Indian elephants have the longest gestation period of any mammal (22 months) and waiting for the baby to be born requires great patience. The gestation period for Indian futures has been twice as long. So long that some of the pioneers of Indian futures have grown bored and jumped ship for faster and more nimble boats. A few months back, the VP overseeing the futures effort at the National Stock Exchange of India grew frustrated and left to join a new dot.com sponsored by a large Indian concern.
But after waiting almost half a decade for regulatory approval, financial futures have come to India. In many emerging markets (Korea, Mexico, and Argentina for example), the advent of futures means that a monopolistic stock exchange opens the only game in town. Not so in India. Here there will soon be three exchanges battling for market share-the oldest exchange in Asia; a six-year-old, gutsy start-up; and an offshore regional predator. This will be a real fight.
Here's the story in a nutshell. The Indian SEC, known as SEBI (for Securities and Exchange Board of India), has decided that financial futures will begin in June with stock indexes and it has approved two exchanges to begin trading on two different stock indexes as soon as certain criteria are met. Options will follow later as will other futures products. The two exchanges are the National Stock Exchange of India (NSE), the gutsy start-up mentioned above, and the Bombay Stock Exchange (BSE), which opened its doors in 1875, three years before the Tokyo Stock Exchange. As we go to press, the NSE says they'll start June 12. The BSE says they'll start soon. And across the Bay of Bengal to the southeast, the Singapore Exchange is rumored to be planning a late summer launch of indexes on India's stocks. Being a foreign exchange, it does not need SEBI's approval.
To understand this competition over Indian index futures, you must first understand the war that has taken place in Indian equity markets over the past decade. In the early 1990s, there were 22 stock exchanges in India. These included 20 small regional exchanges in places like Delhi and Calcutta, a less-than-successful experiment called the Over-the-Counter Exchange of India (an oxymoron to begin with), and the Bombay Stock Exchange.
Bombay is the financial center of India and is home to all the major financial institutions. Given its Bombay location, the BSE would naturally capture the bulk of the business and it did-a 75 percent market share in a field of 22 to be exact. Asia's oldest exchange was for years a well functioning club that produced comfortable results for its members, but perhaps less than exceptional service to investors. Commissions were high and transactions anything but transparent. And until the creation of SEBI in 1988, the BSE was an unregulated market. Even when SEBI tried to implement relatively modest reforms in the early 1990s, reforms like requiring brokers to register and to unbundle commissions from transaction prices, the BSE balked and BSE members went on strike.
In order to create competitive pressure for BSE to reform itself, the Ministry of Finance made the bold decision to create its own exchange, the National Stock Exchange of India. While to Western free-market ears, this sounds like a prescription for failure, the NSE turned into a raging success, surpassing the BSE in turnover within its first year (see chart below). The new start-from-scratch exchange dominated the oldest exchange in Asia in less than 12 months.
Here was the plan underlying the success. The NSE would:
* Increase transparency by trading via an electronic limit order book. (BSE was open outcry with market makers.)
* Increase breadth of the market by allowing trading from all over India via satellite technology. (BSE brokers had to be present on the floor of the BSE.)
* Reduce costs by setting a small and uniform tick size of .05 rupees, about a tenth of a cent. (BSE ticks were five to 25 times larger.)
* Reduce investor/broker conflicts of interest by eliminating brokers from governing the exchange. The NSE would be owned by public-sector financial institutions and brokers would not be allowed on the board of directors. (In contrast, BSE brokerage firms owned and ran the BSE.)
A good business plan is not enough-there are thousands that fail. People make the difference. The crack team of five star performers seconded from the Industrial Development Bank of India, the major public-sector shareholder, made the difference. They were young, bright, naive and devoted untold hours and creative energy to making the NSE a success.
Through low fees, small ticks, greater transparency and truly national reach, the NSE significantly expanded the investor base and the level of turnover. But all of the new business initially went to the NSE while the BSE languished. The BSE quickly got the message and embarked on a road of significant reform. The BSE is now also an electronic exchange and has been growing again during the past several years. So the Ministry of Finance's plan worked. The BSE's instinct for self-preservation spurred reforms.
The push for futures markets began at the NSE. Initially, the BSE fought the idea. Their system for stock trading already had some features of futures markets. They didn't need futures and neither did the country, they argued. The BSE was able to slow the process and was partly responsible for the four-year delay in approval of futures, but eventually the idea became too strong to resist. If futures were inevitable, the BSE wanted to be a major player.
Asian Stock Indexes
Does the history of stock index futures in Asia tell us anything useful for analyzing the Indian situation? Perhaps. As elsewhere, some countries (like Korea) have had spectacular success, while others (like Malaysia) have seen more limited achievements. Korea traded 270 times as many stock index futures and options contracts as Malaysia during the first quarter, even though the Korean market capitalization is little more than twice the size of Malaysia's. India will probably do better than Malaysia, but not as well as Korea. India's market cap is actually a bit greater than Korea's, but the Korean success is too much of an outlier to be easily repeated. Besides, market cap is not the best guide to futures success.
The second lesson is that better designed indexes are not necessarily more successful. In Japan trading is split among three products: the Nikkei 225 and Nikkei 300, both listed at the Osaka Securities Exchange, and the TOPIX, listed at the Tokyo Stock Exchange. The Nikkei 225 was the name-brand leader, the Dow of Japan, and has always been traded much more actively than the TOPIX. In 1996 the government forced the introduction of a better-designed Nikkei, containing 300 stocks in a capitalization average (similar to the S&P 500). It was a technically better index, and the Japanese government exerted tremendous pressure to trade it. Despite the pressure for the 300, the 225 still trades 6.5 times more volume in Japan and 100 times more volume at SGX than the 300. The lesson for India is that the better designed Nifty will not necessarily dominate the much more popular Sensex.
NSE vs. BSE
The NSE has a lot going for it in this battle. It started before the BSE, often a huge advantage in head-to-head competition. (At press time, the NSE had a June 12 start date and the BSE had not yet committed to a specific day.)
The NSE devoted considerable time and resources to construction of a better index. The S&P CNX Nifty was carefully designed to be broader (it has 50 stocks vs. the Sensex's 30) and more highly correlated with a large number of different portfolios, making it a more effective hedging tool. At the same time it allows arbitrageurs to take cash positions with a lower market impact and thus overall lower cost than is true with the Sensex. The product was created for the NSE by a couple of market savvy and well-respected researchers at the Indira Gandhi Institute for Development Research-Ajay Shah and Susan Thomas. One sign of the success of the new index is that more index funds are now based on the Nifty than on the much older Sensex (Nifty 4, Sensex 1). In addition to local investment companies, at least one international investment company has decided to create a Nifty-based fund. The S&P name will likely help the Nifty to gain international acceptance.
Despite the quality of the Nifty, the BSE Sensex has one huge advantage-it is the old, established name-brand index of India. It is the index referred to in TV, radio and newspaper reports on the market. When you ask what the market did, you really mean what did the Sensex do. It is the Dow Jones Industrial Average of India.
The NSE knows this and is pulling out all the stops. It has held educational seminars in 50 cities (the BSE has done only a handful). It is distributing posters, telephone diaries and pocket calendars to call attention to the newer Nifty. And it has been very proactive in training potential trading participants. SEBI requires the personnel of trading members who will be involved in the derivatives markets to pass a financial certification exam. The NSE has trained about 2500 people for this exam, compared to the 100 or so trained by the BSE.
When it comes to participants, the BSE still has the best relationships with the Bombay-based institutions. The NSE, on the other hand has the better reach throughout India. It has terminals in 350 cities vs. the BSE 200 cities. And the daily turnover at the NSE is about 50 percent higher than that at the BSE.
SGX vs. India
The NSE took a surprising gamble and invited another competitor into the arena. It allowed the index it is using for futures, the S&P CNX Nifty, to be licensed to SGX. The risk, of course, is that SGX with its well-developed infrastructure and distribution network could divert all foreign, and even some domestic business to Singapore. SGX has beat out local markets before. SGX dominated trading in the Nikkei 225 for some time because it launched earlier and was much cheaper than the Osaka Securities Exchange. It started earlier with a Taiwan futures index and is currently trading at four times the level of the home-grown product at the Taiwan Futures Exchange.
So what was the NSE thinking? Perhaps they reasoned that SGX would list some Indian index (for example, SGX has a relationship with Morgan Stanley for listing Asian stock indexes), so better that it should be the Nifty, giving the index more international exposure and credibility. Perhaps it was a hedge. If SGX wins out, at least the NSE will earn licensing revenues from a SGX success. Or the decision may stem from the fact the NSE co-owns the index, in fact it co-owns eight Indian indexes, through a joint venture with CRISIL (Credit Rating and Information Services of India Limited). CRISIL is the Moody's of India. It would be in the interests of this joint venture to license many competing exchanges in order to maximize licensing fees and NSE would be putting its own self interest above that of the joint venture if it balked at licensing SGX.
Whatever the reason, the deal is done and it does raise the tension regarding the final outcome of the story. Will the NSE win because of its preparedness and hard work? Will the BSE win because it is sitting on the most popular index in India? Will SGX win because it is a well-oiled machine? Or will the story end with SGX doing the international business and one of the two Indian exchanges doing the domestic business? Stay tuned.
Mike Gorham is a professor of financial markets in the Center for Law and Financial Markets at the Illinois Institute of Technology. E-mail: firstname.lastname@example.org.
Michael Gorham is director of the Division of Market Oversight at the Commodity Futures Trading Commission.