Monday, February 28, 2011

What is gained from cross-border exchange mergers?

Cross-border exchange mergers are in the news. See Indian exchanges must go regional and then global and Global mergers and Indian exchanges, by Jayanth Varma, who points us to LSE and TMX merge by Jeff Carter on Points and Figures. Also see Stock exchange mergers: the fight for global dominance in the Telegraph, and Big bourse mergers are back but hold the hyperbole by Benn Steil.

An article in the Economist, Back for more: Has the global exchange industry lost its marbles again?, is skeptical about various stories that are being told about exchange mergers, but holds forth the possibility that there might be cost savings:

Joining forces does not in itself realise revenue gains or alter this decline. But it may make it possible to combine the technology and back-office platforms being used by different exchanges, cutting costs. Efficiency savings are the one element of the last round of consolidation that did arrive as promised.
Cost savings are being emphasised again now. The Deutsche Borse and NYSE-Euronext combination should yield annual savings of ?300m ($412m), the two firms say, equivalent to about a fifth of the combined entity's pre-tax profits, while the LSE-TMX deal should produce savings of about 7%.

In this article, I focus on the question: Is there a big opportunity for reducing cost through exchange mergers?

Getting a sense of the magnitudes

An exchange is an IT system that matches orders. The computational complexity of an exchange is all about taking in a lot of orders per second and computing a lot of trades per second. The output of the IT facility is purely measured by the number of orders that were produced. In the public domain, we see the number of trades, and not the number of orders. Hence, the number of trades is the best public domain source of the size of each exchange, from the viewpoint of cost.

To illustrate the magnitudes involved, last Friday, BSE got 34.1 million orders and did 1.94 million trades. This is an orders-to-trades ratio of 17.6:1 -- for each trade that BSE produces, they have to have the IT capacity to process 17 orders. The only way to get up to these kinds of values is by having a good deal of algorithmic trading.

The revenue per trade is, of course, very different across countries. In India, the average trade size on the equity spot market is $500 and the tariff for the exchange is hence tiny: NSE or BSE earn Rs.0.65 or $0.014 per trade. Using the above numbers, BSE's earning Rs.0.04 or $0.000795 per order on average. These low low tariffs imply that the revenue, profit and valuation of an exchange in India is tiny when compared with what's seen abroad. But on the question of cost, there is direct comparability: it costs as much to produce a billion trades in India as it does anywhere else.

From this perspective, let's look at the biggest factories in the world that produce trades. This is data from the World Federation of Exchanges, for equity trades on the limit order book, in January 2011:

Rank Exchange '000 trades
1 NYSE Euronext 1,52,922
2 NSE 1,18,200
3 NASDAQ OMX 1,13,753
4 Shanghai SE 1,04,965
5 Korea Exchange 1,00,221
6 Shenzhen SE 76,268
7 BSE 35,157
8 Tokyo SE 27,557
9 Taiwan SE 20,313
10 London SE 19,132

Saving money through unification of data centres?

I do believe that in this business, there are economies of scale. To build a factory that produces twice the trades costs less than twice the money.

Does this mean that exchange mergers can create value? Not necessarily.

Let's take one plausible merger from the above. The London SE is a small exchange: they did 19.1 million trades in January. The BSE did 35.1 million trades.

Can one save money by producing 55 million trades in a single data centre? Yes.

Will a BSE+LSE merged entity drop down to one data centre? Of course not! The problem is the speed of light. Today, the conversations between securities firms and exchanges are reckoned in milliseconds. And in one millisecond, light only travels 300 km. So even without reckoning for switching overheads (which are huge!) it is not feasible to unify data centres apart from local mergers such as CME and CBOT.

Since light moves at a glacial pace, it is simply not feasible to beam orders from London to a data centre in Bombay. So even if BSE merged with London SE, there would be two data centres. This limits the cost saving. Until we find a way to speed up light, there is going to be no data centre consolidation in this business, other than within small geographical areas (e.g. within Chicago or within New York).

Saving money on software development?

Okay, let's look further. Could there be cost saving by building one software system and deploying it twice? We'd still spend money to run two data centres, but we'd have only one expense of building software. Could this work?

It's much harder than it sounds. It is not often that one gets to fully transplant an exchange software system in a new location: all too often, the systems have to be significantly different. Regulatory differences, local preferences, history, what users prefer and are used to: all these shape immense diversity in exchange systems. There can actually be diseconomies of scale, with engineering and political problems of handling multiple versions.

Another key problem lies in the sizing of the software system. An exchange system that works for BSE will generally involve a different set of engineering tradeoffs when compared with the LSE setting. So ground-up implementations could be more efficient. By this logic, there may be a useful role for cooperation between similar-sized exchanges (e.g. NSE and Shanghai), but not across divergent sizes which are more than 2x apart.

When decision makers think `a system' can be readily transported across highly diverse order intensities, without regard for the inefficiencies introduced in this process, I think this has something to do with the lack of engineering backgrounds among these decision makers. On a related note, there isn't much of a role for exchange software as a software product, other than in the zone of tiny exchanges where an android phone will suffice for order matching. By the time you get to anything in the top 20 exchanges of the world, an efficient implementation will involve large amounts of ground-up development.

A skeptical perspective

NYSE merged with Euronext. Did we see cost reductions? A lot was said about cost reduction at the time of the merger, but I haven't particularly seen evidence of this filtering out post-merger.

ASX-SGX: Will they drop down to one data centre? Of course not. Will they unify systems? What will be the cost of system unification? Does it make any sense to unify systems? It helps that both are similar-sized small exchanges, but the institutional settings are highly different.

NSE and NASDAQ produce a similar number of equity spot trades. In the latest year, NSE spends roughly $150 million a year doing this, while NASDAQ spent $850 million. (NSE produces derivatives trades also, and the NSE number includes the cost of the clearing corporation, so the cost-per-trade edge at NSE is probably of the order of 10x when compared with NASDAQ). The two exchanges are similar in size in terms of the trades per second. Yet, this is not an easy merger opportunity. There will certainly be no data centre unification. NSE's knowledge can be used to run the NASDAQ data centre more cheaply, but complex organisational dynamics would have to be navigated in achieving the transition, and this could take decades to pull off. It is hard to get management teams that are able to play for such long-term gains.

Also see Are exchange mergers always good? by Mobis Philipose in Mint.

There is one kind of exchange merger which I have become increasingly skeptical about: one in which a parent foists computer systems upon the recipient. I have started worrying that this is a bit of a con, a method to generate revenues from system sales under the garb of partnership or strategic alliances. This is done to some extent by firms that are primarily in the business of selling software and not in the business of running exchanges. Or, to the extent that high-cost exchanges are able to do this, the systems/software revenues are able to mask the deeper problem of a high cost structure.

I have watched the grand global deal-making between exchanges for a long time. In my reckoning, most of it has been a waste of time and money. As one specific example, in my observation in India, some foreign investments into Indian exchanges has been irrelevant, others have directly done damage. None has as yet helped improve product offerings or cost efficiency.

One contract that comes to my mind as one that really worked was Mutual Offset (MOS) between CME and SIMEX, which was done way back in 1984. This was one deal that really mattered and was a good idea. But it was useful in the age before capital account openness - such connections are less important today when capital flows freely anyway. And, remember that it was a mere contract, it involved no complications of ownership and management. So I do think there will be value if the Nifty futures on SGX, CME and NSE are all unified through a mutual offset system: but this does not require anything more complex than signing a contract.

Jayanth Varma says:

It is tragic that at this point of great opportunities and strategic challenges, the energies of Indian exchanges and their regulators are entirely consumed by the debate about whether exchanges should be regulated like public utilities

I disagree. The global exchange M&A story seems to be overrated, apart from the extent to which systems like MOS which can alleviate home bias (and only require contracts). There isn't much to gain there. On the other hand, the problem of sound regulation and supervision of exchanges in India is a GDP-scale issue. Indian experience and evidence does not support a complacent approach that the regulation and supervision will work out.


My thinking on this was improved through conversations with Ravi Apte and Ashish Chauhan.

Thursday, February 24, 2011

Rapid buildup of currency options open interest

Today, on NSE, derivatives trading showed the following numbers:

Product classTurnover (Billion rupees)
Index futures 353
Index options 1981
Stock futures 391
Stock options 48
Currency futures 178
Currency options 30
Total 2981










Some older materials that you might like to see:

Jittery regimes fix prices

The puzzle




Conflicts beneath the surface



The behaviour of a jittery regime



Three examples





Stability that is illusory








Saturday, February 19, 2011

Interesting readings

My collection of links on the transition at SEBI from C. B. Bhave to U. K. Sinha.

How India's banks killed the future of commerce on the Cleartrip blog.

The defining problem of the Indian State is the tension between spending on program that benefit the few (e.g. the typical UPA welfare program) versus programs that benefit all (i.e. public goods). This problem even extends to skimping on resources for the judiciary. See Dhananjay Mahapatra in the Times of India.

Greasing our shock absorbers by Ila Patnaik in the Indian Express, 3 February 2011. And watch her talk about the economy.

There is quite a bit of debate in India about big government versus small government. On this subject, Blanca Moreno-Dodson and Nihal Bayraktar have a note How Public Spending Can Help You Grow: An Empirical Analysis for Developing Countries. They compare a set of fast-growing developing countries to a mix of developing countries with different growth patterns. Considering the full government budget constraint, the empirical analysis shows that public spending, especially its `core' components, contributes to economic growth only in countries that are capable of using funds for productive purposes. In addition, those countries must have an adequate economic policy environment with macroeconomic stability, openness, and private sector investments that are conducive to growth. Unfortunately, their definition of `productive and core sectors' reflects World Bank ideology, and does not focus on public goods.

IT strategy for the Goods and Services Tax.

A great article on Saudi Arabia by Laurence Wright.

Tunisia and Egypt continue to be incredibly important and riveting. I really enjoy the thought, however fatuous, about every strongman across the world sleeping a little less easy. See Why Egypt should worry China by Barry Eichengreen on Project Syndicate. On the East Asia Forum, Peter Beck tells the story about how the dictatorship collapsed in Korea. Robert L. Tignor on Project Syndicate locates the present discussion in Egyptian history.

Read this interview with Andreas Wesemann.

The wonderful world of Android: link, link.

Is Your Job an Endangered Species? by Andy Kessler in the Wall Street Journal.

Abrupt change in authoritarian regimes: Gary Becker, Richard Posner.

Friday, February 18, 2011

Reliance ADAG consent order

I have long had a complaint that the fines imposed in India for violations of law are too tiny. In SEBI's entire history, big fines - of more than Rs.10 million - have seldom arisen. The economic reasoning suggests that fines have to be way bigger than mere disgorgement, in order to reflect the imperfect probability of getting caught. Fines have to be big enough to really hurt the key decision makers. Only then will they exert an influence on the behaviour of the entire market.

SEBI recently came out with a consent order on certain irregularities in the trading of shares of Reliance Communications. Some of the penalties imposed are eye-popping. Applicant companies shall not make investments in listed securities for calendar 2011 and 2012. Individual applicants shall not trade in the market in calendar 2011. The individuals involved -- Anil Ambani, Satish Seth, S. C. Gupta, Lalit Jalan, J. P. Chalasani -- have paid a settlement amount of Rs.0.5 billion.

Are these penalties big enough to hurt? The corporate treasuries have been shut off from the secondary market for 2 years, the individuals from trading on the market for one year, and a payment of Rs.0.5 billion: I think this is big enough to hurt.

I applaud this development, of moving towards bigger penalties that are big enough to pinch the immense resources commanded by individuals and firms in modern India. At the same time, consent orders require immense regulatory capacity in government. It would have been all too easy for Dr. Abraham and others at SEBI to agree to a penalty which was one-tenth as large, in the negotiation that leads up to the consent order. Nobody in India would have criticised the SEBI leadership if the size of the settlement amount had been Rs.0.05 billion. But that would have made all the difference in shifting from a penalty that hurts, to a mere minor cost of business. It requires immense resources of integrity and toughness to do what SEBI has done.

We must move in this direction, of tough orders. These developments underline the criticality of the appointments process for SEBI and for other financial regulators. In an environment of unprecedented gloom about corruption in India, SEBI's progress on being a tough regulator with the highest ethical standards is noteworthy. It shows us something about the human energies that continue to be found in the Indian State, where some teams and individuals stubbornly stand up against the malpractice and corruption which is increasingly becoming the norm, despite the considerable firepower that crooks are able to command.

This order is one more pillar in the body of case law of C. B. Bhave's SEBI. I think of Bhave's achievement at SEBI as being a series of remarkable orders. SEBI is a quasi-judicial organisation and the technical quality of this organisation is all about the quality of orders that they are able to come up with. Alongside other famous orders -- Sahara, MCX-SX, HDFC AMC front running, ULIPs, Bank of Rajasthan, Pyramid Saimira -- this is a major achievement of SEBI in nailing wrong-doing and (more importantly) scaring off other would-be wrongdoers. For each firm that is visible as having been caught trying to violate rules, there are ten other entrepreneurs who have been dissuaded from similar business strategies by watching these events unfold.

Reliance ADAG consent order

by Shubho Roy and Pratik Datta.

The SEBI Consent order under discussion has garnered wide media attention. The total settlement amount sounds very large. Certainly, it is the largest `settlement amounts' ever collected by SEBI. One could argue that the settlement amount is large enough to deter such behaviour and prevent recurrence. However, if we are skeptical about the functioning of any government agency (as we all should be) we have to wonder. Whenever you consider the size of a fine, the most important thing to remember is that it is always relative. US$150 million sounds like a large amount for a fine. If I were to tell you that this is the total fine Union Carbide paid for the bhopal gas disaster, it does not seem very large.

The traditional method of enforcing laws/regulations in most regulators is through an enforcement action. The regulator sets up an investigation, collects evidence and then places it before an adjudicating body. The adjudicating body then gives the opposite party an opportunity to defend its actions. After both parties are heard, the adjudicating authority is required to record its decision along with the reasons for arriving at such a decision. This process is long and requires large amount of resources to be spent by all parties involved. In most cases the decision of the adjudicating body can be challenged in a court of law. This leads to another round of litigation and delays. Despite these drawbacks the judicial process has one important facet: transparency. The evidence presented, the reasoning and the decision are all open to scrutiny. Any person can look at the facts and decide whether the decision was fair or not. Consent orders are not the same. They function differently.

How do consent orders work? Going by the existing SEBI regulations:

  1. The concerned entity offers the terms for a settlement, by itself, to SEBI.
  2. This offer is considered and debated amongst an Internal Committee (IC) of Division Chiefs of SEBI.
  3. If the IC accepts the terms it is forwarded to the High Powered Advisory Committee (HPAC) which is headed by a former judge of a High Court and other wise men.
  4. The HPAC considers the terms and recommends whether they should be accepted, declined or modified.
  5. Two Whole Time Members of SEBI take the final decision.

These different bodies are created to prevent collusion between the officials of SEBI and the entity offering the terms of settlement. The system is quite similar to the system of consent orders used by the Securities and Exchanges Commission (SEC) in the United States.

On one hand, it appears that SEBI has imported global best practices. At the same time, it is important to remain skeptical about this area. Global best practices often do not work when mechanically transplanted: each institutional arrangement needs to be analysed from scratch, with an aim of understanding how incentives and maximisation generate behaviour under Indian conditions.

The actions that SEBI has taken in the recent months show strong signs of integrity and a tough approach towards wrongdoing irrespective of the size and nature of the entities involved. However, consent orders by their very nature are dependent on other strong institutions. These include reasonable anti-corruption agencies and a general faith in the system of governance. Each of us will have to decided whether in the Indian context the system set up for consent orders can be considered safe or not. Consent orders are a positive part of the present environment, but at the same time all of us must apply the maximal skepticism in watching how consent orders are being produced.

Author: Shubho Roy

On this blog:

Saturday, February 12, 2011

Watching markets work: Bad move, Nokia


So when I heard that Nokia was now going to be quite wedded to operating system from Microsoft [press release], I thought to myself ``That can't be so bright''. Then I looked at the stock price and it said:

So the market seems to have knocked Nokia down by 18% for wanting to run with a loser like Microsoft. And what's more funny, the market seems to have knocked Microsoft down 4% for this contract too (which I don't understand - compared with being wasteland, it seems that it is good news for Microsoft to have the support of Nokia).

Monday, February 07, 2011

How to measure inflation in India

Ila Patnaik, Giovanni Veronese and I have a paper titled How to Measure Inflation in India?. The abstract reads:
You may like to see our stock of papers.

Inflation measurement in India may just get significantly better, with the release of the new CPI. The paper should help in evaluating this new CPI and in evaluating its applications.


This blog post is joint work with Jeetendra.












Sunday, February 06, 2011

What is wrong with Economics

Raghuram Rajan has an interesting piece on what went wrong with the economics profession in the
years that led up to the global crisis. His big issues: specialization, the difficulty of forecasting, and the disengagement of much of the profession from the real world.

I think these, in turn, are directly related to the incentives of academic publishing. It's a recurring theme in agency theory: When the principal rewards the agent for performance in a certain direction, an excessive focus upon that comes about, and performance in other directions gets contaminated. When universities created an incentive structure linked purely to peer-reviewed journal pubs, economists focused on performing for each other, instead of performing for the world.

So in our diagnosis of the crisis, just as we criticise the HR policies of banks, we should also criticise the HR policies of universities.

While I'm quite aware of the narrowing of the mind that comes about from the Western-style process of focusing on pubs and tenure, it is not easy to find an alternative HR framework. George Stigler had a fascinating little article on this (which I was unable to find: do you know it?).

In India, in particular, the economics profession suffers from the twin maladies of low pressure and the historical baggage of development/socialist economics. On average, if an Indian economics department was given strong incentives to publish more, it would be an improvement. Performing for economists is better than not performing. At the same time, on the scale of mankind, it does seem that economists need to do more in terms of performing for the world.

Why does the publishing+tenure process work well in science and engineering? I have an opinion of one element that is in play there. In science and engineering, bringing in resources through research contracts is essential for doing research because research requires expensive equipment, staff, etc. There is, then, a joint production of academic publications alongside performing for the world (which allocates research funding). Hence, when the principal asked for academic publications, this did not generate a closing of the mind. In contrast, most research in economics in the top departments worldwide does not require bringing in external funding. So that source of pressure for performing for the world is absent.

Saturday, February 05, 2011

Author: Jeetendra

Interesting readings


Vikram Doctor about how Bollywood is (not) growing up.

Why Bombay should envy London.





Evan Fraser and Andrew Rimas in Foreign Affairs on food riots.




Importance of the appointments process

A memorable passage from When Irish eyes are crying, the story of Ireland's economic disaster by Michael Lewis, in Vanity Fair:

...the dominant narrative inside the head of the average Irish citizen -- and his receptiveness to the story Kelly was telling -- changed at roughly 10 o'clock in the evening on October 2, 2008. On that night, Ireland's financial regulator, a lifelong Central Bank bureaucrat in his 60s named Patrick Neary, came live on national television to be interviewed. The interviewer sounded as if he had just finished reading the collected works of Morgan Kelly. Neary, for his part, looked as if he had been dragged from a hole into which he badly wanted to return. He wore an insecure little mustache, stammered rote answers to questions he had not been asked, and ignored the ones he had been asked.

A banking system is an act of faith: it survives only for as long as people believe it will. Two weeks earlier the collapse of Lehman Brothers had cast doubt on banks everywhere. Ireland?s banks had not been managed to withstand doubt; they had been managed to exploit blind faith. Now the Irish people finally caught a glimpse of the guy meant to be safeguarding them: the crazy uncle had been sprung from the family cellar. Here he was, on their televisions, insisting that the Irish banks were ``resilient'' and ``more than adequately capitalized'' ... when everyone in Ireland could see, in the vacant skyscrapers and empty housing developments around them, evidence of bank loans that were not merely bad but insane. ``What happened was that everyone in Ireland had the idea that somewhere in Ireland there was a little wise old man who was in charge of the money, and this was the first time they'd ever seen this little man,'' says McCarthy. ``And then they saw him and said, Who the fuck was that??? Is that the fucking guy who is in charge of the money??? That's when everyone panicked.''

Friday, February 04, 2011

Better execution of complex IT systems in government

The TAGUP report has been released. For the background, see the creation of the group and this blog post. The ideas of the report could give a quantum leap in the execution quality of five projects of tremendous importance -- the Goods and Services Tax (GST), the Tax Information Network (TIN), the Expenditure Information Network (EIN), the National Treasury Management Agency (NTMA) and the New Pension System (NPS). In all these areas, political consensus has been achieved but the execution has floundered. More generally, these recommendations add up to an important fresh look at how to modify the ground rules of public administration in India, so as to better cope with the sorts of challenges that are now being faced.

Update (5 May 2011): Movement on implementation of TAGUP

Thursday, February 03, 2011

C. B. Bhave's 3 years at SEBI







Wednesday, February 02, 2011

India: a nascent social democracy?

As India embarks on the early stages of middle income, there is interest in a more expansive outlay of expenditure for the government. This motivates the question: Can India now embark on constructing an array of welfare programs, which would ultimately add up to an approximation to a welfare state or a social democracy?

Vijay Kelkar and I wrote a paper Indian social democracy: The resource perspective on this question, for the 10th `Indira Gandhi Conference' which took place in New Delhi recently.