Market_Assessment_Evaluating_DMA_ Algorithmic_Trading_Market_in_India_M by Sutherland Global Services

Case Study and Sample Slides India: Evaluating DMA / Algorithmic Trading Market in India

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Indian securities market framework Clearing Members / Custodians

Dominant Stock Exchanges

# Registered Custodians: 15 # Clients: 10,301 Assets under Custody: $ 386 Billion * At the end of FY 2008

4,887 Listed Companies

Market Cap: $ 1,175 Billion

1,381 Listed Companies

Market Cap: $ 1,111 Billion

* At the end of FY 2008

Sell Side Participants (Cash Segment)* Brokers: # 9.847

Buy Side Participants

Corporate Brokers: # 4,190

FIIs: # Registered FIIs: 1,635; FIIs Growth (2003-09): 22%

Sub Brokers: # 44,074 Online Brokers: # 305

DIIs: # MFs: 40; # Insurance: 44; # Banks: 170

Retail: Contribute 28% and 55% of the total volume in cash and derivatives respectively Proprietary: # Proprietary trading desks: 550; Contribute 20% & 31% of the total volumes in cash and derivatives market respectively * At the end of FY 2009

Regulators

* At the end of FY 2008

Depositories

Depository Participants

National Securities Depository Limited Central Depository Services (I) Limited

# DPâ&#x20AC;&#x2122;s (Brokers, NBFCs, 654

etc.):

SEBI

RBI

OTHERS

Securities Market regulator Market Participants have to adhere to norms issued by SEBI

RBI as the central bank issues rules , regulations and guidelines for entities operating in India

Market Specific regulators: IRDA (Insurance), AMFI (Mutual Funds), etc.

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Volumes on the Indian equity markets have grown at a CAGR of ~50% over the last six years Disclaimer Avg. Daily Cash Volumes (in USD bn) CAGR: 27.0% 4.7 3.6 2.2 0.8

1.4

2.7

1.5

2003 2004 2005 2006 2007 2008 2009 Source: NSE,BSE,SEBI

Avg. Daily F&O Volumes (in USD bn) CAGR: 72.0% 12.1 10.4 6.8 4.4 1.9

2.3

0.4 2003

2004

2005

Source: NSE,BSE,SEBI

2006

2007

2008

2009

• Average daily volume in India’s equity market grew at an impressive CAGR of 27 percent aided by: − − − −

Strong economic story Global interests in emerging economies Modernisation of trading systems Robust regulatory environment

• Of the total volume, only 2% (100 companies) of the total listed stocks account for around 80% of the volume • In terms of volume break-up, more than three- fourth of the trade is for speculation purpose

• Derivatives account for three-fourth of the total exchange volumes • Futures account for more than half with equal contribution from stock and index futures • Options volume share has increased from only 14% in 2007 to 44% at present • The above was due to change in regulation charging security transaction tax (STT) on premium value as against earlier practice of charging STT on total notional value • In the options segment, only index options are highly traded contributing 93% of the total options volume

% Volume Mix by Type of Trade

70%

71%

78%

30%

29%

22%

FY 2006

FY 2007

FY 2008

FY 2009

Delivery

Speculation

Source: NSE,BSE,SEBI

% Volume Mix by Type of Trade Stock Options Stock Futures 35%

29%

Index Options Index Futures 32%

32% 52%

58%

11%

10%

FY 2006

FY 2007

34%

FY 2008

24% 32%

41%

FY 2009

Source: NSE,BSE,SEBI

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Retail and proprietary trading are the dominant segments with FIIsDisclaimer increasing their share over past three years Participant Wise Equities Turnover (NSE & BSE) 13.5%

11.8%

10.2%

35.3%

35.8%

42.0%

51.2%

52.4%

47.7%

FY 2007

FY 2008

FY 2009

Retail & Proprietary

FII

• Retail volume refers to trades by individuals, HNIs and companies • It contributes around 48% and 56% of the total volume in cash and derivatives respectively • However, only 2% of the retail population has direct equity market exposure • The above is expected to increase in future with increasing awareness and widening reach of trading avenues through sub-brokers and online trading

Proprietary:

DII (Mutual Funds)

Source: NSE,BSE,SEBI

Participant-wise Future & Options Turnover (NSE) 1.4% 8.7%

2.9% 9.6%

28.0%

24.6%

61.9%

63.0%

3.7% 9.6% 31.0%

• Proprietary volume refers to the trades by sell side brokerage firms on their own account • Currently, there are 550 proprietary trading desks contributing around 20% & 31% of the total volumes in cash and derivatives market respectively • Primary research with leading sell side brokers suggests that 35% to 40% of the proprietary trades are for arbitrage purpose

DIIs: • DIIs volume refers to trades by Indian financial institutions like mutual funds, banks, insurance companies, pension funds etc. • Within DIIs, life insurance and mutual funds are the biggest sub segments • Their contribution to derivatives volume is only 3.7% as there are regulatory restrictions on trading in derivatives market. However, there have been some relaxation which has led to increase in their share

FIIs:

FY 07 Retail

55.6%

FY 08 Proprietary

• FIIs volume refers to trades by foreign regulated companies registered in India and their sub-accounts • FIIs are gaining importance as reflected by increase in their share in cash and derivatives volume over last three years

FY 09 FII

DII

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Transaction charges: Bombay Stock Exchange (BSE) vs. National Stock Exchange (NSE) Disclaimer BSE

NSE

* For every executed trade, the order (Limit Orders), which has been placed first on the basis of the order time stamp assigned by BSE system will be considered as a Passive Order; while the order (Market Order or Limit Order), which has been matched against an existing order (or Passive Order) will be considered as an Active Order

• Equity: Delivery Transactions: 0.001% of turnover; Intra-Day Transactions: 0.002% of turnover Stamp Duty

• Future Transactions: 0.002% of turnover • Option Transactions: 0.002% of purchase premium; 0.002% of notional value in case of Sell transaction

• Equity: NIL for equity- delivery and intra-day transactions SEBI Turnover Charges

• Futures: 0.002% of turnover • Options: 0.05% of premium

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There is a steady growth in the number of registered FIIs with higher growth in FIIs activity in the Indian market Disclaimer Year Wise Registered FIIs in India CAGR: 21% 1,635

1,693

1,319 1,020

• Apart from global Interest in Indian growth story, following regulatory

882 685

factors have led to increase in number of FIIs registrations:

540

502

− In 2008, SEBI allowed sovereign wealth funds, university funds, endowments and charitable trusts to register as foreign institutional investors (FIIs) FY 2003 FY 2004

FY 2005 FY 2006

FY 2007 FY 2008 FY 2009

Aug 2009

Source: SEBI

− Fast tracking of FIIs registration process by SEBI

• Along with the growth in numbers of FIIs, there has been a higher growth in FIIs trading in the Indian equity markets clearly represented by:

Annual FIIs Volume (In USD Billion)

− Annual FIIs turnover increased by CAGR of 82% from USD 21 billion in FY 2003 to USD 419 billion in FY 2009

CAGR: 82% 419

− Average turnover per FIIs increased by CAGR of 50% from USD 42 million in FY 2003 to USD 317 million in FY 2009 − The share of FIIs in daily turnover has almost doubled from around 10% in FY

231

2003 to more than 15% as of now

149 89 56 21 FY 2003

FY 2004

FY 2005

FY 2006

FY 2007

FY 2008

Source: SEBI

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International investment funds / advisors, AMC account for 84% of registered FIIs; by geography EMEA region leads FIIs registrations Disclaimer Break-up of Registered FIIs as per Type of Institution Pension Funds, 9%

Insurance , 1%

Banks , 6% Investment Fund / Advisors, 61%

Others, 0%

• Dynamics of FIIs registration changed substantially over the period as share of AMC’s reduced from about 56 percent of total FIIs registrations in

AMC, 23%

1999 to 23 percent in 2009 • On the other hand, the share of Investment Funds / Advisors increased from 37 percent to 61 percent over the same period

Source: SEBI

Break-up of Registered FIIs by Origin (Geography)

• However, of the total 5,314 registered sub-accounts there are 2,597 subaccounts (49%) registered under AMC • Europe, Middle East & Africa (EMEA) domiciled companies account for the

EMEA, 43.0% APAC, 17.2%

highest registered FIIs, primarily because countries in this regions such as Mauritius and Cayman Island have double tax avoidance treaty with India

Americas, 39.8% Source: SEBI

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Five FIIs account for 14% of the equity holdings; ETFs are gaining prominence in the FIIs category Disclaimer Current Key FIIs Players • As per market participants, of the total registered FIIs (about 1,700) registered in Indian market, only around 200 are active. Others are long-term investors with very low number of annual trades (~10–12) • Using number of sub-accounts as a parameter for determining dominant FIIs, there are only 25% FIIs. These account for over 80% of the sub-accounts • The top five FIIs account for 14% of the total FIIs equity holdings • Apart from top five, other dominant FIIs include Fidelity, Golman Sachs, Putnam, Kotak Mahindra (UK), Morgan Stanley, and Aberdeen Source: Livemint

Emerging FIIs ETFs

• Of the total USD 15 billion FIIs investment in current year, USD 2.5 billion is through the ETF route

• Excluding primary market and private placements, ETFs accounted for 25% of the net secondary market FIIs flows • There are three 100% India focused ETFs managing around USD 2 billion of which 2 were launched recently (2008) • Emerging market and BRIC focused ETFs have also increased their investments in the Indian markets • With superior performance and high demand from investors there are five more funds who have registered with SEC for India focused ETFs

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Acceptance of hedge funds by SEBI to register as FIIs on selective basis, might increase their role the in Indian markets Disclaimer • Despite the return of FIIs to the market chasing massive recovery in Indices, the exposure of hedge funds to domestic stocks dipped significantly over the past year and a half • According to Singapore-based hedge fund tracker Eurekahedge Pte Ltd, hedge fund assets in India were in the range of USD 6–7 billion at the end of Aug. 2009, sharply down from USD 18 billion at the end of Dec. 2007

Hedge Fund Investments Declining

• Typically, hedge funds invest in India using participatory notes (PNs) or derivative instruments. Such notes accounted for a major chunk of the USD 18 billion FIIs investment in 2007. From accounting for less than 20 percent of total assets managed by FIIs, PNs rose to around 55 percent in Jun. 2007, prompting the Securities and Exchange Board of India (SEBI) to ban them in Oct. 2007 • Despite SEBI reversing the ban in the wake of the credit crunch, investments through PNs account for 17 percent of assets managed by FIIs now, which to many people is a clear indication of hedge funds reducing exposure

• SEBI granted direct entry in Indian markets to some of the world's top hedge funds by premising them to register as FIIs. This move was initiated in early 2008, just three months after SEBI banned new p-note issuances

SEBI Registering Hedge Funds

• The funds include Old Lane LP Oz Management. Some of the other hedge funds that have been given FIIs status include Eton Park, California-based Oaktree Capital Management and Ecofin • SEBI, after careful scrutiny of hedge fund manager’s track record, granted FIIs status to a few hedge funds

Cayman’s entry to IOSCO may open India door to hedge funds

• Cayman, the Caribbean offshore financial centre and a favorite tax haven of money managers, has been admitted as a member of the International Organization of Securities Commissions (IOSCO), the global standard setter for securities markets • The move could encourage SEBI to give hedge funds - most of which are registered with Cayman - direct access to the Indian market

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Within DIIs, mutual fund has emerged as a dominant player in Indian market with new funds and increased retail interest Disclaimer Mutual Funds AUM: Equity Schemes CAGR: 13% 42

USD billion

28 25

• Mutual funds are the most preferred route for retail investors exposure to the stock market and number of investors taking mutual fund route has increased from 8 million in FY 2004 to 41 million in

October 2009

FY 2004

FY 2005 FY 2006 FY 2007 FY 2008 FY 2009

• To attract the investors, number of equity schemes has more than

Oct-10

doubled from 169 in FY 2004 to 352 in October 2009

Source: SEBI

• These two factors have made mutual funds a dominant force in the

Number of Schemes & Number of Investors

Indian markets with AUM increasing by a CAGR 13 percent from USD Number of Schemes

6 billion in FY 2004 to USD 42 billion in October 2009

Number of Investors (In Mn) 38

• Their annual equity traded volumes have increased by an even higher 40

CAGR of 68% from USD 7 billion in FY 2003 to USD 96 billion in FY 2008, indicating higher portfolio churning

169

188

231

267

313

340

352

FY 2004

FY 2005

FY 2006

FY 2007

FY 2008

FY 2009

Oct-10

10 0

Source: SEBI

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With market on rise, insurance companies are expected to increase their investments in equities Disclaimer Insurance Annual Premium & Equity Investments 78.1

64.8 54.4

54 15.6

37.9

10.0

12.0

13.0

8 7.0

USD Billion

• Under the current regulation, an investee company (insurance company) can’t exceed 20 percent of the total capital employed in equity/preference share/convertible portion of debenture • However, Unit Linked Insurance Policies (ULIPs) can invest from 10

2007

2008

Premium (LHS)

2009

2010E

2011E

Investment in Equities (RHS)

Source: Public News Articles, Edelweiss Research

percent to 100 percent of the fund in the equities subject to the investment mandate made during their offer • As per IRDA, ULIPs had a cumulative investments of USD 30.5 billion in various instruments till FY 2008

Industry Market Share: Weighted Premiums (Percent)

• According to market reports, investment by insurance companies in equities constituted around USD 12 billion in FY2009 as against

Company

FY2008

FY 2009

USD 7 billion in FY2008, registering a sharp increase of over 70 percent from previous year

LIC

48.1

41.1

ICICI Prudential

6.2

8.9

Bajaj Allianz

10.3

7.7

• The country’s largest life insurer, Life Insurance Corporation (LIC)

Reliance Life

3.4

5.8

with a market share of 41 percent, alone invested around USD 9.2

Birla Sun life

3.4

5.3

billion in the equities in FY2009 and plans to invest around USD

HDFC Standard

4.1

4.5

Max New York

2.4

3.1

Others

22.1

23.6

• It is expected that investment by insurance companies will continue to rise with amount exceeding USD 15 billion in 2011

11.4 billion in FY2010

Source: Enam Research

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Equity investments constitutes around one-fifth of total asset under management by insurance companies Disclaimer Life Insurance Companies’ AUM 5.9

USD billion

4.8 13.1 2.6 134.4

162.1

• Asset under management by life insurance companies increased by a CAGR of 19.4 percent from USD 125.7 billion in FY 2006 to

113.5

USD 213.7 in FY 2009

95.8

• Equity investment as a percentage of total Asset Under 27.3

33.4

FY06

FY07

54.7

45.7

FY08

FY09

Management (AUM) in FY2009 constituted around 21.4 percent, down from 28.2 percent in the previous year

Equity

Fixed Income

Others

• The downfall in the AUM of Insurance companies in FY2009 is

primarily attributed to the sharp downfall in the market in the later half of FY 2009

Source: Life Insurance Council

• However, strengthening of markets coupled with rising collection

Private Life Insurers AUM (USD billion) Company

FY2009

in premium amount by insurance companies, a large portion of AUM is expected to get diverted into equity investment in FY2010 • State-run insurance behemoth, LIC continues to be the largest

ICICI Pru

7.5

Bajaj Finserve

3.9

SBI Life

3.4

HDFC Std Life

2.4

Birla Sun Life

2.1

Reliance Life

1.4

Max New York

1.2

domestic institutional investor with asset under management of around USD 200 billion as on Sep 2009 • Among private life insurers, ICICI Pru has the largest asset under management followed by Bajaj Finserve and SBI Life

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Mutual funds based on arbitrage schemes could initially drive theDisclaimer DMA bandwagon in India… Arbitrage Funds’ Investment via MF Schemes

Arbitrage Funds’ AUM Distribution by MF, 2009 SBI 13% (2)

Arbitrage Funds' AUM (USD Million) LHS Arbitrage Fund' AUM as % of total MF' AUM

USD Million

1,100

CAGR: 75%

0.8% 0.7%

850

0.6%

IDFC 22% (8) Birla 5% (3)

0.5%

600

Kotak, 19% (2)

0.4% 350 100

0.3%

18 Oct' 06

Oct' 07

26 Oct' 08

Figures in circles indicate # Arbitrage Fund (AF) Schemes Source: AMFI, Adventity Research

25 Oct' 09

0.2%

Religare 7%, (2)

HDFC 23% (6)

JM 12% (2)

% indicate AUM as percent of total Arbitrage Fund AUM in Oct’2009; Figures in ( ) indicate # AF schemes Source: AMFI, Adventity research

• Arbitrage based funds have slowly found flavor with the Indian market as the AUM investment in AF’s growing by a whopping 75% to reach USD 1.1 billion in 2009. Also, the number of AF schemes has also increased from mere 4 schemes in 2006 to 25 schemes in 2009 • AF Potential in India: Since arbitrage funds take advantage of opportunities between cash and futures markets, Indian market presents enough opportunities due to intra-day upswings and downswings in a highly volatile market - These funds are increasingly being perceived as better tax saving (since they are treated like equity) instruments compared to liquid funds. HNIs in India have been seen moving some of their money from liquid funds to arbitrage funds as they don’t need money on a daily basis and can park the same for a longer period - A host of AMCs including SBI, JM Financial, Kotak, UTI and IDFC have offered such schemes for investors who want low risk profile but expect decent returns. In 2008, the average returns from arbitrage funds was recorded at about 8.8% with some funds registering more than 20% return - Adoption of DMA: With a flurry of arbitrage based funds expected in Indian markets, MFs could be early adopters of DMA, provided that AF AUMs reach a substantial proportion (currently 0.62% of total MF AUM) in value and volume terms in the near future. In such a case, MFs based on arbitrage strategy might well ask for DMA facility from brokerage firms. Also, many of the existing brokerages of AMCs employing arbitrage schemes do have or are in the process of acquiring DMA licenses * Exchange Rate: INR to USD - 0.02288

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… with Mutual Funds based on Quant models likely to follow Disclaimer Quant Funds’ Investment via MF Schemes Quant Funds' AUM (USD Million) LHS 90

CAGR: 14.6%

USD Million

0.10%

Quant Fund' AUM as % of total MF' AUM

0.08%

70 0.06% 60 0.04%

50 40

2 Oct' 06

4 Oct' 07

12 Oct' 08

0.02%

Source: AMFI, Adventity research

Oct' 09

Figures in circles indicate # Quant Fund (QF) Schemes Source: AMFI, Adventity Research

• Current Status of Quant based investing in India: Quantitative based funds are new and not proven in the Indian market, currently accounting for a meager 0.08% of total mutual fund AUM in India. Very few AMCs in India i.e. Benchmark, Reliance and Religare have offered mathematical, quant based schemes up till now. Also, these funds have not fared well, for e.g. Religare Agile Fund lost 32% since inception compared to 12% of its Benchmark • Global Scenario: Globally, over $800 billion in assets under management are invested in quant funds. There are around 200 fund houses in the quantitative space with 120 in the US alone. However, majority of the funds are operated by hedge funds and not public funds where HNIs account for majority of the investments • Potential for the Indian Market: Although, few AMCs have come up with quant based funds recently, the growth potential of mathematical and quant based funds seems challenging on account of many regulatory and fundamental hurdles: - In India, investing and trading is primarily done on a discretionary model rather than a rule based mathematical model - For back testing, validation and developing a robust mathematical model, historical data of at least 10-12 years is required, availability of which is the key constraint in India - The restrictive regulations on domestic hedge funds (prominent users of mathematical model based strategies around the globe) in India is a key dampener for the growth of quant funds * Exchange Rate: INR to USD - 0.02288

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End of Presentation