Why BSE Has Failed To Boost Equity Derivative Volumes

BSE Ltd. saw its equity derivatives turnover hit a record on Aug. 25 and 31 as Asia’s oldest exchange offered another round of incentives to boost volumes. But that’s half the story.The daily turnover stood at an all-time high of Rs 1.44 lakh crore on Aug. 31, BSE said in a statement. Yet, it doesn’t either truly reflect an increase in volumes or the success of the incentives, called Liquidity Enhancement Scheme. Offered as a fee, these incentives are aimed at bringing liquidity to new products and increase participation.Real Turnover LowThe record turnover BSE referred to is notional—arrived at multiplying volume or the number of contracts with the strike price. In practice, it’s the premium that is traded on the exchange, not the strike price, that matters.The notional turnover on Aug. 31 was high because it is calculated based on the settlement price on the day of the expiry. For BSE, premium turnover based on the highest premium of the day was less than 1% of the notional turnover.Even National Stock Exchange of India Ltd., India’s largest stock exchange, referred to ‘notional turnover’ since 2000 till recently when the tax authorities, looking to shore up revenue, started closely monitoring the high notional turnover in the futures and option market.The NSE peak notional turnover was at Rs 41.8 lakh crore in July and Rs 39.88 lakh crore in August. But the exchange changed its reporting to the realistic ‘premium turnover’, on which the government charges securities transaction tax and stamp duty.BSE’s low premium turnover underscores its struggle to gain a foothold in the equity derivatives since they were allowed in 2000. And the regulator’s liquidity enhancement scheme hasn’t worked for the exchange..Liquidity Enhancement Scheme DudTo help exchanges boost liquidity and participation, the regulator in September 2011 allowed Liquidity Enhancement Scheme to incentivise market participants.It allows exchanges to offer brokers a fee for providing two-way quotes and on trading turnover in the segment. Exchanges also reduce transaction charges to zero. 75% incentives are kept for market makers to provide continuous, fair and transparent two-way quotes, not for trading large volumes, said BSE.One way to gauge success of the liquidity enhancement scheme could be the turnover in the product for the next six months after incentives are withdrawn. But the turnover vanishes as soon as the incentives are withdrawn.BSE offered the previous round of liquidity incentives on equity derivatives of S&P BSE Sensex and 50 stocks starting September 2019 till June 11 this year. But currently there is no liquidity in stock futures and options or on the Sensex 30 Index. Meaning the liquidity created is artificial, in return for incentives.According to a senior market participant, who spoke on the condition of anonymity as regulatory oversight is involved, turnover is being morphed by incentives. Exchanges are not even able to recover the marketing costs, the person said.BloombergQuint’s emailed queries to SEBI on effectiveness of the incentives remained unanswered.Low ParticipationBSE is has offered incentives under the liquidity enhancement scheme 26 times since it was allowed. The latest set of incentives are available on derivatives for the underlying S&P BSE Sensex 50. The index has a high degree of correlation and mirrors the Nifty 50 Index as BSE aims to tap Nifty 50 Index options.BSE also hoped to benefit from the interoperability between the exchanges after SEBI allowed trading on the same margin on different indices having high correlation.While brokers are not allowed to net off positions between exchanges, it allows them to come out of their position in a liquid market when they have a position outstanding in a low liquid market, the exchange said.And to reap maximum benefit, BSE shifted the expiry of its weekly contract to Monday from Thursday in the equity derivatives segment starting June 29. This allows market makers and traders to rotate trading between NSE’s weekly options expiring on Thursday and BSE’s contracts expiring on Monday, helping them earn incentives from BSE.According to the exchange, its average daily turnover in the equity derivative segment has jumped sixfold over the previous month to Rs 26,196 crore in July. That came in return for incentives worth Rs 6.77 crore in July, a minuscule amount given the benefit. In August, the average daily equity derivatives turnover was Rs 88,006 crore. Data on incentives is not readily available on the BSE website yet..Still, incentives and changes in the index didn’t help improve participation. According to BSE’s July disclosure, the total volume traded in the index stood at 71.58 lakh. Of this, top 10 of 934 members on its derivatives segment accounted for 92.79%.Top five brokers traded 76.92% of the volumes in the top five contracts—or almost the entire liquidity is the weekly index options. The exchange has yet to disclose details for August.In an emailed response to BloombergQuint, the exchange said it will be adding more brokers to the segment. Existing members are also devising algo and trading strategies to track Sensex 50, it said, adding that will ensure greater participation in the future.Concentrated TradesOn Aug. 31, the F&O segment’s notional turnover touched Rs 1.44 lakh crore but the premium turnover was Rs 43,203 crore, according to BSE’s bhav copy, a daily summary of trades. If the turnover and open interest of the weekly and monthly Sensex 50 futures and options expiring on Aug. 31 is removed, total ‘premium turnover’ for the options segment in Sept. stood at Rs 15.37 crore.That’s because most of the trading took place at deep out-of-money options—strikes which are far from the current prices. These command low premium as traders take positions at minimum risks.Trading in at-the-money strikes, or near the index levels, are subject to market volatility and risks. Accumulation of trades in out-of-the money strikes doesn’t serve the propose of increasing the market-wide acceptance of derivatives..BSE said in its statement that the exchange doesn’t promote liquidity at any particular strike price and it’s the prerogative of members, clients, and traders. Pricing is based on real-time market dynamics, it said.Few Positions Carried ForwardOpen interest, or the total value of outstanding contracts that provides a measure of exposure by market to a segment, was Rs 7.33 crore for BSE’s F&O segment on Aug. 31, indicating there is hardly any rollover to the next series. That compares with a corresponding figure of Rs 1.24 lakh crore for the NSE.Meaning, most brokers squared off F&O positions by the end of trade on BSE. This lack of open interest or reluctance to carry forward positions is also one of the reasons for low liquidity. Moreover, since there is hardly any liquidity near the index prices, institutions, which drive volumes, are wary to trading in this segment.HurdlesThe BSE said the liquidity enhancement framework needs changes to provide level-playing field to all exchanges. The restrictions on order-to-trade ratio, or the total number of trades allowed for a single successful transaction, is a deterrent to create and sustain liquidity, said BSE.The regulator caps this ratio to prevent manipulation and avoid putting pressure on the system. It, however, eased the order-to-trade ratio to 2,000 from 500—meaning an investor can punch in 2,000 trades for every successful buy or sell order.But for BSE, the problem again is lack of contracts near the current prices.BSE also said that since brokers and traders have to pay for using the software, the don’t subscribe to illiquid segments. And the exchange blamed vendors for not providing access to its derivatives segment.After the regulator allowed interoperability among segments, brokers and traders shouldn’t be charged for accessing BSE’s derivatives segment. But most vendors still charge by exchange, not segment, BSE said..SEBI’s New Margin Rules Protect Trading Ecosystem, Says Zerodha’s Nithin Kamath

Why BSE Has Failed To Boost Equity Derivative Volumes

BSE’s low premium turnover underscores its struggle to gain a foothold in the equity derivatives since they were allowed in 2000.

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