Session 4 financial markets background

Financial Markets in India

A Background

Relative Size of a few markets

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2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07Years

Turnover in Financial Markets in India

Money Market

Government Securities Market

Foreign Exchange Market (Inter-bank)

Equity Market (cash segment)

Equity Derivatives at NSE

Shareholding Pattern

Stock Market Performance

Stock ExchangesExchange Market Cap Companies listed Turnover

(USD mill) Total Domestic Foreign velocity

NYSE Group 9,363,074.0 3,330 2,910 420 233%

Tokyo SE 2,922,616.3 2,389 2,373 16 148%

Nasdaq 2,203,759.6 2,919 2,586 333 1038%

Euronext 1,862,930.9 1,013 1,013 0 135%

London SE 1,758,157.7 3,072 2,399 673 147%

Shanghai SE 1,557,161.3 864 864 0 114%

Hong Kong Exchanges 1,237,999.5 1,262 1,252 10 82%

TSX Group 997,997.4 3,830 3,747 83 104%

Deutsche Börse 937,452.9 832 742 90 218%

BME Spanish Exchanges 871,061.4 3,557 3,517 40 163%

Swiss Exchange 761,896.1 323 253 70 115%

Bombay SE 613,187.6 4,925 4,925 0 28%

BM&FBOVESPA 611,695.0 393 384 9 66%

Australian SE 587,602.7 2,003 1,918 85 108%

National Stock Exchange India 572,566.8 1,405 1,405 0 74%

OMX Nordic Exchange 503,725.8 821 799 22 132%

Korea Exchange 470,417.3 1,796 1,792 4 196%

Borsa Italiana 456,206.7 300 294 6 174%

Johannesburg SE 432,422.1 410 366 44 62%

Shenzhen SE 389,248.3 740 740 0 225%

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Primary Markets

Rise in listing

Stock, Debt, Currency and Derivative Markets

Most debt is privately placed

Bonds available for trading

G-Secs dominate trades

Who trades

Overnight rates

Roadblocks in the development of the corporate bond market TDS Stamp Duty Too many small issues Procedural complications in making public issues Lack of centralized information on bond trading, prices

and defaults Lack of uniformity in market practices like lot size and

conventions for coupon calculations Lack of market makers Financial institutions not allowed to hold anything below

top-rated corporate security Restriction on these bonds being used as collateral for

repo transactions.

Individual stock futures are most popular

Liquidity

Access

Capabilities of Players

Mutual Funds

FII Flows

Cumulative FII Investment Since Nov 1992 (US($) billion)

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Commodities

Turnover at MCX, Mar 08 3.6 trillion

Derivatives Turnover at BSE & NSE

8.4 trillion

Turnover at MCX, June 09 5.1 trillion

Creating More Efficient and Liquid Markets

Rajan Committee Recommendations

In markets that exist, apart from the equity market for large capitalization stock, the ability to trade consistently at low cost (that is, liquidity) and the tendency of market prices to reflect fundamentals (that is, market efficiency) are typically low for most markets. This needs to change for markets to play a bigger role in inclusion, growth, and stability

Proposal 13: Bring all regulation of trading under the Securities and Exchange Board of India (SEBI).

Proposal 14: Encourage the introduction of markets that are currently missing such as exchange traded interest rate and exchange rate derivatives


Proposal 15: Stop creating investor uncertainty by banning markets. If market manipulation is the worry, take direct action against those suspected of manipulation

Proposal 16: Create the concept of one consolidated membership of an exchange for qualified investors (instead of the current need to obtain memberships for each product traded). Consolidated membership should confer the right to trade all the exchange’s products on a unified trading screen with consolidated margining

Proposal 17: Encourage the setting up of “professional” markets and exchanges with a higher order size, that are restricted to sophisticated investors (based on net worth and financial knowledge), where more sophisticated products can be traded.


Proposal 18: Create a more innovation-friendly environment, speeding up the process by which products are approved by focusing primarily on concerns of systemic risk, fraud, contract enforcement, transparency and inappropriate sales practices. The threshold for allowing products on professional exchanges (see Proposal 16) or Over the Counter markets should be lower, so that experimentation can take place

Proposal 19: Allow greater participation of foreign investors in domestic markets as in Proposal 2. Increase participation of domestic investors by reducing the extent to which regulators restrict an institutional investor’s choice of investments. Move gradually instead to a “prudent man” principle where the institutional investor is allowed to exercise judgment based on what a prudent man might deem to be appropriate investments. Emphasize providing access to suitable equity-linked products to the broader population as part of the inclusion agenda

The role of financial markets in growth, stability and Inclusion

Well functioning financial markets allow risks to be borne by investors

It provides clear signals about which companies and sectors are doing well, which commodities are likely to be in short supply

They can also bring the users of capital and savers together at low cost, eliminating layers of intermediation, and thus costs.

The role of financial markets in growth, stability and Inclusion

Better risk sharing, better information signals, and lower costs combine to Reduce the cost of finance for firms,

households and the government, allowing them to finance investment and innovation and growth

Allow for better allocation of resources in the economy

Equity and bond markets also serve as a buffer, passing losses from risky ventures to more fragile institutions

Improve macroeconomic policy setting as well as transmission

Why are markets becoming more important in India today?

Corporations Indian firms have improved productive

efficiency, increased their focus on R&D development with overseas investments moving towards greater technological risk

Effect of exchange rate movements on competitiveness

Equity Financing More important as India moves away from

the asset-intensive mature industries of old to the human-capital-intensive industries of the future


Virtues of Equity Financing Risk is spread across so that riskier, higher-

return projects can be financed Not dominated by one bureaucratic view Control is not concentrated in a few financial

institutions which could limit competition in the market

Corporate and Government Debt Borrowing from bond markets rather than from

banks can achieve a better asset liability match Reduce the risks the banking system is

exposed to


International Require international financial services as

they turn themselves into multinational corporations, and engage more closely with the world economy

Households and Diversification Many are over exposed to the Indian market

and its fluctuations, and would well benefit from a more diversified global portfolio

Indian firms and investors need better access and thus enhance production of international financial services

Are markets casinos?

True that there is certain amount of luck in who makes money and who loses money in any single market transaction

Need to understand that price fluctuation in financial markets does not mean more economic instability

Flexible financial prices are a shock absorber Financial markets are far from casinos when

they function well Have to create sound deep liquid markets by

fostering transparency, competition, and enforcement against fraud ,so that can derive the maximum benefits from markets

Financial markets and competition

Competition in the economy is fostered by a financial sector which is able to enable firm entry and growth by infusing debt and equity capital

External financing is important from the view of competition in the economy

Banks could play a role in nurturing new firms, typically are better at financing mature well understood technologies than green-field projects

The Inclusion Agenda

Participation of more poor investors in Indian markets improve liquidity and depth, making them even less susceptible to unwarranted fluctuation

Poor will be great beneficiaries from hedging markets when financial firms and NGOs improve their own levels of financial sophistication and the efficiency of transactions processes

Cutting transactions costs of micro-payments (SIP) is also part of the inclusion agenda

Need to find innovative ways for small businesses to raise debt and equity, to hedge their financial risks

Getting the Full range of Markets and its Effect on Policy Bond-Currency-Derivatives Nexus is the

interlinked set of markets on government bonds, corporate bonds and currencies

Implications when India achieves a well functioning BCD Nexus

Enable funding the fiscal deficit at a lower cost Produce sound information about interest rates Would strengthen financing for debt-heavy

infrastructure projects Would enable the `monetary policy transmission'

through changes in the short-term policy rate Financial markets produce a unique array of

information including forecasts of volatility of all traded products further helpful in decision making

Markets and Risk-taking Participants have to develop a level of

sophistication to use them well Corporations make losses all the time

making real products, and will make them in financial products also

Real regulatory concerns Do participants have a level of sophistication to

understand the products and their consequences?

Are products sold with adequate disclosure so that they can understand the risks they are taking?

Are the systemic consequences of price movements in any direction likely to be limited?

The Need to Improve Liquidity and Market Efficiency Critical features of a well functioning

financial market Market efficiency

Extent to which information & forecasts about the future are impounded into financial prices

High liquidity Immediacy is the ability to execute trades of

small size immediately without moving the price adversely

Depth refers to the impact cost suffered when doing large trades

Resilience refers to the speed with which prices and liquidity of the market revert back to normal conditions after a large trade has taken place

The Need to Improve Liquidity and Market Efficiency

The two concepts of efficiency and liquidity are linked in order for markets to be efficient.Market efficiency assures uninformed participants that market prices are up-to-date and reflect fundamentals, so they can trade safely. This in turn provides volumes that ensure liquidity.

Diagnosing the sources of difficulty Why are so many markets illiquid and

inefficient? Banned products and markets

A market that is banned obviously cannot attain liquidity or efficiency

Missing market can hamper the efficiency of other markets

Restricted Participation These include outright bans, regulatory restrictions on

some kinds of activities or quantitative restrictions Rationales for restriction

Belief that some participants are new and therefore should proceed cautiously at the outset

Desire to limit capital inflows and outflows so as to make exchange rate management easier

Diagnosing the sources of difficulty

Restricted Participation Rationales for restriction

Need to finance the government through restriction on investments other than government securities


Inadequacy of financial institutions Restrictions on ownership and shareholding

especially to institutions like banks and exchanges, clearing corporations and depositories

Limits on how much shares an individual shareholder can hold, limits on ownership by foreigners makes it difficult for new institutions to be started

The way to resolve this problem is to increase competitive pressures in the market ecosystem by removing constraints for the entry of new players


Infirmities in Regulation India uses a `silo model' where the financial markets

are broken up across three agencies: SEBI, RBI, and FMC which reduce competition, hamper economies of scale and scope.

Steep barriers to innovation are in place like approvals take years and no question of obtaining a temporary elevation of profitability

Frictions caused by taxes Existence of a transaction tax reduces incentive for

day traders & speculators to provide valuable liquidity to the market

Disadvantage of low tax on mutual funds is debt fund investments are made only to make use of tax benefits

Proposals Reforms within existing legal and institutional

framework Improvements in market design Rapid and Simplified product approval Professional Markets with light regulation Domestic Hedge Funds Staffing of regulatory institutions Uniform accounting treatment Securities Transaction Tax Remove segmentation within exchanges Restrictions on participation Fiduciary responsibility based on investment

objectives Currency Derivatives Interest Rate Derivatives

Proposals Use Capital Account Liberalisation to

Deepen Markets Broader participation for Foreign investors in

the markets which Indian investors have little experience could allow more attractive debt structures to emerge and greater liquidity also

Restrictions need to be eliminated with FII transactions on equities and equity derivatives

Foreign mutual funds should be able to raise money directly in India, and Indian mutual funds should be able to raise money overseas to invest in India obtaining same tax treatment as FII

Proposals Modifications to legal framework and

financial regulatory architecture Merger of all market regulation into SEBI will

reduce transaction costs and improve liquidity in financial markets

Enactment of a legislation that would bring all market regulations under a single roof, and ease the transition from a rule based approach to a principles based approach to regulation

Proposals

Implement Debt Management Office Establishing independent Debt

management offices (DMOs) which sell bonds for the government

Rules that force financial firms to buy government bonds are relaxed and greater demands will be placed on the DMO

Session 4 financial markets background

Business

Transcript of Session 4 financial markets background