Exchanges: Onwards and Upwards

28 Mar 2024 , 03:00 PM

Analysts of IIFL Capital Services interacted with Mr. Sundararaman Ramamurthy, MD and CEO of BSE Ltd., so as to understand the potential of the Indian Capital market and the prospects of BSE Ltd. He firmly believes that Capital markets in India are still under-penetrated and will see huge growth, given the favourable demographics, rising income levels and wider participation aided by technology. On the exponential equity derivative volume growth in the Indian market, he is not overtly concerned, as he believes that the strong risk management guardrails mitigate any systemic risk. As for BSE, he is confident of further volume ramp-up — both in the Cash and Derivative segments — aided by higher participation. On the Equity Option segment’s profitability, he shared that further tariffs hikes would be taken at the appropriate time as well as they are in discussion with NSE to optimise the clearing and settlement costs.

The Indian Capital market has grown exponentially in the last few years. What are the factors driving this growth and is there headroom to grow more?

In the last four years i.e. over FY20-24 – retail participation in the Capital market has been growing. This is evident from the ~4x jump (to 150mn) in demat accounts and ~3x increase in (to 90mn) in registered investors on the stock exchanges. Such sharp growth is a concoction of multiple factors including India’s favourable demographic profile (a large part of India’s population is in the earnings age bracket) and the digitisation age, which is working as a catalyst for wider inclusion. Increasing literacy is helping people to assess the risk associated with financial investments; thereby increasing preference for financial assets. This can be substantiated with the rising trend of financialisation of household savings.

Favourable demographic and increasing access to technology to a larger population, is driving higher participation in the Indian Capital market

Regulations and Technology are also aiding deeper penetration. For instance, the increasing penetration of internet and mobile, and digitisation of broking — have led to an ease of trading, resulting in higher conversions. Also, a favourable regulatory environment enabling democratisation of information has ensured that small investors have equal access to material company information; thereby instilling confidence in the Equity markets. Despite the strong growth seen in the investor base in the last few years, penetration remains low vs PAN card holders or number of bank accounts. Favourable demographic (28yr median age and 2/3rd population falling in the income earning age (18-65 years)) and rising income levels (aided by a likely strong economic growth) — would lead to further addition in the investor base.

Volumes on exchanges have grown multi-fold, especially in the Equity Options segment. Do you perceive any risk?

Trading intensity in the stock markets has increased across countries, probably in varying degrees, in the last few years. Volumes in itself should not be seen as a risk; but what is important is the dispersion of volume concentration i.e. broker-wise, type of broker-wise, strikeswise, expiry-wise, etc. Many studies have been done in this regard, and there is nothing to suggest any systemic risk at the current volumes. In fact, India has one of the best risk management practices, given the superior regulations that have ensured market safety. Among many, the country has implemented a real-time, client-level, portfolio-based, upfront risk management system – this ensures that the margins are collected on a real-time basis directly from the client trading – this mitigates any pool risk at the broker level, exposing the system.

Further, concerns around volume decline during market correction may not hold, as Options are versatile product providing different strategies across different market behaviours. So, it is highly likely that in a bear market, new strategies would evolve; which could sustain or even drive volumes.

As far as BSE is concerned, one should not combine index volumes across two exchanges, as the products on the two exchanges are different. For e.g. Sensex and Bankex contracts can only be traded on BSE. Similarly, NSE indices can only be traded on NSE platform. These may be similar products, but would have their own market. Post the re-launch of its Equity derivative segment in May’23, BSE is seeing a liquidity build-up in its Equity Option segment and is confident of further growth with the increasing participation.

Are there any regulatory interventions that could help BSE gain market share?

The regulator is mindful of concentration and the risk associated with it. For e.g. any sort of technology risk or cyber security risk, coupled with high volume concentration, could impact market resilience. Thus, the regulator has always supported multiple trading venues to sustain and grow. In order to achieve this, regulators are ensuring a level playing field so that all the bourses have equal opportunity to grow. One such recent instance was the Aug-23 circular, which allowed all investors who were trading in any segment of an Exchange, to trade in the same segment in all exchanges without doing the KYC again. Regulator would consider any changes if it would lower the risk in the market.

In India, other than Equities, we have not been able to develop a robust secondary market for other asset classes such as fixed income, commodities, etc. Why is this?

For a product to be successfully traded on the exchanges, a healthy retail market is a must. Unfortunately, most of the bond placements in India are done privately. Thus, as there are no primary issuances to people at large; the scope for trading is limited. Same is the case with government bonds and treasuries. One of the solutions is to promote retail participation in primary debt issuances. This could be done through: 1) mandating minimum quota in corporate bond issuances for the Retail segment, as is the case in Equities 2) small and periodic government issuances for the Retail segment. With the increased retail ownership, the secondary market for fixed income instruments would also develop over time. This would not only lead to trading in bonds, but also in other innovative products such as interest rate derivatives, etc.

In commodities, although there is active retail participation, liquidity is seen in only a few commodities. This has restricted the overall market development. More innovative products and wider participant base (institutional trading is miniscule currently) are required to create depth in the Commodities market.

Internationally, market data monetisation is a big revenue driver for the exchanges – what is the potential of this in India?

Unlike in the West, the potential to monetise market data in India is limited. This is due to the evolution of regulatory structure in India, which keeps investor protection and investor knowledge as prime objectives. As the market data is a result of investors trading; the regulatory thought process is that this data belongs to the investors. Thus, an exchange is required to share market data with investors without any costs. As most of the data generated on Indian bourses is freely available (through trader work stations, websites, new channels, etc.), which across the globe is sold internationally — data monetisation is unlikely to become a major revenue stream for the Indian exchanges. However, if one is able to do value addition on such raw data, then this can be monetised. As of now, BSE is not working on this; but in long run, this could be a possibility. Having said that, it’s still unlikely to become a major revenue contributor for Indian exchanges.

BSE had a runaway success in Equity Options in a short span post the re-launch in May’23. How did this happen?

BSE was continuously losing market share in the Equity Cash segment and was struggling in the Equity Derivatives market for long. However, the re-launch of Sensex-30 contracts in May-2023 led to a steady increase in volumes. BSE’s market share in the Equity Options now stands at 18% on a notional turnover basis and 7% on a premium turnover basis. This success can be attributed to the product familiarity within investors and exclusive Friday expiry. In early 2023, BSE met around 350 brokers to understand what changes are needed to ramp up volumes on its platform. Among many inputs, key suggestions were: 1) to again introduce Sensex-30 contract (given its high recall) 2) ensure that the product expiry does not overlap with NSE expiries. The second suggestion was critical as trading member’s capital remains blocked on NSE expiries. For instance, in 2023 beginning, member’s capital was partly utilised on Tuesday, while fully utilised on Wednesday and Thursday. However, capital remained under-utilised from Thursday to Tuesday. Thus, it was obvious that BSE had to choose an expiry between Friday and Monday, and thus, Sensex-30 contract was re-launched with a Friday expiry on May 15, 2023. Another challenge was the weak trading eco-system around the BSE platform. On recommencement of Sensex-30 Options, only eight brokers had the complete infrastructure to trade on BSE. Two software vendors alone were providing software for BSE derivatives and a handful of back office vendors. The company worked seamlessly to re-build this ecosystem and today, there are 400+ brokers trading on BSE. All front-end providers have started coming in. New vendors are developing front-end solutions and seeking the company’s approval. All back office vendors, too, are supporting the BSE platform now. All these factors have been the key reasons for ramp-up in volumes on the BSE platform.

After the successful launch of Equity Derivative segment, what are the targets for FY25?

In FY25, BSE would focus on increasing investor participation in both its key products i.e. Equity Cash and Equity Options. In 2023, the company targeted brokers, while in 2024, the target would be financial institutions – both domestic and FPIs. In the Equity Cash segment, BSE has seen an improvement in market share from 5-6% to 8-9%. The company is now targeting 15% market share, supported by higher traction on its derivative platform. The company believes that more than the cannibalisation of volumes, it will be the market’s expansion with increased participation from algo and retail players in both segments. BSE would specifically target domestic institutions, so as to increase share of trading in the Equity Cash segment. FPIs, in the absence of a single VWAP, are likely to come in gradually.

As far as Equity Options are concerned, BSE does not compare the market share, given that the two exchanges offer different products (though similar in nature). Thus, target here is to increase participation, both retail and institutional, and improve liquidity on non-expiry days. Targeting 100 more brokers (to 450) to trade regularly on the BSE derivative platform as well as increasing FPI participation from 60 to 250. Increasing FPI participation is also likely to aid create liquidity in far month contracts vs only on expiry day currently (~99% of BSE’s volumes comes on expiry). The endeavour is to achieve trading on all days of the current week as well as in the following weeks and months.

BSE’s market share in Equity Options have picked up, but revenue share and profit share remain low. What steps are you taking to improve this?

Unlike volume share, revenue share is much lower. This is because BSE is still charging much lower (Rs50 per mn of premium turnover) than the market leader; only in November’23, BSE increased tariff on its current week Sensex-30 contract — still ~30% lower than the competition. BSE has been mindful of not hiking tariffs sharply, given the low liquidity in its underlying contracts and resultantly, the concern of higher sensitivity to pricing. The increase in Sensex contract was taken, considering the impact on the bid-ask spread; the same would be done for Bankex contract as well at an appropriate time. Higher tariffs would improve both revenue and profit share.

As far as profits are concerned, the segment is hit be three things: 1) low tariffs as discussed 2) lower premium ratios, as most of the BSE volumes are on the expiry day 3) higher impact of clearing and settlement (C&S) charges, given lower value per trade on BSE. The first two parameters are partially in control of BSE; however, C&S charges are payable as per a bilateral agreement signed between Exchanges and Clearing Corporations. The interoperability of clearing corporations, since FY20, allowed members to choose a clearing corporation to settle all their trades across exchanges. Given that most large-members chose NCL for their clearing and settlement of trades; any trade done by such members on BSE requires BSE to pay a fee to NCL for clearing and settlement and vice-versa. It is these charges that BSE pays to the other clearing corporation that partially impacts its profitability in the Equity Option segment. As the C&S charges are payable either on the basis of contracts traded or value of premium (whichever is higher); while revenue is earned on the premium turnover — the lower premium value per trade of BSE (1/3rd of NSE) is resulting in lower profitability.