Traditional brokers strike back
A strike by brokers! It reminds me of the good old days of 1992 when BSE brokers last went on strike, protesting the most minimal standards of fairplay on the equity market that were being pushed by SEBI at the time. Three weeks into the new design of the equity market, with rolling settlement and without badla, we are seeing traditional stock brokers mobilise politically, aiming to reverse or dilute the reforms. What does the experience of these three weeks teach us, and what can we expect, looking forward?
The first three weeks. NSE's volumes dropped from an average of Rs.6,000 crore per day in February 2001 to Rs.2,000 crore per day in May. The average in July seems to be slightly below this. Is this a problem?
First, we should be careful about index movements. Nifty has dropped by roughly 25% this year, so when we observe a daily NSE volume of around Rs.1,800 crore, this is comparable with values of Rs.2,250 crore before the drop in the index.
A second perspective can be obtained by using international comparisons of turnover. A thumb-rule used internationally is that a well-functioning stock market trades its market capitalisation once a year. This is called "a turnover ratio of 100%" where the turnover ratio is defined as the latest one year's trading volume divided by today's market capitalisation.
Given the market capitalisation today of Rs.6 trillion, the turnover ratio proves to be 100% with daily volume of Rs.2,500 crore. So, we're at a plausible level of turnover, by international standards. This is not to say that turnover in India has no upside potential. This is just to say that if NSE's daily volume is around Rs.3,000 crore, which is what is likely in the coming months, this is not a bad state of turnover by international standards.
Last and foremost, we should always focus upon stock market liquidity, which is defined as the transactions costs of engaging in market transactions. From the viewpoint of the Indian economy, the securities markets performs only one function: that of delivering mechanisms for transacting in securities at a low cost. Hence, the discussion should centre on the liquidity in the Indian equity market. This is measured by the impact cost when doing transactions of Rs.5 million on Nifty. Turnover is directly relevant for the revenues of securities firms and stock exchanges, so their anxiety about it is understandable. But turnover is a highly imperfect measure of transactions costs.
The most exciting new developments have taken place on the derivatives market. The index futures market has taken off. Turnover on the index futures market has gone up by roughly 10 times over the last 12 months, to a peak of Rs.100 crore in a day.
More importantly, the index futures have attained a very high level of liquidity. From June 2001 onwards, on numerous days, the near index futures contract has been more liquid when compared with the underlying cash market. This is in line with the international experience, where derivatives are much more liquid when compared with the underlying spot market. Indeed, this is one of the important economic functions of derivatives: that of offering highly liquid, leveraged proxies for important underlyings. Today, we in India now have a tradeable Nifty where we get leveraged positions at a lower impact cost when compared with the underlying spot market. This is an important achievement.
Why the strike? There are two different parts of the brokerage industry. There are firms which are moving on into learning new things and getting wired up for the new world. This is not easy; it requires substantial re-engineering of business processes and acquisition of new human capital.
There is a simple test that can be used to measure the outlook of a brokerage firm: Firms that are serious about change are doing more than Rs.1 crore of turnover per month on the Nifty futures. The number of such firms rose from 39 in January 2001 to 72 in June 2001. This number has probably risen to over 100 firms in July 2001. This suggests that there are around 900 firms which have, as yet, ignored the index futures market. This is a remarkably large number. These firms would obviously be very pleased if the reforms could somehow be rolled back or diluted.
In the newspaper advertisement, put out by the BSE Broker's Forum and ANMI, there is a complaint about a lack of avenues for investing shares or funds into the market. There are three aspects to this:
- Supplying avenues for investing shares or funds into the market is not a goal for public policy, so by itself this is not a problem.
- Under margin trading, leveraged longs and shorts take loans separately, without the netting that takes place under badla. So we should expect greater demand and higher rates of return for borrowed shares or funds in the new world. The mechanisms for margin trading have not quite fallen into place, and brokerage firms should put efforts into building these. There is also a strong need for a transparent trading mechanism, which runs on the exchange, through which shares can be borrowed.
- The authors of the advertisement have clearly not understood how funds and shares can be deployed into arbitrage on the derivatives market. There are enormous rates of return to be found in this, given a crying shortage of arbitrage capital on the derivatives market today.
The policy question. Last time around, in a burst of reforms which took place in 1993, we got NSE and banned badla. After that, reforms were stalled or rolled back. We have seen the consequences of this failure of judgement in the following years. In terms of knowledge and institutional development, the securities industry stagnated with a focus on leveraged stock picking using badla. In terms of systemic integrity, rolling settlement would have greatly attenuated the crises of Summer 1998 and 2001.
The ironies of history are endlessly fascinating. The BSE would have been a viable competitor to NSE today, if badla had not been resuscitated in 1995. As John F. Kennedy said "Those who make peaceful change impossible, make violent change inevitable". In the case of BSE and badla, the pursuit of the most conservative path took us to the most reformist outcome.
Today, we are on the threshold of a brave new securities industry. Some firms will go out of business. Others will figure out index derivatives and rolling settlement; they will join the elite club of firms that do over Rs.1 crore of turnover in the Nifty futures every month. These changes are for the better. Securities firms would be most pleased if the human capital connected with badla was rescued from obsolesence; and if they did not need to reorient themselves from a pure stock picking focus to a new world-view that embraces index derivatives. This is exactly what policy makers should avoid.
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