Cognizant 20-20 Insights

Assessing Liquidity Enhancement Schemes

Executive Summary
The Indian equity derivatives market has grown to approximately five times the volume of the cash market in the last decade. This growth has not been consistent for all derivatives products or exchanges. Product-specific index futures and options (F&O) accounted for nearly 70% of the total volume of the equity derivatives market in the last four years, with liquidity largely present in near-month contracts only. In the first half of 2010-11, the National Stock Exchanges (NSE) index F&O rose to nearly 82%. Stock-specific trading accounted for just 18% of overall futures and options trading. On the Bombay Stock Exchange (BSE), stock-specific trading barely exists. The NSE and BSE logged an average monthly F&O turnover of 1.17 lakh crore and 4 crore, respectively, over the past year. As of August 2011, there were 1,599 listed companies in the NSE and 5,085 in the BSE. Only 221 securities (of which 134 were added in July 2011) and 236 securities are traded in the F&O segment of the BSE and NSE, respectively. In its circular in June 2011 (see Figure 1, next page), the Securities and Exchange Board of India (SEBI) provided a big push to Indian stock exchange operators to identify, formulate and implement various liquidity enhancement schemes (LES) to boost the illiquid equity derivatives segment. The goal is to trigger changes in the existing market structure and provide challenges and opportunities for exchange operators and participants. This white paper identifies and evaluates steps that can be taken to take advantage of this regulatory change.

Proposed Liquidity Schemes

In its circular, SEBI suggested a few ways to create liquidity in the equity derivatives segment. Taking the boards suggestions, and based on our experience with other exchange operators and participants, we have identified several ways to achieve this in the Indian trading context (see Figure 2, next page). Following publication of the circular, the BSE launched incentive programs (lower transaction fees, volume- and open-interest-based cash incentives) for its members and also plans to spend over Rs 100 crore in the coming months on market-making schemes. The NSE also launched incentive programs for near-month and following two months contracts on the S&P 500 and Dow Jones Industrial Average indices.

cognizant 20-20 insights | october 2011

SEBI Circular Details

Key Points

To be implemented in illiquid securities in the equity derivative segment only. All LES schemes, such as Maker Taker, Market Maker and Liquidity Provider, can be adopted. Incentives can be paid in the form of fee discounts/adjustments, payment for order flows and stock, in the form of options or warrants of stock exchanges within prescribed limits.

Entry Criteria
New securities. Securities getting listed on a new exchange and new segment. Securities where average trading volume for the last 60 days on the stock exchange is less than 0.1% of market capitalization of the underlying security. If above is not satisfied, then conditions must exist on a particular stock exchange, and the scheme can be enforced by another exchange on the same/similar security.

Exit Criteria
Advance notice of 15 days. Last 60 days trading volume = 1% of market cap of underlying or six-month average, whichever occurs earlier. Exit of LES by initiating stock exchange, then all other stock exchanges must exit.

Gray Areas
Lack of continuity of LES will discourage exchange participants and create confusion. Uniform exit criteria proposed on all LES; this might be applicable for some simple schemes but might not work for other complex schemes. Detailed guidelines not present on issues (communication channel, timeline, etc.) to be created due to interdependency of exchanges to initiate/exit LES.

Complexity arising out of simultaneous,

multiple LES schemes on same security for exchange participants. Ambiguity on co-relation between illiquid security present in cash segment and their impact on derivative segment.

Figure 1

Proposed Liquidity Scheme

LES
Market Maker

Description
Exchange members who are responsible for creating liquidity by
providing two-way quotes during the trading day, as stipulated by the exchange. trading day.

Pros/Cons

+ Ensures liquidity is maintained throughout the Not relevant in prevalent order-driven markets. + Quickest way to incentivize members and easy to Additional cost to exchanges and limited duration. + Indirect and less costly form of incentive given by No immediate return for members. + Allows members to quote better price and Discourages customer origin order flow. + Allows exchanges to concentrate pool of liquidity
at pre-determined intervals/actions and enables price discovery. Difficult to implement by exchange. remove the customer priority factor. exchange to members. implement by exchanges.

Fiscal Incentive

Payment for order flows. Discount/Adjustment in transaction fees. Exemption from other exchange fees, such as membership fees. Guaranteed allocation of order flow among participating
members. Shares, including options and warrants, of stock exchange.

Non-Fiscal Incentive Maker Taker

Transactional charges are levied differently between traders

that bring vs. take liquidity to/from the market. Makers of liquidity are given rebates, and takers of liquidity are charged.

Order trigger mechanism: An incoming customer order starts an

Call Auctions auction, which is flashed to trading members, who can respond with opposite side orders. Liquidity concentrator mechanism: Auctions are held at predetermined time intervals. During the auction, buy and sell orders are netted to trade at a single price point, at which the maximum number of orders can be cleared (e.g., pre-open sessions).

Source: Cognizant Figure 2

cognizant 20-20 insights

Challenges of Market Maker Model

Challenges
Exchange Operators

Need to identify the criteria to select/appoint

Exchange Participants

Market Maker. Need to formulate rules around key areas such as: > Assigned contracts/series number. > Time for continuous quoting. > Maximum time limit for responding to QR. > Minimum display time, maximum bid/offer spread. > Non-market-making hours obligations. Additional reporting to regulators. Create awareness and train registered exchange participants. Clear rules governing trading between Market Makers need to be in place. Strong surveillance system needs to be in place to avoid any collusion between Market Maker for their own interests.

Access to/integration with software, which en> >

ables quotes to be created, maintained and disseminated. Option 1: Front-office software that interacts with market to generate quotes. Option 2: Exchange-supplied auto-quote system. Risk management system capable of maintaining and monitoring inherent risk in real-time. Integrate/build position management system that updates Market Maker net position in real time.

Regulators

Ensure the policies and procedures formulated

by the exchange operators are fair and transparent.

Figure 3

Market Maker Model The Market Maker (MM) model has been adopted by many exchanges across the world, and it plays a key role in the derivatives segment of the market. The following are some characteristics of the Market Maker model, according to Delphine Sabourin:1

Market Makers are more effective in small- and mid-caps, which are less liquid compared with large caps. The Market Maker model also poses several challenges for exchange operators, participants and regulators (see Figure 3). The Sydney Future Exchange was able to apply the Market Maker model, with the following benefits:

Clearing frequency is higher in a limit order market with Market Maker. The presence of Market Maker entails a higher level of competition for the execution of limit orders.

Decline in average bid ask spreads for the period Nov. 2003 to Jan. 2006 (see Figure 4). Rise in average quarterly trading volume for the period Feb. 2005 to Jan. 2006.

Sydney Future Exchange Pre- and Post-Trade Quote Spread & Volume Comparisons
0.08 0.07 0.06 350,000 300,000 250.000

Pre

Post

Quoted Spread

Volume
11/17/03 12/17/03 1/17/04 2/17/04 3/17/04 4/17/04 5/17/04 6/17/04 7/17/04 8/17/04 9/17/04 10/17/04 11/17/04 12/17/04 1/17/05 2/17/05 3/17/05 4/17/05 5/17/05 6/17/05 7/17/05 8/17/05 9/17/05 10/17/05 11/17/05 12/17/05 1/17/06 2/17/06 3/17/06 4/17/06

0.05 0.04 0.03 0.02 0.01 0.00

200,000 150,000 100,000 50,000 0 Nov 03 - Jan 04 May 04 - Jul 04 Aug 04 - Oct 04 Nov 04 - Jan 05 Jun 05 - Aug 05 Mar 05 - May 05 Sep 05 - Nov 05 Dec 05 - Feb 06 Feb 04 - Apr 04 Mar 06 - May 06

Spread

Source: Market Insights, University of Sydney Figure 4

cognizant 20-20 insights

Fiscal Incentive Fiscal incentives are the most tangible form of incentives provided by exchange operators to exchange participants, including trading members, brokerage firms, Market Makers, etc. (see Figure 5). Non-Fiscal Incentives Another way to incentivize exchange participants is through non-fiscal measures. For instance, the exchange can provide trading advantages to Market Makers (i.e., guaranteed allocation of order flow among participating Market Makers). This practice is currently followed by one of the largest options exchanges in the U.S. The Market Makers are assigned 40% of the allocation during an internalization auction if they are quoting at the best price. In addition, the Indian Exchange regulator has allowed operators to allocate shares, including options and warrants, of the stock exchange as incentives, not exceeding 25% of the issued and outstanding shares of the stock exchange as on the last day of the preceding financial year.

Maker-Taker Model The Maker-Taker pricing model in the options area has gone in and out of fashion. There have always been two schools of thought. Some exchanges in 2010 (NASDAQ OMX PHLX and JSE) adopted this pricing model (see Figure 6, next page), whereas the International Security Exchange launched a modified version of the model to suit its requirements. Call Auctions: Order-Triggered Mechanism Incoming orders trigger an auction process, which is flashed to members to allow them to participate and improve the price (see Figure 7, next page). This gives order originators a chance to trade at a price better than what is available in the book. This can also be applied to present blocked deals to the market, when one order of the deal is an agency order and the other is a proprietary order. When the Boston Option Exchange (BOX) adopted order-triggered call auctions, it saw an average improvement in trade price for July 2011, clearly showing how an auctioned order fetches an improved price compared with the best available price for a trade (see Figure 8, page 6).

Incentive Plans Adopted by Various Exchanges in Derivative Segments

Exchange Incentive Start Segment Incentive Detail
No transaction charges will be levied on trades done. Additionally, based on number of contracts, waiver of transaction charges will be increased. No. of Contacts Waiver of transaction charge 10 to 30 2 times 31 & above 3 times Waived off stamp duty, trading fee and transaction levy for Market Maker. Differential discounted fees for Market Maker on different products. Applicable until Dec. 2009, free of charge. (Clearing fee will be charged.) Applicable until March 2010, free of charge. (Clearing fee will be charged.) Applicable until Jan. 2010, 40 JPY. (A new fee schedule [70 JPY per contract] will be given 30 JPY discount during the period.) For brokers, trading members, Rs 1,050-1,100 to brokers for Rs 1 crore turnover for both buy and sell orders. Nearly double incentive for Market Makers that give both buy and sell quotes.

Fiscal Incentive Type

National Stock Exchange

Jan-08

F&O of Nifty Junior, CNX 100 and Nifty Midcap 50

Exemption of fees

Hong Kong Stock Exchange

Feb-07

Stock & index Futures & options Single stock & index options, options on JGB futures Mini contracts like mini Topix futures, mini JGB futures Topix futures

Exemption of fees Discount/ Adjustment in fees Exemption of fees

Tokyo Stock Exchange

Oct-09

Exemption of fees Discount/ Adjustment in fees Payment for order flow

Nov-09 Bombay Stock Exchange

Jul-11

Derivative segment

Source: Various exchange Web sites

Figure 5

cognizant 20-20 insights

Exchanges That Adopted/Discontinued the Maker-Taker Pricing Model

Exchange
NYSE Arca Options Chicago Board of Stock Exchange (CBSX) Boston Options Exchange (BOX) Nasdaq Options Market (NOM) London Stock Exchange (LSE) Bombay Stock Exchange (BSE) Bombay Stock Exchange (BSE) Nasdaq-OMX-PHLX Johannesburg Stock Exchange (JSE) August-07 September-08 August-09 September-09

Start Date
January-07 May-07 August-07

Discontinued
NA June-11 August-09

Remarks
Uses Maker Taker pricing for penny-pilot options.. Pricing model was changed to flat fee structure.. Reverse of the Maker Taker pricing schemes: will pay a $0.30-per-contract rebate to those who remove liquidity and charge those posting liquidity $0.30 per contract. Shifted back to the traditional model. New fee structure is dependent on value traded by individual market participants on the exchange per month. Cash equity segment Equity derivative segment Derivative segment Equity derivative segment

October-09 December-09 January-10 July-10

NA NA NA NA

Source: Various exchange Web sites

Figure 6

Call Auction: Liquidity Concentrator Scheme Under this type of call auction, liquidity is concentrated at a pre-determined interval. It can be at the opening, closing or during the trading day. Most stock exchanges rely on the opening call auction method to determine opening prices and the continuous auction method during the remainder of the trading session. In contrast, stock exchanges in Malaysia and Taiwan utilize the call market method as the sole price and order matching method.

world, we have evaluated the above schemes on certain parameters (see Figure 9, next page). Exchange operators should identify securities eligible for LES and start implementing schemes with minimum time to market. They should simultaneously work toward building infrastructure and systems for complex schemes, as well as awareness of these schemes. They should also build mechanisms to measure the effectiveness of ongoing schemes. Exchange participants should build a tool to evaluate which LES would be beneficial. Additionally, they should work toward scaling up their systems to leverage market making schemes.

Evaluation of the Proposed Schemes

Based on our extensive experience with exchange operators and exchange participants across the

Exchanges Adopting Order-Triggered Auction Mechanism

Exchange
International Securities Exchange (ISE) Chicago Board Option Exchange (CBOE) Boston Option Exchange (BOX)

Auction Name
Price Improvement Mechanism (PIM) Automated Improvement Mechanism (AIM) Price Improvement Period (PIP)

Description
An auction process through which an ISE member may trade with its customers order as principal or execute its customers order against orders the member has solicited. Automated process for crossing of any origin type, which provides potential for price improvement and participation right through an auction process. PIPs are initiated under specific circumstances on a voluntary basis. PIPs can be initiated by broker-dealers who are willing to provide their customers guaranteed execution with their own contra-order or through the directed order process.

Source: Respective exchange Web sites

Figure 7

cognizant 20-20 insights

Impact Of Order-Triggered Auction Mechanism On Price

July 2011
Date
July 29, 2011 July 28, 2011 July 27, 2011 July 26, 2011 July 25, 2011 July 22, 2011 July 21, 2011 July 20, 2011 July 19, 2011 July 18, 2011 July 15, 2011 July 14, 2011 July 13, 2011 July 12, 2011 July 11, 2011 July 8, 2011 July 7, 2011 July 6, 2011 July 5, 2011 July 1, 2011

Classes
1.575 1,575 1,575 1,575 1,577 1,577 1,577 1,577 1,578 1,568 1,568 1,569 1,569 1,569 1,571 1,571 1,571 1,571 1,571 1,572

Calls
389,033 326,423 388,595 308,764 313,817 371,724 440,880 386,599 449,558 426,532 338,507 332,084 360,937 290,539 320,933 254,099 322,028 225,792 233,459 265,588

Puts
334,246 258,914 310,805 207,659 245,475 268,842 306,884 255,937 255,411 275,082 265,980 274,578 231,800 276,830 230,514 222,273 222,273 167,138 169,956 200,502

Total Volume
723,279 585,337 699,400 516,423 559,292 640,566 747,764 642,536 704,969 701,614 604,487 606,662 610,080 522,339 597,763 484,613 544,301 392,930 397,425 466,090

Contracts PlPed
342,833 282,792 346,289 260,978 302,658 374,287 387,781 383,108 412,582 386,131 306,648 309,451 354,500 280,754 331,734 271,995 338,211 235,885 240,453 250,157

Average Improvement*
$0.0063 $0.0063 $0.0066 $0.0068 $0.0065 $0.0065 $0.0064 $0.0065 $0.0062 $0.0052 $0.0075 $0.0066 $0.0057 $0.0050 $0.0048 $0.0055 $0.0067 $0.0061 $0.0055 $0.0068

* Average improvement is the trade-weighted average for all contracts auctioned during the trading session. Figures are calculated by comparing the auctioned execution price with the best bid or offer, as appropriate, available on the other six options exchanges at the beginning of the auction.

Source: Boston Option Exchange (BOX)

Figure 8

Evaluation Parameters For Exchange Operators & Participants

Fiscal Incentive Evaluation Impacted Parameter Player
Business Complexity Adaptability Factor EO EP EO EP EO Cost EP EO EP EO EP

Non-Fiscal Incentive
Guaranteed Allocation of Order Flow Low Low Low Low Low NA Low Low Low NA Shares, Options and Warrants Medium Medium Low Low Low NA High High Low Medium

Call Auctions

Market Maker
High High High High High High High High High High

Order Flow Payment Low Low Low Low Low NA Low Low Low Low

Discount/ Adj. in Fees/ Margin Low Low Low Low Low NA Low Low Low Low

Exemption/ Waiver from Exchange Fee Low Low Low Low Low NA Low Low Low Low

Maker Taker
Medium Medium Medium Medium Low Low (if taker) Medium Medium Low Medium

Order Trigger Mechanism Medium Medium High Low Medium Medium High High High Medium

Liquidity Concentrator Mechanism High High High Low Medium Medium High High High Medium

Technical Complexity Time to Market

EO: Exchange Operator

EP: Exchange Participant

Source: Cognizant Figure 9

cognizant 20-20 insights

Gradual Outcomes
The introduction of any of these schemes will result in the following outcomes over a period of time:

The monopolized derivative market share of NSE will be challenged. This will create the opportunity for BSE to make improvements.

Liquidity enhancement schemes will add depth and reduce the current lopsidedness in the derivatives area. A gradual increase will occur in the number of eligible securities to be traded in the derivatives segment. There is the possibility of leveraging the schemes to other segments, such as currency derivatives, interest rate derivatives and the cash segment. The Market Maker model will take time to pick up in the Indian trading environment.

Exchange participants will look for solutions regarding the framework and not particular asset classes.

Along with the LES scheme, policy changes will achieve the objective of creating worldclass liquid markets. Such policy changes include rationalizing minimum contract value to attract greater retail investor participation; allowing participation of insurance firms, mutual funds and pension schemes in all types of derivative contracts trading; and removing security transaction tax (STT) as implemented in Indian markets.

References
Improving Liquidity in a Securities Market, Alberta Market Solutions Ltd., October 2003. Understand Charges other than Brokerage When Buying and Selling Shares, Enrich Wise blog, http://enrichwise.com/2010/03/28/understand-charges-other-than-brokerage-when-buying-and-selling-shares/ Market Maker for SME, Securities and Exchange Board of India Circular, April 2011. Comprehensive Risk Management Framework for the Cash Market, Securities and Exchange Board of India Circular, February 2005. Annual Report 2009-2010, Securities and Exchange Board of India.

About the Authors

Vinod Malpani is a Manager in Cognizant Business Consulting (CBC). He leads a large team of consultants in the area of exchange operations, brokerage services and related investment banking areas. He has 12 years of experience in leading consulting engagements and strategic application development of exchange operators and brokerage firms. Vinod can be reached at Vinod.Malpani@cognizant.com. Keshav Jhunjhunwala is an Associate Consultant within Cognizant Business Consulting (CBC). He has over six years of experience in products, domain consulting, application support and application delivery in the retail and investment bank area. Keshav can be reached Keshav.Jhunjhunwala@cognizant.com.

Acknowledgments
The authors would like to thank CBCs Rohit Bendre (Rohit.Bendre@cognizant.com) and Tarun Kumar Jain (Tarun.Kumajain@cognizant.com) for their critical and valuable research efforts.

cognizant 20-20 insights

About the Practice

Cognizants Investment Banking Practice employs over 150 subject matter experts and 3000 associates. As part of the practice, Cognizant has a sound understanding of the exchange operations business, as well as vast experience in all the processes involved. Through our association with leading stock exchanges, including the largest options exchange in the world and leading dealer exchange in the U.S., Cognizant has approximately 300-person years of experience in this area.

About Cognizant
Cognizant (NASDAQ: CTSH) is a leading provider of information technology, consulting, and business process outsourcing services, dedicated to helping the worlds leading companies build stronger businesses. Headquartered in Teaneck, New Jersey (U.S.), Cognizant combines a passion for client satisfaction, technology innovation, deep industry and business process expertise, and a global, collaborative workforce that embodies the future of work. With over 50 delivery centers worldwide and approximately 118,000 employees as of June 30, 2011, Cognizant is a member of the NASDAQ-100, the S&P 500, the Forbes Global 2000, and the Fortune 500 and is ranked among the top performing and fastest growing companies in the world. Visit us online at www.cognizant.com or follow us on Twitter: Cognizant.

World Headquarters
500 Frank W. Burr Blvd. Teaneck, NJ 07666 USA Phone: +1 201 801 0233 Fax: +1 201 801 0243 Toll Free: +1 888 937 3277 Email: inquiry@cognizant.com

European Headquarters
1 Kingdom Street Paddington Central London W2 6BD Phone: +44 (0) 20 7297 7600 Fax: +44 (0) 20 7121 0102 Email: infouk@cognizant.com

India Operations Headquarters

#5/535, Old Mahabalipuram Road Okkiyam Pettai, Thoraipakkam Chennai, 600 096 India Phone: +91 (0) 44 4209 6000 Fax: +91 (0) 44 4209 6060 Email: inquiryindia@cognizant.com

Copyright 2011, Cognizant. All rights reserved. No part of this document may be reproduced, stored in a retrieval system, transmitted in any form or by any
means, electronic, mechanical, photocopying, recording, or otherwise, without the express written permission from Cognizant. The information contained herein is subject to change without notice. All other trademarks mentioned herein are the property of their respective owners.