The Present State of the Indian Capital Market

The Indian capital markets are entering an important phase of both technological and regulatory evolution. The economic crisis showed that, while the ‘decoupling theory’ was not necessarily true, it had some things right. There was an exodus of foreign funds from the market, but it remained resilient – ample proof that the risk management and regulatory norms were more than capable of providing a stable market environment. This, and the fact that India has been one of the rare growing economies across the globe, have made the Indian markets an important investment destination.

However, there are fundamental problems in the Indian capital market structure, such as lack of liquidity and limited depth and breadth. Many listed securities on stock exchanges are not traded; among the traded securities, not many are traded actively. The market is highly concentrated; a few companies dominate trading at the exchanges. This clearly narrows the breadth of the market, giving rise to liquidity problems for many stocks. Geographic breadth is another problem for Indian markets. Around 80% to 90% of total cash trading and 70% to 80% of mutual fund ownership come from the top 10 cities, with the top two cities (Mumbai and Delhi) accounting for about 60% in each segment. This implies that a large portion of the population is untapped. These shortcomings can be addressed by technology development, better regulations and focus on financial inclusion. India’s capital market regulator, Securities and Exchange Board of India (SEBI), has been addressing many of these issues.

Although the equity market in India is vibrant and developing fast, the debt market is lagging by some distance. The debt market is dominated by government securities. The corporate bond market is very small for a number of reasons, including lack of market infrastructure and adequate regulatory framework, low liquidity, lack of investor interest, etc. Stringent regulations for foreign and domestic institutional investors, and the conservative investment policies of domestic financial institutions, hinder them from investing in the corporate debt market. Efforts are being made to develop the corporate bond market. Some of the measures include increasing the limit for foreign participation, reducing issuance and transaction costs for corporate bonds, applying similar mark-to-market accounting requirements for loan and corporate bonds to discourage banks from relying heavily on loans, and setting up a basic framework of credit default swaps on corporate bonds in the country. Some positive results have been observed in recent years, but debt market development will require long-term efforts and commitment.

Derivatives Market

By contrast, India has a healthy exchange-traded derivatives market. India started off with trading in derivatives in the early 2000s, initially allowing trading in index futures (2000) and index options (2001). Options and futures on stocks were allowed in 2001. Since then the product universe has expanded, as has the investor base, resulting in higher volumes and a robust trading platform with sound risk management practices. Index futures and options and stocks futures dominate derivative contracts traded at Indian exchanges.

The investor segment is broadly classified into retail and institutional segments. The retail segment brings in the volume, but its trades are essentially low value. A key concern has been this segment’s drop in participation in the secondary market and also in initial public offerings (IPOs). This decline began with the crisis in 2008, but the lackluster performance of most IPOs has contributed to what has become an alarming drop. Foreign institutional investors (FIIs) have been a dominant contributor to Indian markets. Since economic reforms started in 1991, India has focused on attracting foreign investment flows by relaxing eligibility conditions for FIIs, relaxing investment limits and expanding investment instruments.

A key reason for the success of the Indian capital markets has been the efficiency of SEBI, the capital market regulator. Four regulators control the participants in the securities market. There have been turf wars, and the future might see a super-regulator.

The intermediaries in the market include the exchanges and brokerages. India has 22 stock exchanges registered with SEBI, with over 8,000 registered brokers and over 60,000 registered subbrokers. However, most of the trading takes place at the two major pan-Indian exchanges, National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). NSE is the largest exchange in the country, with around 70% of the equity volumes, while BSE is the second largest. Exchanges are upgrading their infrastructure as they turn more competitive to gain market share. The entry of MCX-SX has opened up the possibility of a highly competitive future for the investors, with a number of products to choose from. Brokers, both domestic and international, are competing in a highly fragmented market. The next wave of growth will probably arise out of technological capabilities, and hence brokerages are trying to outdo each other by providing advanced trading tools such as direct market access (DMA) support and algorithmic trading solutions.

Brokerages are entering a highly competitive era with consolidation and new alliances appearing on the horizon. On the institutional side, domestic brokerages seem to be holding their own despite the intense competition from foreign brokerages. In the retail segment, increasing the user base has been the predominant focus of the incumbent players. In the past few years, the market has seen a few domestic brokerages shifting focus towards the retail segment, while a few big retail players have made the transition towards the institutional segment. Domestic institutional brokerages in India have been the followers of their international counterparts in terms of market share, innovation, technology, and product expertise. However, the industry is on the verge of a new order where these brokerages are expected to increase their market share. They have become more sophisticated in product offerings over the years. Another advantage the domestic brokerages have is that their domestic clients are growing quickly and becoming more influential in the capital markets at a time when many FIIs are still plagued by the home market syndrome or still finding their feet after the credit crisis. Going forward, it is the domestic brokerages that are expected to perform better.

The Adoption of New Technology

India has been an early adopter of the various technological changes occurring in the capital markets. With electronic trading picking up along with the adoption of the internet, booming retail equity business evolved in the past 10 years. Surprisingly, due to the market boom and IPO bonanza, retail adoption of technology initially outgrew technology adoption on the institutional side, where voice brokers still played a large part. As foreign participation in the Indian markets picked up, it brought in a rigor and technological requirement essential for international competition leading to adoption of the latest technologies by domestic market participants.

The basis of all technology adoption is connectivity, a fundamental building block for advanced trading techniques, and it involves support for smart order routing, colocation facilities, end-to-end electronic trading systems, and multiple venues. In India, multiple venues and colocation facilities are available. India has traditionally operated in a multi-exchange environment. Colocation has been a recent addition, with both NSE and BSE providing support for the buy side to access colocated servers. But the service does not make much sense unless latency is reduced in other aspects of the trade.

For DMA clients, co-location provides faster execution support. With proprietary trading business on the rise in India, the proprietary traders will adopt colocation services, and this will be a key revenue source for exchanges in the years to come.

DMA, launched in 2008, has still not picked up, but with the internationalisation of the Indian equity markets, adoption is accelerating. DMA is also boosting the growth of execution algorithms as more and more international players provide algo trading solutions for their customers. While the advantages of DMA are there for all to see, the launch of DMA coincided with the crisis, and this impacted adoption. The timing could not have been worse – brokerages and institutional equity firms cut down on their IT investments. Thus 2008, which was supposed to be the peak adoption year for DMA, was in reality a disappointment. There has been a positive response from the brokerages, as well as exchanges, regarding adoption of DMA of late. The sophistication of the market has not yet reached a stage where alternative trading systems or dark pools will be supported anywhere in the near future. Regulatory issues, as well as lessons learned from the economic crisis in other markets, have put a hold on the adoption of these technology tools. SEBI has recently approved the usage of smart order routing (SOR), and it will be available to all classes of investors. This is a positive move for all market participants and will enable investors to execute their trading strategies more efficiently.

The foreign brokerages, which already possess the technological capabilities and know-how, are bringing a sea change in terms of the technology adoption among the domestic brokerages. In an already fragmented brokerage market, any technique to increase market share is embraced. One key differentiator was the technological one – foreign brokerages appeared to be technology savvy. Now, this is changing. To gain market share, even from foreign investors, domestic brokerages are driving technology adoption, with the top players already ready for DMA. DMA remains high-touch, mainly due to regulatory requirements and constraints. However, even this manually intrusive DMA has reduced manpower and costs, and the brokerages are starting to appreciate this efficiency improvement. Fully automated DMA stands as a distant dream, with the regulator not yet fully convinced about the implications of such a system.

Conclusion

India’s advantage lies in its sound regulatory environment, which shielded the markets – to some extent – from larger negative impacts of the global financial crisis and helped it regain its mark quickly afterwards. The regulator has been cautious in expanding the market, and transparency and investor protection have always been high on its agenda. This has sometimes created conflicts with industries as well as among regulators, but it has taken the markets along the right path of development.

Expansion of the retail base of investors remains an issue. SEBI’s moves of late have paid particular attention to this, and there is country-wide emphasis on financial inclusion from a number of regulators. Low financial literacy and the geographic breadth have been barriers to achieving this goal. With the advancement of technology in trading and distribution, this is likely to be overcome. The first phase in advanced technology adoption in the Indian capital markets is under way.

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