Lower costs, more risks

The effects of competition between exchanges

The competition between the National Stock Exchange, or NSE, and its rival MCX-SX, which is gearing up to launch equity and debt operations on Diwali, promises to be tough. MCX-SX has embarked on an aggressive membership drive, offering favourable terms for fees, deposits and net worth criteria, including discounts for professionals and members from non-urban areas. The NSE has countered by creating a new Alpha membership class. It has halved its deposit and net worth criteria as well as waived initial membership fees and allowed existing members to convert to Alpha. Though the NSE’s deposit and net worth criteria are higher than in the proposed MCX-SX structure, transaction costs will reduce to near-zero for some NSE members. The Bombay Stock Exchange, or BSE, which has the lowest deposit structure, will likely respond similarly, since it cannot afford to be left behind. And then there’s the Delhi Stock Exchange, which is setting up a state-of-the-art trading platform, courtesy its technical collaboration with the London Stock Exchange.

Competition between the exchanges could lead to an expansion of high-frequency trading (HFT) in particular. Members with co-located terminals directly linked to exchanges stand to gain the most. Algorithmic HFT generates around 20 per cent of current trading volumes and may rise. At present, the NSE logs about 80 per cent of cash market volumes, and the BSE 19 per cent. In the equity futures and options segment, ratios are less lopsided. The BSE generates a large share of index option transactions; the NSE leads in the stock futures segment. MCX-SX will ideally expand the market. Its launch is timely: recent policy actions have put heart back into the trader community and inflows from foreign institutional investors have also increased. Competition should also promote greater trading efficiency. Price discovery will improve as friction in the form of transaction costs is reduced. The presence of high-frequency traders guarantees that even small price imperfections will be arbitraged. Client members, and even small traders, will shop for the best deals, since the exchanges will all offer much the same products with a few tweaks. For example, MCX-SX reportedly intends to launch a proprietorial index to compete with the Sensex and the Nifty. However, the number of index-construction methodologies is limited and the new index is unlikely to be very different in nature from the existing ones.

Financial instruments are inherently volatile. Derivatives are also highly leveraged. HFT can cause sudden volatility spikes, as in so-called flash crashes. Big price swings are always on the cards on Budget day, or during elections, or if there is a “black swan event” such as a war, natural disaster or terrorist strike. The integrity of the margining system is crucial. Indian exchanges use standardised VAR (value-at-risk), SPAN (standardised portfolio analysis of risk margin) and exposure margins. At need, member deposits can cover margin calls. There have been occasions when the system has been stretched by exceptional events, but there has never been a systemic default. However, if deposit and net worth criteria are lowered, the risks of default will rise on big days. The market regulator will have to keep an eagle eye on the margin system and ruthlessly ensure compliance if the benefits of more competition are to be enjoyed without exposing the financial system to excessive risks.