The introduction of smart order routing (SOR) in India is a big step forward from a best execution perspective, but long-standing issues related to post-trade settlement will present roadblocks to its fast adoption, traders say.
India's stock market regulator, Securities and Exchange Board of India (SEBI), issued a circular on 27 August permitting SOR in the securities market. One implication of the move will be a gradual reduction in arbitrage opportunities between the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE), which account for around 20% and 80% respectively of trading. According to a report released in August 2010 by Credit Suisse's Advanced Execution Services (AES) division on the potential impact of SOR in India, the BSE offers the best execution prices around 35% of the time despite its relatively small share of trading.
The two markets are not completely synchronised, suggests Murat Atamer, head of AES product, Asia Pacific, at Credit Suisse. “There are people who try to arbitrage between them, but the bid-offer spreads on the two exchanges are equally tight, so you're going to have some price mismatches where the bid will sometimes be better on BSE than on NSE. At present, the BSE might have a better price either on the bid or the offer a third of the time. That will disappear in a perfect market where you can take and hit right away,” he said.
According to James Rae, director and head of AES sales for Southeast Asia, Credit Suisse, SOR will reduce price differences across the two exchanges. “Fragmentation exists today because it's difficult to manually trade both exchanges simultaneously,” he explains. “By alleviating this, SOR actually helps reduce fragmentation, increases price parity between the exchanges and results in improved executions.”
Many brokers have applied to offer SOR in India and are awaiting the go-ahead from the stock exchanges. In concept, SOR technology will route prices from the stock exchanges to the trader's desktop and automatically identify the best price for executing an order. However, the fact that the BSE and NSE have traditionally had different settlement systems inevitably results in more manual work post-trade.
“Unless and until clearing and settlement is synchronised, SOR is not expected to pick up too quickly in India,” said Anshuman Jaswal, senior analyst, capital markets at financial research and consulting firm Celent. “I don’t believe synchronisation will be possible in the next few years because the clearing and settlement mechanisms are vertically integrated.” Jaswal adds that the current situation in India is in line with global trends: both NYSE Euronext and the London Stock Exchange are expected to create their own clearing houses.
Ian Smith, head of electronic execution product for Asia Pacific at Citi, concedes that having two separate sets of settlement instructions makes things “a little more complex” than in the other markets where Citi runs SOR. “If those two were streamlined, it would make it much simpler for our clients,” he said.
“Some clients will deem the price improvement and the better execution that we can get through a SOR worth the hassle [of multiple settlement instructions per trade] but there are other clients who might trade hundreds of names a day and that complexity in their booking process would be prohibitive. So it's on a client-by-client basis as to whether the price improvement is sufficient for them to do the additional work,” Smith added.
One regional head of trading at a global investment firm said the introduction of SOR is likely to provide greater opportunities for price improvement, but pointed out the need to provide the buy-side with greater transparency.
“Right now I can do electronic trading with no issues through one exchange or the other, but if I'm going to use both exchanges, and as those fills come back electronically, I won't know where they came from if I'm trading the order myself. If I give it to the broker to work on both exchanges, he's going to use the SOR and ideally my fills are going to be better and more complete. But at the end of the day, I need the breakdown from him that I did X amount on the BSE and Y amount on the NSE, then I have to split the ticket,” the buy-side source explained.
Based on daily turnover averaging US$4-8 billion, India is on its way to becoming the third largest equity market in Asia Pacific behind China and Japan, according to the Credit Suisse report. NSE has garnered the bulk of trading because of its established derivatives market as well as the fact that its key index, the Nifty 50, is a widely used benchmark. While the adoption of SOR is expected to lift volumes on BSE as more trades get done at best execution prices, it is unlikely to take liquidity away from the NSE in a big way.
“NSE is much bigger in terms of bid-offer quantities at each price level. Additionally, given the dual settlement issue, the impact on trading volume shifts between exchanges may not be as significant as a market place without frictions may suggest,” said Atamer.
“Because you can cross-margin the derivatives business on the NSE, a lot of people have moved their positions to the NSE. Inherently once an exchange has captured liquidity, its very difficult to for it to migrate elsewhere. Liquidity begets more liquidity,” added Rae.
Most believe that SOR will be slower to catch on in India than other aspects of electronic trading such as direct market access, co-location, algorithmic trading and high-frequency trading, which are growing at a robust pace. Celent's Jaswal estimates that 15% of cash equity trading volume on NSE is accounted for by algorithmic trading and around 20-25% by futures and options.
“India is sometimes a challenging market, but it's also a huge opportunity for electronic trading,” noted Smith at Citi.