Liquidity on steroids

The Bombay Stock Exchange (BSE) has managed to achieve a daily turnover close to Rs 100,000 crore in equity futures and options contracts, largely courtesy an incentive scheme (liquidity enhancement scheme or LES, for short) that it launched last September. In the process, the country’s oldest bourse has closed in on the National Stock Exchange, which used to enjoy a 99 per cent share in the derivatives market segment. That was until BSE came out with the LES, which incentivises brokers to act as counterparties to bonafide investors by offering to be on either the ‘sell’ or the ‘buy’ side of the market, depending on the investor interest at any point of time. The cash incentives, linked to volumes, prompted the market intermediaries to trade BSE derivatives through their own accounts, in turn, boosting turnover in the exchange as well. The question that naturally arises, then, is whether these volumes can sustain themselves once the incentives are withdrawn. The LES on Sensex options – accounting for more than 95 per cent of derivatives now being traded on BSE – is, in fact, scheduled to come to an end this month.

What is even more intriguing about the trades currently taking place is the absence of retail participation, with the contracts not being even offered on online trading platforms of leading brokerages. An exchange, ultimately, is only a market for buying and selling shares. How can any market sustain itself, if the shopkeepers only trade between themselves, which is what seems to be the case here? There are some, though, who believe that retail investors may eventually get tempted into trading because of rising volumes. But that still does not justify BSE paying incentives to brokers, many of whom are its members, by dipping into its coffers. The exchange last year actually paid out a quarter of its net profits earned in 2010-11 as incentives. Clearly, such largesse, given the incestuous nature of these trades, amounts to a distribution of the exchange’s surpluses to a select set of members, when these ought to be retained for improving the overall market infrastructure or surveillance systems.

To be sure, what BSE is doing is not in violation of the current regulations of the Securities and Exchange Board of India (SEBI), which do permit exchanges to design schemes promoting liquidity in illiquid derivative instruments. But the present incentive ceiling of 25 per cent of their previous year’s profit or free reserves not only needs to be reduced; it should also be mandated that the counterparty is a genuine retail or an institutional investor. In the absence of any end-use conditions, there is a danger of the LES being reduced to a sham that drains the coffers of an exchange for no worthwhile purpose.