Surge in sales volume of products linked to Indian equities can threaten NSE's pricing power: Experts

The volumes of equity-linked Indian products traded on offshore exchanges are picking up thick and fast. The cumulative sales volume of offshore trading instruments with Indian equities as their underlying assets – such as Exchange traded funds (ETF), American depository receipts ( ADR) and SGX Nifty – has reached a historic high of $1.6 billion per day.

Experts believe Indian exchanges are losing their turnover to offshore exchanges, which provide better hedging opportunities and superior risk management as investors can switch trades between two exchanges.

Experts say this could affect trading volumes in India and possibly threaten the National Stock Exchange’s ability to set prices. In a recent note, Saifullah Rais of Kotak Institutional Equities said, "Indian market turnover is losing out to offshore markets as they score both on time and money over the NSE. An offshore exchange provides hedging opportunity for market makers on Indian equitylinked products even when the NSE has closed and with lesser transaction cost. In addition to this, mutual offset system provides them additional benefit of managing overnight risk."
The increased activity in the equitylinked Indian products traded on offshore exchanges can be attributed to several reasons. The first is that investors are being drawn to Indian equities as the country’s markets are among the best performing in the world.

This can be gauged from the fact that daily volumes of the US-denominated ETFs with Indian equities as their underlying asset have increased by as much as six-fold in the past five years.

The daily turnover of dollardenominated Indiadedicated ETFs has increased to $160 million per day from a mere $25 million in 2009, according to the data compiled by Kotak Institutional Equities.

Similarly, the NYSE-listed ADRs of Infosys, ICICI Bank, Tata Motors and HDFC Bank are fetching a daily volume of nearly $300 million. "Dollar-denominated ETFs listed in the US provide very easy and hassle-free investment for FIIs. This is one of the key reasons why volumes of dollar-denominated ETFs have picked up," said UR Bhat, managing director of Dalton Capital Advisors.

"For global investors who desire to take exposure to the Indian equi-ties without worrying about the tax incidence, this is the most convenient route. Hence, we are seeing increased volumes in these dollar denominated ETFs."

The second reason for increasing volumes on the offshore exchanges is the better hedging opportunity. When Indian markets are closed for trading, these exchanges provide a hedging option and the transaction cost is also much lower.

The transaction cost on Nifty futures is five times higher than the SGX Nifty. The third factor is superior risk management. The offshore exchanges offer superior risk management by providing the mutual offset system (MOS) between the exchanges to manage the overnight risk.

Under the MOS programme, a trader can mitigate overnight risks by opening a position in one exchange and squaring it off on another exchange. An agreement between the CME and SGX for MOS gives a trader the opportunity to initiate trade on CME and close on SGX.

Experts say the increase in volumes on offshore exchanges could result in fall in volumes on the domestic exchanges as the products are dollar denominated.

This could also threaten the price-setting status of the NSE, which is the trendsetter at present since domestic future volumes are significantly higher than that on the offshore exchanges.