Restrictions imposed by India’s central bank on bank financing of proprietary trading could push trading firms to relocate their operations and could force smaller players out of business, according to executives and analysts.
The proposed regulatory changes, which prohibit banks from lending for proprietary trading and require 100% coverage for all other financing provided to brokers, could cut profit margins in half and lead to as much as a 20% drop in derivatives trading volumes, these executives said.
Reuters spoke to executives from six trading companies, domestic and foreign. All declined to be identified as they were not authorized to speak publicly.
The Reserve Bank of India’s (RBI) initiative – set to come into effect on April 1 – is part of a series of measures taken by the government and markets regulator to curb the explosive growth of India’s equity derivatives market. This market has massively attracted small investors, nearly 90% of whom are recording losses, according to an official study.
Analysts believe that policy makers fear the risks of contagion for household finances and the economy as a whole.
FALLING LEVERAGE
Currently, trading companies use bank financing to increase their leverage and reap significant profits, outperforming retail investors with their expertise. Recourse to other sources of capital, generally more expensive, would seriously eat into their margins, according to managers and analysts.
“Domestic proprietary trading firms fear that their business model has become obsolete,” said an official at a mid-sized trading firm.
“Large companies still have some of their own capital, but this will limit their growth prospects,” said the head of a major domestic high-frequency trading (HFT) company.
The National Stock Exchange of India (NSE) is the world’s leading marketplace for equity derivatives, accounting for 70% of global index options trading, according to data from the World Federation of Exchanges.
Proprietary trading represents almost half of the NSE derivatives activity by value. HFT companies represent around 50% of proprietary trading, according to Jefferies.
SMALL TRADING COMPANIES IN DIFFICULTY
“Small proprietary trading firms, which have traditionally relied on broker funding, will be most penalized as they have neither strong balance sheets nor access to alternative credit,” Mumbai-based brokerage IIFL said in a note published this week.
The response from trading companies echoes that of the brokers’ lobby, which on Thursday called for a six-month delay in the entry into force of the new rules in order to allow consultation and an assessment of their impact.
The Reserve Bank of India and the Securities and Exchange Board of India did not respond to email requests for comment on the article.
Policymakers face a major challenge: India’s derivatives market has grown to more than double the size of the underlying spot market, a stark contrast to the 2-3% ratio seen in major global exchanges.
Measures taken so far include increasing trading fees on derivatives, reducing the number of contracts offered by exchanges and increasing taxes on profits from these operations.
However, while these measures have reduced the number of contracts traded, the total value of transactions remains high, a sign that significant capital continues to be committed.
According to trading company executives, the RBI’s new initiative could, in fact, penalize domestic players.
Foreign trading companies could suspend their plans to set up operations in India and shift their operations to offshore centers where financing is cheaper, giving them a competitive advantage, said three of the executives interviewed.
