NSE vs. SGX vs. BSE

One of the most interesting features of the global securities markets in the late 1980s and early 1990s was the battle which took place between Singapore and Japan on the question who would dominate futures trading on the Japanese stock market index.

Index derivatives are purely cash settled; there is no physical settlement involving shares. Hence, an exchange anywhere in the world can trade index derivatives using any index, regardless of capital controls or the lack of connectivity to the depository. This is in contrast with trading shares, where a foreign exchange is unable to compete with an Indian exchange without access to settlement at NSDL.

The Singapore International Monetary Exchange (SIMEX) commenced trading on the Nikkei 225 index futures on 3 September 1986. Prior to this, in 1985, the index futures had started trading at the Chicago Mercantile Exchange (CME). At the time, Japanese regulators were dithering about whether or how index derivatives should trade. The Japanese regulators were fearful of cash settlement. They first permitted a physically settled index on the Kabusaki 50. This was the world's only attempt at a physically settled index derivatives product, and it failed. On 3 September 1988, exactly two years after SIMEX got started, cash--settled Nikkei 225 futures started trading at Osaka.

In the early days, Osaka and Chicago dominated the market, while SIMEX struggled along. In 1991, the regulators of Japan did SIMEX a great favour. Osaka raised margin requirements (from 9% on 23 August 1990 to 20% on 31 Jan 1991) while SIMEX cut margin requirements (going from 12% on 30 July 1990 to 9.5% on 31 Jan 1991). As of early 1992, the margin required at Osaka was 30% while SIMEX was at 14.2%. In addition, brokerage fees and transaction charges at SIMEX were lower. Within a matter of weeks, the Nikkei 225 market started moving to SIMEX, with volumes going from 4,000 to 20,000 contracts a day.

This led to a remarkable situation where a flourishing market for the Japanese index futures was to be found in Singapore. This lasted all the way to the late 1990s, when Japan started remedying these problems and the market significantly moved back to Japan.

What about India? The Singapore economy is too small to sustain a serious financial market, so Singapore's future lies in being an international financial centre. The Nikkei 225 product did a world of good for trading at SIMEX, and for the positioning of Singapore as a centre for international finance. With this market fading away, Singapore needed to look for a country with a large economy and a good chance of finding incompetent regulators.

The natural choice for this is the Indian stock market index and the dollar-rupee exchange rate. On both these, SIMEX can easily do cash--settled derivatives without requiring any cooperation from Indian authorities. Both these products have regulators in India with a conservative track-record. Hence, SIMEX, now in its new incarnation as SGX, looked at the field, which consists of the NSE-50 index, the BSE Sensex, and the Morgan Stanley, IFC and Barings indexes. They needed to choose the index which had the best chance of winning the domestic index derivatives market, so they picked Nifty. The Nifty futures started trading at NSE in June, and on SGX in September.

There are a few important differences between the Nifty product in Singapore versus that on NSE:

NSE now faces the battle of its life. SGX is a competitor with technology, branding, proven track record of high ethical standards, and managerial capability that equals or exceeds that of NSE. NSE is constrained by the speed at which India's regulators allow derivatives trading to grow, and by the speed at which India's securities firms plunge into derivatives trading. However, NSE has one great edge: monopolistic access to the great Indian retail market. India's remarkable equity market liqudity is dominated by retail trading, and until capital account convertibility comes about, this investor base cannot go to SGX. This edge will fade away as India moves towards capital account convertibility, but it will take a while for SGX terminals to be as prevalent in rural Andhra Pradesh as NSE terminals.

These developments open up one new market: arbitrage between Nifty at SGX and Nifty at NSE. As mentioned above, there is one catch in this arbitrage, which is the currency. Hence, arbitrageurs will fall into two groups: (a) those who use the dollar-rupee forward market that prevails in Hong Kong or Singapore, or (b) those who are permitted to engage in forward transactions on the dollar-rupee forward market in India under existing RBI regulations.

What does this mean for the BSE? The BSE suffers from several problems. The first is a weak product, the BSE Sensex, which delivers inferior hedging effectiveness and higher impact cost. The BSE spent many years engaging in political lobbying to block index derivatives. In this period, NSE has become strongly associated with the idea of derivatives. In this period, NSE also got a head start on systems, procedures and product design. The NSE is the largest equity market, a fact which hurts the extent to which futures on the BSE Sensex can obtain efficiency. Finally, the BSE will be sidelined in the arbitrage activities between Singapore and NSE.

The BSE Sensex has greater mind--share amongst the less sophisticated part of the market. Hence, the more knowledgeable users will initially converge on Nifty, and then there could be a catch--up for BSE as the less-knowledgeable participants come into the market.

This will be an interesting horse race. The score so far is : Nifty futures are at Rs.9 crore a day at NSE and Rs.7 crore a day at SGX. BSE Sensex futures are at roughly Rs.6 crore a day. International investors and NRIs, with an interest in hedging India risk, already know about derivatives; they will quickly start using the SGX products. The question is about Indian retail: how quickly with India's securities firms and retail investors get comfortable with using index derivatives?

I believe that this is only a question of when and not whether. India's retail users will switch from stock trading to derivatives trading, and when this happens, India will own the Indian index futures market. How fast this happens significantly depends on how fast India moves on a variety of policy questions on the spot and derivatives markets. Until these questions are resolved, I think it is quite possible to see SGX pulling ahead of NSE.

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