Sebi is at it again. NSE, BSE investors can’t ignore regulatory risks

Last month, this column pointed out that National Stock Exchange Ltd’s valuation has risen 2.5 times in less than two years. Among other things, investors were enthused about the double-digit growth at the company, despite its high base.

Some of that excitement may dissipate after Securities and Exchange Board of India’s (Sebi) latest interventions in the markets. In its board meeting last week, the regulator ushered in a number of changes in the equity derivatives markets and the algorithmic trading space, which threaten some of the revenue streams of Indian stock exchanges.

The regulator has said exchanges should provide tick-by-tick data feeds to its trading members free of charge. This is perhaps with a view that access to such trade data shouldn’t be to only a privileged few, especially on the back of findings that NSE officials provided a few trading members preferential access to its servers. Even so, a diktat that data should be provided free is taking things too far. Globally, exchanges earn revenues from sale of data feeds, and in some cases, these add meaningfully to their topline.

“Exchange data are generated based on infrastructure owned and paid for by the exchange and its constituents; as such, it makes sense for the exchange to enforce a reasonable charge while disseminating the data,” Marti G. Subrahmanyam, Charles E. Merrill professor of finance and economics at the Stern School of Business at New York University said in an interview last month.

While NSE’s or BSE’s earnings from the sale of tick-by-tick data may not be too large to move the needle, the regulator’s decision to infringe upon their revenue model is worrisome. Who’s to say Sebi may not impose similar burdens that impact other revenue streams? “This reeks of a socialistic bent of mind; Sebi is forcing its way into areas that are best left for market participants to decide,” an expert on market microstructure points out.

Another major policy change is the decision to move gradually towards physical settlement for single stock derivates contracts. To start with, Sebi has asked exchanges to carve out a list of stocks which don’t meet its enhanced eligibility criteria. Derivatives on these stocks will compulsorily be settled physically for a period of a year, after which they may be excluded from the derivatives list altogether if they continue to fall short of the eligibility criteria. Stocks that meet the criteria may also be eventually moved towards physical settlement, depending on the liquidity in the securities lending platform, Sebi chairman Ajay Tyagi said at a press conference last week.

A study on a similar transition for Australian single stock futures shows that physical settlement led to higher volatility in both the futures as well as the underlying cash market. On the flip side, the new contracts became more effective hedging instruments.

While there may be a case for introducing physical settlement, Sebi would have done well to publish its reasons for the move. It did publish a skeletal discussion paper on the matter, but that contained only a list of questions for market participants. When it announced its decision last week, there was no way to know what the general feedback to its paper was, or what influenced the regulator’s decision.

Needless to say, physical settlement as well as a smaller list of stocks for derivatives will result in lower volumes, and hence lower revenues for exchanges, risks that their investors now need to price in.

Then, Sebi wants to restrict participation by individuals in the derivatives markets by imposing limits based on their income. This is a flawed thought process, because it can leave out those who may not have high incomes, but sufficient assets including equity shares, which enable them to take derivatives positions. In addition, a person who has a long futures position worth Rs10 lakh and has also written a call option on the same underlying for the same amount is effectively hedged. He imposes zero risk to the system. But income-based exposure limits may not permit many individual traders to take such positions.

The market structure expert says that unless a regulator can clearly demonstrate what market failure it is trying to address, there is no need to fix anything. “If the regulator is worried about wild speculation, it needs to show this with relevant data,” he says.

Such strictures typically result in a shift in volumes to over-the-counter markets. Since these are not legally permitted in India, trading may well shift to the kerb, as this article in Business Standard points out. Note also, that this comes at a time when overseas exchanges are trying their best to capture a share of the single stock derivatives market. If market participants find the rules in India restrictive, they could move their trading to these or other platforms. Given the number of such missteps by the markets regulator over the years, it’s high time the government imposed a requirement of impact assessment on Sebi.

If its measures aren’t helping, or worse, leading to unintended consequences, they should be corrected sooner than later. Till then, investors will need to price in large doses of regulatory risk while valuing stock exchanges.