Saturday, December 19, 2009

Of brokers, stock exchange wars and trouble in getting early to work

The stock broking in India is a cottage industry. It is an unorganized sector, with no common interests except that of making money. Each one has a different play. About a dozen large ones are the only ones that can be viewed as a broking house, akin to what is prevalent abroad.

The bulk of them have no business to be in this business. Many of them use the platform for proprietary trading. Many of them ‘rent’ out terminals to punters for intraday trading. Most of them employ an army of arbitrageurs, who keep skimming the inefficiency in the market to make money. If they were to pay a brokerage charge on this, the business would disappear. The myth used to explain their existence is that they create liquidity. I beg to disagree. The liquidity to the market is given by the promoters. It is no secret that most promoters have undisclosed ‘promoter holdings’ which is used as an inventory to make a market. They operate through a clutch of ‘house brokers’ who create circular trades in the stocks. They are the ones who let the arbitrageurs come in and make a living. These market makers are not only funded with the promoter stocks but they also arrange money by pledging these shares. They are the vital link between the promoter and the buyer / seller.

It is no secret that the key drivers of the Indian markets are the FII investors. Without the market makers, there is no way they can transact the volumes that they presently trade in. When they buy, the market makers step in and provide the supply. Depending on the action by other large holders of stocks and their trades, the market maker optimizes the price. When there is a bullish trend, the market maker creams the buyer. Similarly, when there is a one sided selling, no one has bothered to find out or report who the buyer is. The focus has always been on the glamour boys (FII, Institutions etc). At these times, the market maker crashes the price and absorbs the selling. It helps if some other buyers step in.

Of course, with the spread of institutional investors (mutual funds, insurance companies etc) the market makers role is made easier. Often, they will have to ‘push’ inventory by creating research reports. And since the market maker is a promoter link, he is able to offer some information edge and create a demand.

Let us look at the volumes. On any given day, the average volume is supposed to be Rs.100,000 crore. But this is a wrong number. Of this anything from 75 to 90 percent is the value of stocks traded in the F&O segment. If we exclude this, the actual volume is around Rs.10,000 to 20,000 crore. And of this, a substantial part relates to buying that has been done by arbitrageurs who have bought for cash and sold in the F&O. So, the actual trading volume is a much lower figure.

If the markets were really liquid, we would never witness any stock that is ‘locked in to a circuit’. Let us accept it. Barring a few stocks, liquidity is a myth. How many companies can say that they have a lakh of shareholders, with each holding at least 1000 shares? This is not a fancy number, but used to be one of the requirements for a company to get a listing on the NYSE!

The main fault in our industry lies in the fact that the entry price in to the broking industry is abysmally low. In the old days, I understand that Rs.5,000/- used to be sufficient. I also recall a sum of Rs.50.000/- for ‘professional’ category! I cannot imagine that any broker who cannot write a cheque for at least Rs.10 crore without running to a bank or a lender should be in this industry. To put it in perspective, the BSE has so many old members, who will perhaps not fulfill even the present day minimal requirement of net worth for being eligible to be a broker. A brokerage firm has to have enough liquidity to be in business. To be a full service broker they should be able to offer margin financing to clients also.

The recent move by the exchanges to start business at 9 am, has been met with lot of ‘objections’ from the fraternity. Let us look at them:

i) Operational Issues

Back office capabilities are today at a primitive level, except in the dozen odd large brokerages. The small ones survive on outsourced bullock cart systems, which are created by bucket shops. This needs investment of a large order. The other related issue is one of extension in working hours. This is unavoidable and the solution is to either have two shifts. Merely paying people higher, will not resolve the issue of fatigue. If systems are robust, why does the back-office have to come in two hours early? Also, if trading halts at 330 pm., ideally the back office should be able to wind down in an hour. Unfortunately, here the stock exchanges are the culprit. The day end prices are not frozen till 6 30 pm! I have seen mutual fund back offices waiting only to get that number. In today’s computerized world, why can not the closing prices be frozen by 345 pm? If this is done, then the back office can shut down by 5 pm or so, which is acceptable even if they have to start at 8 am. I have seen operations in Malaysia, in 1990’s, where the markets would start at 8 am and close at 2 pm. Even there, the staff would vacate the office by 5 pm. There is also some work which starts later and continues beyond the scheduled close. Surely, a shift system can handle this.

ii) Banking issues

This is another primitive area. Brokerages have clients who live on credit. Margins are not paid and the broker has to wait two days to get a cheque which again takes another two days to get cleared. This goes back to my argument about the low financial entry barrier. The other thing is that the brokers have hit themselves in the face with their price wars. Brokerages of one paise etc are going round. If they make the minimum brokerage to, say, Rs.100/- per trade or 0.50% in respect of cash business, their viability would be better. In F&O, they trade for their clients without taking margins. Why? I have seen large foreign banks trade in F&O and not pay margins. Brokers would take this business if they could arrange finance. Suppose the exchanges make it unlawful (with severe penalties), then this need would not arise. Giving credit to a speculator is like giving champagne to an inebriated person. The crux of the problem is that giving financial accommodation to clients has become a way of getting more business. One fine day, one client defaults and the entire month’s commission income gets wiped out.

iii) Commuting etc

Assuming that the most affected city is Mumbai, I actually see this move to start early, as a positive. Coming to work at 8 or 830 am means ducking the peak hour traffic and if you can close down by 5 pm, your quality of life will surely be better. Let the exchanges put their house in terms of giving their feeds to the brokers by 4 pm and this is a workable proposition. In the old days, the stock markets would open at 11 am. Only when the NSE came in, did the timings move up. Surely, the two exchanges have started a war of one-upmanship without any tangible benefit. If they expect arbitrageurs to generate more trading volumes they are on the right track. Investors and traders are not going to increase their trades. And my heart goes out to the army of arbitrageurs and the quant traders, who sit at their desks without a break. It is essential that the exchanges think about a lunch break, like is the practice in Japan and some Eastern Markets.

iv) Banking

India has lazy banking. Most banks have very relaxed banking hours. With everything getting technology driven, it is high time banking became a round the clock activity. We do not need physical banks to remain open to help the brokers or investors to trade. Maybe the nationalized banks can never get there, but all one needs is a few branches to do this.

v) Profiteering and the exchanges


And finally, BSE vs NSE. The BSE is a crony club that has robbed every customer blind, in the past. Only after the NSE stepped in, did the system stop the theft by the brokers. As regards NSE, one hopes it does not get complacent. Neither exchange should be run on a ‘for profit’ basis. Unfortunately, by selling stakes at ridiculous valuations, the exchanges have clearly indicated that they are out to screw the investors. If they have to satisfy investors, then they will only think of ways to increase revenue. That should NOT be the role of a stock exchange.

4 comments:

Rupa Bose said...

This is a great article... it should be published somewhere besides your blog.

Rupa Bose said...

In fact, with your permission, I'm going to download it and save it in case I update my book.

Anonymous said...

Keep at it Bala. India's finance blogs are absolutely dismal. It's great to see a veteran write in a reader-friendly style, about important topics. Looking forward to your posts in the future. And I agree with Rupa - this should be printed somewhere in a larger forum. I'd say use your energies (which have only increased since you retired) for writing. Appearances on television are meaningless given that the channels have their own agenda and rarely let you speak at length.

An Old Fan.

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