By James E. Shapiro
When I accepted a job in the Indian financial markets six months ago, my thinking was simple. First, I believed (and still believe) that India has an once-in-a-lifetime opportunity to pull away from the pack and establish itself as the largest and most dynamic financial market in Asia. Second, I thought I could contribute to the efforts of my new employer to compete more effectively and grow its business.
From most perspectives, the opportunity in Indian financial markets today is spectacular. There is the confluence of factors that – unless some or all of them are seriously derailed – will allow Mumbai to emerge as a major global financial center.
First, India has the virtue of a large domestic market. In Asia, this gives China and India, a big advantage over Singapore and Hong Kong, today’s front-runners in the race to become Asian Financial Centers.
Second, the Indian economy is growing rapidly and this growth, because of India’s early stage of development, is likely to continue in the 6-8% range, and quite possibly the 8-10% range, for the next decade. Even if the size of India’s financial sector relative to GDP stays constant, it will double in absolute terms over the next decade, assuming 7% growth. A much more likely scenario, however, is that we will see dramatic financial deepening in India over this time period.
Third, India already has much of the basic financial market infrastructure in place. Admittedly, there are a few gaps – such as a vibrant “Stock Borrowing and Lending” market. And there is always room for improvement – especially when it comes to coming more into line with global best practices and standards. But, most would agree that India’s financial market “plumbing” is working well. In terms of trade processing in the equities market, for example, Indian exchanges match, clear and settle a phenomenal number of transactions each day – putting both BSE and NSE easily in the top ten globally.
Fourth, India has a reasonably effective and transparent regulatory environment – focused on investor protection and market development. Regulators are appropriately cautious in some areas. The focus has been on risk management and the gradual introduction of new products. This has generated some frustration at times for market participants who want regulatory changes to come more quickly. But, by and large regulations are evolving well, taking into account the views of the market, international practices and Indian ground realities.
Fifth, Indian financial markets are quite open to foreign participation. While there are some notable impediments — for example, restrictions on foreign retail investors – it remains true that offshore participation by foreign institutional investors (FIIs) is substantial. More significantly, if a foreign securities firm wishes to come “onshore” in India, it is to a very large extent free to compete with domestic firms. The benefits from this foreign participation, in my view, have been substantial, bringing global practices, global talent (much of it Indians working at foreign firms), and global competition into the market.
Sixth — and most relevant to my comments here – India has a competitive exchange environment that will be a critical factor in lowering trading costs, increasing liquidity and driving the development of the markets through innovation.
The Greatest Risk
At the moment, one of the greatest risks to India’s continued development into Asia’s leading global financial center is the emergence of a single exchange monopoly. Exchange competition in India is driving innovation, pushing exchanges to build capacity to attract new participants in the market (such as high frequency traders), and putting considerable downward pressure on trading costs, which in turn is attracting greater volume and liquidity. Should any exchange solidify its market position into an effective monopoly, many of these benefits will fade and India will be far less attractive to market participants, particularly foreign ones. Two contentious issues have emerged in recent months that demonstrate how the exercise of market power can unbalance a level playing field, disrupt the development of the market and hold back innovation.
Approval/Disapproval of Algo Trading
One exchange in India, the NSE, has implemented an approval process for members who wish to deploy automated or algorithmic trading strategies (including automated market making and smart order routing). This approval process has a feature which I believe is objectionable from a regulatory point of view. NSE insists, on the one hand, that no member can deploy an algorithmic trading strategy on its market unless they seek prior approval of the algorithm used. On the other hand, they also insist that no algorithm will be approved if it involves trading or analytics involving trading on an exchange which competes with the NSE.
In my view, NSE’s regulatory stance on algo trading is holding back the development of the Indian market because – among other things — it has effectively banned firms from deploying smart order routing strategies, which are standard market practice in other markets around the world with competing exchanges or trading platforms. Smart order routing (SOR) helps firms get their customers the best price – automatically – wherever that price may be. It also disciplines pricing across markets and makes them more efficient.
More importantly, this intrusion into the legitimate activities of firms retards the development of the Indian market because it allows one exchange to prevent a firm from trading on other competitor exchanges, by exploiting its market power and regulatory authority. In practice, if a firm does not refrain from using algorithmic trading to trade on BSE, NSE will NOT approve its algorithm to trade on the NSE. This is significant because algorithmic trading is one of the fastest growing segments of trading in India, by both foreign and domestic firms and by new smaller members.
As demand for accessing markets with automated high-frequency trading strategies grows in India, the demand by firms to co-locate their computer servers closer to the exchanges also continues to grow. Both exchanges now offer firms the ability to co-locate servers on exchange premises. NSE imposes a condition on any firm that wishes to co-locate at the NSE facility – you must promise that you will not use your computer server to send an order to any exchange except the NSE.
This restrictive stance of NSE regarding users of their co-location facility is also holding back the development of the Indian market, in my view, for a number of reasons. First, it significantly raises the costs and complexity for a firm that wishes to engage in algo trading on other exchanges – because it requires that firm to set up a separate infrastructure and makes it impossible to route all orders to Indian exchanges through one server. Second, it holds back development of the market by restricting the ability of firms to trade on the exchange of their choosing at any point in time, depending on opportunities that arise. In effect, NSE uses its market power and regulatory power to lock up firms and prevent them from trading on competitor exchanges in the future.
The exercise of market power
How does one ensure that a dominant exchange does not abuse its market power to create an unlevel playing field for its competition?
First, you must be able to distinguish between fair competition and other behavior which crosses some kind of regulatory threshold. This is admittedly not a trivial job for a regulator. It requires expertise in microeconomics, regulation of firms with significant network externalities, anti-monopoly laws, etc. Are the practices noted above in violation of any specific rules or regulations? I am not a securities lawyer. But ever since I started my career on Wall Street, I have been a believer in the“smell test.” If something doesn’t pass that test, you don’t do it.
Because a large percentage of activity in securities markets is often dominated by less than ten or twenty firms, resistance to the abuse of market power by an exchange can often be orchestrated by a combination of regulatory action and collective action by major market participants. For many years, for example (until 2000 when the rule was finally fully revoked), the NYSE tried to prevent its members from trading NYSE-listed stocks in the OTC market through something called Rule 390. The ability to impose such a rule – in the absence of regulatory intervention – is directly proportional to an exchange’s market power. If a smaller market with 10% market share had tried to do so, customers will simply stop being members of that exchange. If a dominant market with 95% market share does so, it is difficult for a customer to leave.
NSE’s policies on algo trading and co-location noted above are tolerated by firms because of NSE’s tremendous market power. In the end, Rule 390 was abolished because the largest member firms objected to it and convinced the SEC that what was positioned as an investor protection rule was actually anti-competitive. Similarly, I believe that only when Indian market participants find their collective courage and voice, will NSE’s policies change and will the drift toward increasing monopoly power be halted.
Where do we go from here?
Robust competition will be an essential driver of financial market development in India in the next decade. I believe that regulatory authorities in India will increasingly turn their attention to issues of regulating competition in order to more effectively achieve their twin goals of investor protection and market development.
But preserving competition in a market is a bit like preserving liberty. As Andrew Jackson put it: “. . . eternal vigilance by the people is the price of liberty, and . . . you must pay the price if you wish to secure the blessing.”
Beyond the role of the regulators, who must be vigilant and intelligent in preserving a competitive environment, there is also the important role of market participants. For in the end, if a dominant exchange engages in market practices that are detrimental to the development of the market and harmful to the preservation of a competitive environment, market participants cannot be passive. As Edmund Burke said: “The only thing necessary for the triumph of evil is for good men to do nothing.” If we, as market participants, want Indian financial markets to flourish and attain their potential over the next decade, we must be willing to speak up when we see practices that are harmful to the preservation of a competitive environment and the development of the market.
The views expressed by the author in this article are personal.
By James E. Shapiro