the index fund in full confidence that his interests are protected. The investor has a simple way to check whether the fund manager is doing a good job: he has to simply compare the returns on the index fund against the returns on the index. If the scheme is not performing as well as the index, the investor should move his money to another index fund. This kind of day to day monitoring of the fund manager is not possible with mutual fund schemes which are not index funds, where the investor has no way to get day to day feedback on what the manager is doing with his money.

For these reasons, all over the world, investors have found index funds to be very valuable to them. In countries like the US, a full 40% of the total investment in mutual funds is now in index funds!

Index funds are a new idea in India. This is partly because good market indexes were not available, where index funds could be properly implemented. The NSE-50 index is the first index which can be meaningfully used for making index funds. It has helped make possible India's first index fund, the "India Access Fund", an index fund based on the NSE-50 (Nifty) which has been launched offshore by UTI, SBC Warburg and Commercial Union. This fund now has $75 million invested in it.

Several companies, including IDBI Mutual Fund, have plans to launch index funds aimed at domestic investors. This is likely to be a very important new avenue for investment for investors.

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