About a decade ago, the Indian stock market had a reputation as something of a casino. The Bombay Stock Exchange (BSE) in Mumbai was controlled by powerful brokers and buzzed with hot tips that promised huge profits but were thinly disguised tools of market manipulation. The securities market regulator had yet to assume charge, trading was done by open outcry and the markets were not yet open to foreign portfolio investors.
Since then, India’s securities markets have changed dramatically. Trading in the equity market is now done on electronic terminals around the country, paper shares and bonds have all but disappeared, a clearing corporation now guarantees settlement of trades and settlement has been crunched from a fortnight to just two days after trade.
Various crises forced reform. In 1992, a stock market scam revealed the ugly underbelly of the capital markets. Several state and foreign banks were defrauded of large sums, siphoned off from the government securities market to fuel a stock market rally. Mumbai stockbroker Harshad Mehta and several top bank officials were arrested, a parliamentary panel was set up to determine how to clean up the financial system and the government decided to overhaul the securities markets. U R Bhat, head of equity at JP Morgan Chase, says: “After the securities scams of the early to mid-1990s, the government resolved to fix the problem, even if it meant taking on the powerful broker cartel.”
Modern exchange
India’s then finance minister Manmohan Singh, the architect of India’s economic reforms, mandated the Industrial Development Bank of India, a state financial institution, to establish a new, modern securities exchange. Among those who drew up the blueprint for the National Stock Exchange (NSE), India’s first demutualised stock exchange that led the reform of the Indian securities markets, was R H Patil, a development banker who later became the NSE’s founder chairman. “Our mandate was to set up a nationwide securities exchange that would offer modern trading facilities across the breadth of the country,” he says.
A Hong Kong-based consultant was appointed and in eight months the plan was ready. India’s biggest state-controlled financial institutions owned the exchange and entrenched lobbies, particularly linked to the broker-controlled BSE, opposed it even as plans were afoot to protect its turf. “We saw that there is a conflict of interest when brokers manage an exchange,” says Dr Patil. Egged on by the market regulator, the BSE is also moving towards demutualisation, though some question the merit of making the two national exchanges identical to each other.
No single global exchange was used as a role model for the NSE; even the New York Stock Exchange was not fully electronic, says Dr Patil. “We looked at NYSE systems for the big stocks that they traded, Nasdaq for its spread and the Mexican and Vancouver securities exchanges for their modern trading systems,” he says.
The new exchange was conceived as one that would extend across the country, using satellite communication network technology to make modern trading systems available to individual investors as well as large institutions. The NSE started electronic, screen-based and order-driven trading in mid-1994 and within a year it became the largest equity exchange in the country, surpassing the BSE. About 365 cities have NSE trading screens. The BSE launched electronic trading a year later.
All of India’s stock exchanges now operate a screen-based trading system. In February 2000, the NSE launched internet trading, which gave investors direct access to the cash market, and the BSE followed in March 2001. Today it provides access through hand-held devices using wireless application protocol (WAP) technology.
Market leaders
Consolidation is under way and there is virtually no trading on half of India’s 23 exchanges. The NSE and the BSE accounted for 63.7% and 32.4% of turnover at the end of March 2003. The BSE is being transformed into a “process-driven” organisation, and Rajnikant Patel, BSE chief operating officer, says it is the first stock exchange in Asia to meet the ISO 9001 norms for its surveillance system. Trading in equity derivatives was launched in 2001 on the BSE and NSE, and the NSE has a dominant market share in cash and derivatives trading.
The roots of the NSE’s success lie in the fact that it made the market democratic, transparent and efficient. Unlike other securities exchanges that were exempt from income tax, the NSE was set up as a company that paid corporate taxes. Brokers from small cities and towns, eager for business but finding it hard to break into the closed club at the BSE, were the first to join. The NSE made educational qualification mandatory for membership, and nearly half of its 872 members are first-generation traders, several of them professionally qualified. Unlike the BSE, the NSE does not restrict the number of trading members, and member fees are refundable.
A hit with investors
Investors loved the new system. For the first time, an investor anywhere in the country could see their order inputted into a computer and the transaction completed on screen. The price was transparent and the broker commission was a fraction of that paid in the past. The maximum brokerage chargeable by a broker is fixed at 2.5% of the contract price. A trading member on the NSE pays the exchange transaction charges of 0.004% (Rs4 per Rs100,000) of the cash market turnover, and Rs2 per Rs100,000 of the derivatives market turnover.
Moreover, on the NSE, a clearing corporation is the legal counterparty to all transactions, and it guarantees the settlement of all trades irrespective of whether members meet their obligations. This has eliminated counterparty risk and was a key reason why the new trading system quickly replaced the old one. The NSE’s clearing corporation is backed by a Rs23bn ($510m) settlement guarantee fund.
As trading volumes soared, new risks emerged. “Settlement of trades was still done with paper securities and this posed a huge risk to the new exchange which guaranteed settlement,” says Dr Patil. The screen-based, order-driven system aggregated securities from sellers from all over the country to meet a large buy order. Back then trades were settled once a fortnight, and weeding out forged paper and authenticating share certificates from the company was a nightmare for the clearing house.
The task of introducing paperless trading or dematerialising shares was entrusted to the National Securities Depository (NSDL), which was set up in 1996 and now has five million dematerialised accounts. A second depository, the Central Depository Services, was set up by the Bombay Stock Exchange a few years later. Both depositories are electronically linked.
C B Bhave, managing director of the NSDL and a former Securities and Exchange Board of India (SEBI) official, says: “The question before us was: where do we start the process? We had a rough estimate of the task at hand. Around of a third of shares lay with core shareholders of companies and were not traded, another third each was with institutional and retail investors who traded them. We began with institutional holdings in about eight large stocks.”
Jayesh Ghia, senior vice-president, operations, at DSP Merrill Lynch, recalls trading with paper securities, when the delays and risks involved in transfer of ownership routinely took up to six months, during which time the owner could not sell the securities. “The cost of ownership of securities collapsed almost overnight from 50 basis points to just 2bp or 3bp,” he says. More importantly, a large amount of bad paper was weeded out of the market.
Trading goes paperless
Issuers of securities and investors quickly took to paperless trading and it was extended to 30 stocks. In 1997, all subscriptions to initial public offerings could only be through a dematerialised account – the recent $3bn sale of government shares in six companies in February and March this year was completed entirely in electronic form. By 1999 almost all trading and settlement was paperless.
What made the Indian experience a challenge, says Mr Bhave, was that more than 5000 companies traded on its stock exchanges as well as large numbers of people who owned small numbers of paper shares.
The stock market was prone to price manipulation and the new rules sought to make manipulation difficult, costly and punishable. The clearing house imposes limits on turnover and exposure on each member in relation to their capital, or the funds and securities they keep with the exchange. At the NSE, gross intra-day turnover (buy plus sell) of a member can not exceed 33 and a third times their base capital (cash plus securities deposit). Gross exposure (aggregate of cumulative net outstanding positions in each security) at any point in time cannot exceed 8.5 times free base capital up to Rs10m. The exposure of a member with a higher capital base is calculated at Rs85m plus 10 times the capital in excess of Rs10m.
The clearing corporation monitors the exposure limits of trading members online in real time. Alerts are built in at pre-set levels that warn members approaching their limits at 70%, 85%, 95% and 100%. It automatically disables members who exceed their limits.
Circuit breakers
A daily margin comprises both a mark-to-market margin and a value-at-risk margin. The margins are computed at client level and paid by trading members on T+1. An index-based, market-wide, circuit breaker system applies when the index moves either way by 10%, 15% and 20%. These circuit breakers bring trading in all equity and equity derivatives markets in India to a halt. A movement in either of the two benchmark indices, the S&P CNX Nifty or the BSE Sensex, can trigger the circuit breakers.
The main business at India’s regional exchanges emanated from a system in which trades were settled once a fortnight, with different account settlement days for each exchange. This allowed speculators a free hand, as they could shift open positions from one exchange to another without settling them, says the BSE’s Mr Patel. Matters came to a head in 2000, when Ketan Parekh built up dangerously high positions that caused a stock market crash and a payment default on the Calcutta Stock Exchange. Soon afterwards the SEBI shortened the settlement period for equity trades from a fortnight to a week and in July 2001 all exchanges adopted rolling settlement (trades are settled a fixed number of days after the trade is executed). In the same year, settlement of equity trades was shortened to T+5, then in April 2002 to T+3 and finally to T+2 in April 2003.
This put the Indian securities markets ahead of the G30 recommendations which prescribe that final settlement for all trades should occur no later than T+3. According to the Standard & Poor’s Settlement Benchmark, which measures settlement efficiency across securities markets, India’s score improved from 8.3 in 1994 to 89.3 in 2002 (source: S&P’s Fact Book 2002). And in the Operational Risk Benchmark (which takes into account the level of compliance with G30 recommendations, the complexity and effectiveness of the regulatory and legal structure of the market and counter-party risk) India moved up from 28 in 1994 to 65.2 in 2002.
T+1 target
Indian regulators have drawn up an ambitious plan to put Indian markets at the forefront of international securities settlement by moving to T+1. Initially slated for April this year, the market regulator now says it will happen once a real-time gross settlement (RTGS) system for payments is in place.
Yet exchange officials, traders and foreign brokerages do not appear too keen on the move. An equity trader at a foreign brokerage says: “Most foreign brokerages have their trading desks, back office and custodial services in different time zones around the world. Validating and completing trades by T+1 is not something they are ready for.”
DSP Merrill’s Mr Ghia points out that the foreign exchange market still works on T+2. And the firm’s head of research, Andrew Holland, says the Indian authorities should relish the dramatic progress achieved so far in modernising settlement and clearing systems to world standards. JP Morgan’s Mr Bhat says: “It might be pushing the system too far too soon.”
Upgrading the payment system to meet the needs of T+1 will be a challenge, particularly in the hinterland. India’s vast banking system is dominated by 27 state banks and is not yet fully computerised. “Traders in small towns have a tough time bringing in funds even with T+2,” says an NSE spokesperson. Electronic funds transfer, which enables inter-bank transfer of funds within two hours, is available in about 8500 (15%) of bank branches, and only up to Rs20m per transfer. Most clearing banks for the BSE and NSE are high-tech private or foreign banks, but their network is limited outside major cities. Straight-through processing, introduced in December 2002 for institutional investors, will be available to others from July.
Reform in the bond markets kicked off in the early 1990s, when interest rates were deregulated. “Once markets were free to set interest rates, market intermediaries or primary dealers became necessary who would underwrite offerings, create liquidity and offer two-way quotes,” says Anil Ladha, senior vice-president at ICICI Securities, one of the six primary dealers for the gilts market appointed by the central bank in 1995. That has now been expanded to 18 primary dealers, including foreign dealers such as JP Morgan.
India has a large, liquid government securities market and an underdeveloped corporate bond market. A major part of India’s rupee corporate bonds are privately placed with investors, and outside the purview of the market regulator. Trading in the debt market, dominated by institutions, is largely done by telephone. The trades must then be reported electronically on the Negotiated Dealing System (NDS) of the Reserve Bank of India, the central bank. Market participants hold a subsidiary general ledger account with the bank to trade securities.
Debt market review
A contentious issue that is being debated in the context of debt market reform is whether this “inefficient” and “opaque” system should be replaced, as it has been in equity trading, by an order-driven, screen-based trading system that is accessible nationwide and is open to retail investors. V Harikrishnan, senior vice-president and head of operations at ICICI Securities, says: “Under the NDS system, the trade is reported as an afterthought once it is clinched on the telephone and it does not have the finality that an equity transaction on screen has. Moreover, the seller reports the trade to the NDS and the buyer approves it once the deal is clinched on the phone. Sometimes there are delays.”
The NSE, as can be expected, backs the screen-based system while debt market brokers – who could see their commissions shrink if that were to happen – say the existing system works well enough.
In January 2003, the central bank gave this reform a regulatory push when it allowed trading of national government securities on the NSE, BSE and the Over-the-Counter Exchange alongside the NDS system. Settlement is through a deferred net settlement system based on contractual agreements between the banks and the Clearing Corporation of India. This nets the sell and buy positions of members over a period of time, and each member settles only the net amount on a specified day.
The move towards a full delivery versus payment system for settlement of government securities will happen once RTGS is in place and cash and securities are exchanged continuously throughout the day.
Reforms pay off
The economic benefits of reform to the securities market are enormous. Foreign portfolio investors have invested more than $25bn in Indian stocks; the cost of raising capital is reduced for companies, and the Indian securities markets are safer than ever before. Turnover on India’s equity market grew from Rs1640bn for the year ended March 1995, to Rs9689bn for the year ended March 2003.
“It is hard to eliminate market manipulation but you can make sure than no-one can manipulate it without paying the costs,” says Mr Holland.
The margin system and risk control reforms have vastly improved the integrity of the market, says Mr Bhat. “It made the market anonymous. Before, there were always rumours about who controls the market and for whom.”
