The decision of Indian stock exchanges to terminate foreign derivative trading was a nasty shock for foreign investors – and a reminder of why this market is known for its uncertain regulatory environment. Indrajit Basu reports.
In a joint statement on Friday, February 9, India’s top bourses, the National Stock Exchange (NSE), Bombay Stock Exchange (BSE) and Metropolitan Stock Exchange of India (MSEI) announced that they would stop licensing their indices and securities data to foreign exchanges.
The move terminated the entire data-sharing agreements of the Indian stock exchanges with their foreign peers, preventing foreign exchanges from listing instruments such as Indian index or single-stock futures for trading and settlement on their trading platforms.
Foreign investors who trade in Indian derivatives offshore will be forced to unwind their positions and buy into the country’s onshore derivatives markets only. Small wonder that many of them are alarmed.
The NSE had licensing agreements with Singapore Stock Exchange (SGX), Chicago Mercantile Exchange, Osaka Exchange and TAIFEX (Taiwan) for trading derivatives products linked to its flagship index, Nifty. BSE had licensed exchanges in Brazil, Russia, China, South Africa, Germany and Dubai to list derivatives based on its flagship index, the S&P BSE Sensex.
Over the years, these offshore exchanges had offered foreign currency derivative contracts on Indian indices and stocks, boasting low transactional costs, advantageous tax structures and a predictable regulatory environment.
“It is a clearly negative development for the accessibility of the Indian equity market for international institutional investors,” was the reaction from MSCI, the global index provider. MSCI warned it might lower India’s weight, currently about 9%, in its global indices if the Indian exchanges and their regulator, the Securities and Exchange Board of India (SEBI) did not reconsider “this unprecedented anti-competitive action before it leads to any unnecessary disruptions in trading”.
Disruptions, though, are already evident. “Whenever something like this happens that is very sudden, investors always step back to figure out ways to work around the system,” says Hirander Misra, chairman and chief executive of London-based investor GMEX Group. “Right now investors are taking stock and figuring out what they are going to do.”
Joel KO Hyun Sik, president of Singapore-based Marvelstone Group, which also invests in India, is concerned by the breadth of the restrictions. “This is a reversal of the liberalisation process for the trading sector,” he says. “Every change in regulation forces a foreign investor to take a step back and go into the wait-and-watch mode. I, for instance, would like to hold on and wait for the right time to enter the Indian market.”
In the past, investors had multiple reasons to prefer foreign exchanges. The most significant was that transactions abroad could happen in dollars while, in India, they must happen in rupees, says Suresh Swamy, partner, financial services at consultancy PwC. “Foreign investors eliminate the currency risk by trading in exchanges abroad,” he adds.
Besides longer trading hours and lower transaction costs in offshore exchanges, taxation for exchange-traded derivatives abroad was zero, compared to 30% on short-term capital gains in India.
The restrictions also come at a time when foreign investors have been hit by a 10% tax on long-term capital gains in equity investments imposed by India in the February 2018 Budget, stirring the thorny issue of unpredictability in the country’s regulations.
“Registering as a foreign investor is time-consuming too and there are a number of compliances that the fund has to go through,” says Swamy.
The Indian exchanges say that their decision was “in the best interest of Indian markets”.
The joint statement by NSE, BSE and MSEI stated: “It is observed that for various reasons, the volumes in derivative trading based on Indian securities including indices have reached large proportions in some of the foreign jurisdictions, resulting in migration of liquidity from India.”
SGX Nifty futures contracts, for instance, accounted for 46% of the $793 billion of Nifty futures trading revenue in 2017, up from 12% two years ago. This growth has turned the Singapore Exchange (SGX) into the biggest trading centre for offshore Indian derivatives.
“Over the past few months, regulator SEBI, the Finance Ministry and the stock exchanges were concerned about the growing SGX market share and migration of trading volume from the Indian market to overseas exchanges,” says Swamy.
SGX was pushing ahead with its launch of single-stock futures in the first week of February 2018, despite the concerns expressed by India’s national stock exchanges. This launch, India feared, could have resulted in a greater shift of activity overseas, just like the volume of NSE’s Nifty futures that moved to SGX.
India hoped that stopping offshore derivatives trading would make the domestic capital markets “less volatile and insulated from foreign market sentiments,” says Swamy.
A gift to Gujarat
The Indian bourses’ freezing is also seen as a tactical move to lure foreign investors to the international financial services centre called Gujarat International Finance Tec-City (GIFT), which opened in January 2017 and is widely considered a pet project of prime minister Narendra Modi.
Compared to the domestic exchanges, the GIFT City is designed to offer benefits such as lower transaction costs, no registration requirement and lower hedging costs. Proposals to grant tax incentives on derivatives are in process, according to reports.
“The GIFT City was not on the radar of foreign investors because it was new and they were allowed to trade in foreign exchanges. But with that route blocked, foreign investors are expected to increasingly start looking at GIFT,” says Manish Sonthalia, chief investment officer, portfolio management services, Motilal Oswal Asset Management.
Still, few expect the transition to Indian exchanges to be easy.
Foreign investors say that despite the recent advancements in its markets, India still lacks a one-stop shop that allows trading across asset classes. India also has to make its markets more competitive rather than making others markets less competitive.
“While I appreciate the fact that India wants to build strong domestic markets, the way to do that is not to necessarily create a restrictive market that restricts market competition elsewhere,” says Misra of GMEX Group. “The way to do that is by creating conducive markets that open up domestically so that Indian markets get more efficient and become the first port of call naturally, as opposed to restricting things happening elsewhere.”
Misra also argues that the bar on market feed and licensing agreements does not stop foreign investors from using the alternative route of trading through market-making firms that operate in offshore jurisdictions.
A market maker is a bank or a brokerage firm that buys and sells securities in order to provide liquidity to the markets. Being registered members of stock exchanges, market makers always have access to real-time data feeds, which cannot be stopped.
“As an alternative, foreign investors who wish to trade on India’s main stock indices without landing in the country may prefer the P-note route,” says Swamy.
Participatory notes, known as P-notes, are instruments issued by India-registered foreign institutional investors to overseas investors that wish to buy Indian stocks without registering themselves with the market regulator.
The Singapore Stock Exchange has already announced it will launch instruments to succeed the SGX Nifty family of products, which will cease to exist following the termination of data feed by the Indian bourses.
In the absence of details, it remains to be seen how the new SGX products would help those foreign investors that are unwilling to invest onshore.
However, some analysts say foreigners are becoming more comfortable with investing on India’s onshore exchanges.
Viraj Kulkarni, founder and chief executive of Pivot Management Consulting, a foreign investor adviser, says: “I am confident that as trading at GIFT City starts gaining traction, more and more foreign investors would prefer to trade there than on other international Exchanges like Dubai and Singapore.”
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