THINK GLOBAL, LOSE LOCAL
Regulatory arbitrage is causing derivatives trading volume in Indian indices shift to overseas exchanges gradually but dangerously
In the last couple of weeks, despite the trading action in the Indian stock market being subdued due to the bear grip, the liquidity of Indian equity units listed abroad has risen. Some market players in India are apprehensively watching this trend as it means the revenue from brokerage, depository operations and other intermediary activities, that otherwise would occur here, is now shifting overseas bit by bit.
On the Singapore Exchange's (SGX's) derivatives trading segment, the last seven months (from November 2007) has seen multiple times increase in the value of trades and open interest positions in its listed-futures contract on India's most actively traded index – the National Stock Exchange's (NSE's) 50-stock Nifty. The number of Nifty futures traded in the first ten months in 2007 averaged at just 16,202 per month. From November 2007 to May this year this has zoomed to 744408 Nifty units per month, a 45 times increase.
There is a reason for this. Many global hedge funds and some global equity investors prefer to take country exposure through an investment in futures contracts on the leading index of that country. In the core 2005-07 period of the bull run, these investors did this for India through the Nifty futures traded on the NSE. It was done through participatory notes (P-notes) issued by foreign institutional investors (FIIs) where the underlying Indian asset was Nifty futures. These accounted for a third of all FII investments through P-notes.
The central government, in order to curb the sliding rupee due to very high dollar inflows, made the Securities and Exchange Board of India (Sebi) ban FIIs from issuing P-notes that had derivatives as underlying and impose tight limits on the rest of the P-notes. This happened in October 2007. "It is no coincidence, therefore, that the November-onwards rise in Nifty futures volumes on the SGX coincides with the Sebi ban," says Sanju Verma, head of institutional business, at HDFC Securities.
Nifty futures is one of a couple of other international indices' futures traded on the SGX. The average traded value of Nifty futures in SGX is now around 15 per cent of that on the NSE (see graphs 'Kidling tries to overtake adult') (click on the two graphs below to enlarge them so that they can be viewed clearly) and the open interest position is still higher at around 60 per cent. The same corresponding figures in the first ten months of last year used to be 2-5 per cent and 10-12 per cent.
The threat. Can the Indian market lose its liquidity and trading volumes to other markets even as global equity investors continue, by and large, to get the exposure on India they seek? "The SGX Nifty futures trading seem like a kidling now but it will ignite at some point when most investors realise they get better liquidity there," says Ajay Shah, a senior fellow at the Institute of National Institute of Public Finance and Policy. "It is premature for me to comment on the threat but if your overseas client is not trading through you in India your business will reduce," says Trivikram Kamath, senior vice president of operations, finance and technology at Kotak Securities.
It will not be a first in case it happens. "In SGX, it has happened in the past that international indices had more volumes than the home exchange," says Ashok Jain, managing director of Arihant Capital Markets, a NSE brokerage firm. Jain also weighs the pros and cons: "there is a genuine risk of business shifting overseas but we believe it will create new business and improve depth and allocation to Indian equities."
There are also over 15 exchange-traded funds (ETFs) based on Nifty or Sensex being traded on overseas exchanges in Europe and US, including on the SGX. Trading volume in these ETFs are however not significant yet to worry about. But it is picking up, at least in comparison with trades in depository receipts of Indian companies (ADRs in the US and GDRs in European exchanges).
A recent analysis done by Instanex Capital, a Bombay-based investment advisor, revealed that during October 2007 to March this year the trading volume in eight Indian ETFs listed in the US (four in NYSE and four in Nasdaq) made up for 16 per cent of the total trading in ADRs, GDRs and the eight ETFs. Its share was more than the 12 per cent share of GDRs while the balance 73 per cent was in ADRs.
Regulatory arbitrage (due to P-note restrictions) apart, increasing transaction costs can also provide an impetus to an impending transfer of domestic liquidity to international markets. Since the last one month the effect of the removal of tax benefits on securities transaction tax is being seen. "It has not only killed arbitrage volumes but impaired price discovery and led to fall in depth and breadth in the futures and options space," says HDFC Securities' Verma. "Why would FIIs want to trade in a market which is fraught with poor depth and even the cost of transacting is higher."
The way forward. BW learns that under the new Sebi chairman, C.B. Bhave, there is an openness to re-consider the ban on P-notes having derivatives as underlying. "The ban will be replaced with limits similar to those on P-notes with cash market positions as underlying," says a senior vice president, global transaction services, of a foreign-bank custodian that along with other custodians have been in extensive dialogue with Sebi in recent weeks.
Such dialogues resulted in Bhave recently reversing his own step in imposing upfront (initial) margins to FIIs for their trades in the cash market with effect from 16 June. Now, FIIs have to pay the initial margin on T+1.
For an opportunistic government, the dollar inflows problem seems to have subsided as seen from the latest relaxation in the external commercial borrowing norms. That might give Bhave a chance to persuade the government to allow it to relax the curbs on P-notes as well.
But it was also the issue of Indian hot money being routed through P-notes that was of concern to market players if not the government. Contrary to such concerns, Sebi, on 29 May, relaxed its FII regulations to allow international funds set up by non-resident Indians to be eligible for registration as FIIs in India with the proviso that they would not be permitted to invest their proprietary funds. "A well thought out approach that distinguishes between hot money and long term flows is required, though that is again easier said than done," says Verma.
In the meanwhile, the traders in many of the domestic brokerage firms look at SGX but not with wariness. The SGX opens when the Indian time is only around 7 am. They take cues from of the change in Nifty futures as a reaction to other global markets and events that happened overnight. "That Nifty is actively traded abroad only shows India is a hot destination and it is wrong to say that it is coming at the cost of volumes here," says R. Venkatraman, executive director at India Infoline.
But it is often the case that those could get hurt the most do not realise until it is too late. When NSE started its equities market in November 1994 with counterparty risks removed through the settlement guarantee it sucked in the greater part of liquidity from that on the BSE. Even though BSE followed suit after 2-3 years the comfort level of investors—domestic or institutional, large or small0—was established with the NSE. Today, the cash market trading volume on the NSE is more than double that of the BSE. The SGX threat should not be dismissed lightly.