Overview:Broking sector

Evolution of Broking Industry

The stock markets in India are one of the oldest in the world and have a strong presence and network of domestic and local intermediaries. Owing to the high incidence of indigenous equity broking, India got a Native Share Brokers’ Association as early as 1875; this association later came to be known as the Bombay Stock Exchange (BSE). In 1864, there were more than 1,000 brokers in Mumbai who traded in stocks; high premium was also a familiar concept during that time. One of the earliest stock market booms that occurred in 1860s after the American Civil War led to the creation of many joint stock cotton/ginning mills and this phenomena stirred an equity culture that saw share prices touch stratospheric levels.

In the 1970s the Foreign Exchange Regulation Act (FERA) was introduced that encouraged multinational companies to divest their foreign equity; this phenomenon gave a fresh impetus to retail investing.

The Securities and Exchange Board of India (SEBI), which was set up in 1988 as an administrative arrangement, was given statutory powers after the enactment of the SEBI Act in 1992. The main function of SEBI was to protect investor interests in securities, to promote the development of securities markets and to regulate the securities markets.

Introduction of a wide range of economic reforms that revolved around the central theme of liberalisation of financial markets revived the exuberance in the stock markets during the nineties. Due to the greater freedom and flexibility that accompanied the reforms, stock markets in India set out on a growth journey that was to last in the next one-and-a-half decades. Despite major setbacks in the early 1990s and 2000s, which caused the Joint Parliamentary Committees to conduct extensive investigations in the stock markets, the markets continued their impressive growth.

The reforms brought about many fundamental changes that fuelled the pace of market growth and at the same time brought some orderliness in the manner and conduct of operations. Reforms also equipped the Indian markets with the best processes and practices. Some of these processes were: Abolition of open outcry; introduction of electronic trading (secondary markets); consent for foreign ownership (foreign institutional investment) of shares and for Indian companies to raise capital from overseas (ADRs/GDRs); expansion in product range (equities/ derivatives/debt); book building process and transparency in IPO issuance (primary markets); T+2 settlement cycle (payments and settlements); depositories for share custody (dematerialisation of shares); governance of stock exchanges (demutualisation and corporatisation of stock exchanges) and internet trading (e-broking).

Due to all these changes, the stock markets in India grew unprecedentedly and so did the equity broking firms. The broking industry is fast emerging as a high growth segment in the Indian financial services map, in terms of business growth, distribution and network, and enterprise value.

Structure of the Indian Securities Market

The Indian securities market is fairly large as compared to several other emerging markets. As on March 2008, there were 19 stock exchanges in India; however, the money raised by all these exchanges was shared between the country’s two national level exchanges, the National Stock Exchange (NSE) of India and Bombay Stock Exchange (BSE). These stock exchanges carried out trade through registered intermediaries, viz. brokers. The number of registered brokers in various stock exchanges rose from 9,443 in FY07 to 9,487 in FY08, while the number of registered sub-brokers increased from 27,541 in FY07 to 44,074 FY08. Besides brokers and subbrokers, some other intermediaries that existed in the market are shown in the table below:

Household financial Savings find their way into capital markets

Investors are the backbone of a capital market as they are the ones that lend their surplus resources for funding the establishment or expansion of companies in return for financial gain. During FY08, the gross financial savings from the household sector stood at Rs 7,346.9 bn. Although , the ratio of gross financial savings from the household sector to GDP fell to 15.6% in FY08 from 18.5% in the previous year, the investment in shares and debentures grew by over 79%. Also, retail participation increased in capital markets by way of mutual fund investment which grew by over 42% over FY07.

Trends in the Indian financial markets

Financial markets see rapid growth in the last decade

The last few years have been very critical for the financial markets around the world as investor interest has risen phenomenally all across the world in these years owing to the global economic boom, high income levels, and greater efforts and transparency at stock exchanges. The availability of many, structured, equity products has also aided the upswing in equity markets.

As seen in the below exhibit, equity trading remained on a downturn in 2001, due to the IT bubble burst; this downfall was very much in line with the global economy. However, with the revival in the economy in 2004, the share markets around the world started looking up and this exuberance continued till 2008.

The total value of shares traded across the world rose from US$ 42.3 tn in 2007 to US$ 113.6 tn in 2008. Though the stock market rally was widespread, stock markets in Americas held a majority share of 64.5% in the total value of shares traded in FY08. Nevertheless, the bourses in emerging nations of the Asia-Pacific region also grew owing to greater influx of FII investments and increasing appetite of domestic investors.

Emerging markets record better growth

The increase in the market capitalisation of stock markets in emerging economies underlines the significance of emerging markets in the global arena. Emerging economies caught the attention of institutional investors because their economies were opened up to foreign investors, their companies were recording winsome growth and the income levels were looking up in the country.

The huge untapped potential of emerging countries prompted domestic companies to implement ambitious plans that aimed at turning around the economies of these countries. The companies went public to finance their plans, which increased the number of listed companies in the various stock exchanges.

Indian stock exchanges follow global peers

The last decade was exceptionally good for the broking industry as the frontline stock indices touched new highs. The stock market activity recorded robust growth due to the wide-ranging reforms in regulation and market practices. Particularly the growing participation of FIIs turned the fortunes of the broking industry in the last decade. During FY98 to FY08, the BSE’s sensitivity index rose from 3,816.87 to 15,838.38, by more than 300%. Similarly, NSE’s NIFTY rose from 1,116.9 to 4,734.5, by more than 320%. In January 2008, both indices achieved their all-time high value of 17,648.71 (SENSEX) and 6,287.85 (NIFTY). In respect of the total interest in stock markets and rising trade, the Indian markets follow the global cues. The market capitalisation of BSE increased by 370% to US$ 1,819.1 tn in 2007 from 2004, which was equivalent to 165.3% of India’s GDP (dollar terms) in 2007.

Impact of the global crisis on stock markets

The global financial crisis completely changed the scenario for stock exchanges. After the crisis, the market cap collapsed and trading volumes became thinner. The housing bubble in the US increased the valuation of properties to unsustainable levels and the defaults rose to dangerous levels in subprime category loans; as a result, the housing market came crashing down during March-April 2007 and so did the prices of properties. Eventually the effects of this collapse snowballed to the banking system in the US, as banks were left with lot of illiquid and toxic assets. These assets, which were used to create market backed securities or MBS and collateral debt obligations or CDO caused further damage to the financial markets owing to the redemption pressure. Ultimately these upheavals crippled some major banks and financial institutions. Due to lack of liquidity, the situation worsened and FIIs pulled out from major stock markets thus affecting the capital markets.

The subprime crisis had a disastrous effect on stock markets globally. During FY08, NASDAQ declined yearly by about 6%. The impact of this crisis was global and the indices in the Euro area (FTSE 100) and in Japan (Nikkei 225) declined yearly by about 15.7% and 27.6%, respectively. However, the emerging markets were fairly isolated from the ongoing financial crisis during FY08 as compared to global markets.

However, the recessionary situation in the developed economies gripped the emerging markets in FY09. Even though these markets did not have a direct exposure to distressed assets, their stock markets took a toll. The major reason for this dismal performance was the capital outflow from emerging markets, as valuation of securities hit the worst levels owing to high inflation and impending recessionary situation.

Market capitalisation tanks across the world

With the fall in volumes and sharp correction in valuation of assets, the market capitalisation across the globe witnessed a slump during FY09. NIFTY and SENSEX both reported y-o-y decline of more than 50% in dollar terms and approximately 40% in rupee terms. The loss in dollar terms was higher because of the significant weakening in the rupee; the rupee fell against the dollar y-o-y by more than 20% as on March 31, 2009.

The market capitalisation at all the major indices across world reached its peak during 2007. The market capitalisation of Nasdaq Composite was at US$ 4,182.1 bn for June 2007 registering a growth of 18.1% over June 2006 market cap. Major indices across emerging market also registered considerable growth with Shanghai SSE Composite’s market cap growing by 335.2% over June 2006 market cap. However, as the financial crisis spread across the world, the institutional investors started dumping stocks and all indices tumbled. The affect was firstly felt through western world, where the crisis initiated, and hence indices in developed markets of west registered negative growth in 2008. By the end of 2008, the crisis has spread across the globe affecting emerging markets as well.

Performance of equity markets in India

In the last 2 quarters of FY09 the Indian economy was in the midst of the financial crisis and moderation in economic activity. Likewise the Indian equity market faced turbulent times as both the primary and secondary markets saw a downturn. Lack of investor interest and a dip in corporate confidence affected the primary market badly; as a result, there was a sharp plunge in funds mobilised through equity issues (including rights issues). Due to a crash in the secondary markets, companies refused to come out with their IPOs. During FY09, funds mobilised through equity (including rights issue) was Rs 146.7bn as compared with Rs 823.9 bn in FY08, and represented an enormous decline of more than 450%.

The cash market segment saw a drastic fall in business after the financial crisis and due to the outflow of capital in the recessionary conditions. During FY09, FIIs sold equity worth Rs 5,545.9 bn as against purchases of Rs 6,022.9 bn, which meant a negative net investment of Rs 477.1 bn. Due to these developments, both NSE and BSE reported a yearly fall in turnover of about 22% and 30%, respectively. Moreover, the total market capitalisation of both the exchanges witnessed a 40% decline. The decline in market cap significantly affected the topline of the broking industry; likewise, intense competition among the industry players and the resultant fall in broking rates further eroded their bottomline. Due to the run-up in equity markets in the past few years, the market participants had huge capital expansion plans, but the sudden downturn made them curtail those plans. However, the excess capacity and investments made in executing these plans drained the companies’ profitability.

FII exit emerging economies; Indian markets feel the pinch

FY08 started on an optimistic note, as in January 2008 institutional investors brought in additional liquidity, which caused the SENSEX to cross the 20,000 level and the NIFTY to go beyond 6,000. However, during December 2007, the fall out of global markets amid the subprime crisis, the liquidity crunch and fear of impending recession caused a huge outflow of funds. In FY08, FIIs reported net investment inflows of Rs 539.3 bn.

Trends of FII (Rs bn)

In FY09, funds continued to flow out of the Indian equity market and caused the SENSEX and NIFTY to fall below 10,000 and 3,000, respectively. The outflow also exerted a downward pressure on the rupee, which stood at Rs 50.95 per US$ as on March 31, 2009 as against Rs 39.99 per US$ in the previous year, reporting a depreciation of more than 20% y-o-y.

After a dull period during September 2008 to February 2009, the equity markets in India are looking up. FIIs have started buying and the confidence of retail investors has started picking up. The mutual fund activity in recent times has also picked up and fund houses are coming up with new fund offers. The primary market has also seen activity of late and a few IPOs are lined up. The markets had seen a rally leading to the budget, after which there was a correction. In the immediate future the quarterly results of companies may give directions to the market. Though the broking industry benefits from either selling or buying it’s the foreign and institutional funds flow that is consequential and keeps the broking industry at its edge.

The Indian debt market

The debt market operates under retail, corporate and wholesale segments. The retail segment allows participation of retail investors in government securities, whereas securities like T-Bills, floating rate bonds issued by public sector undertakings/corporates/ banks, zero coupon bonds (ZCB), commercial papers, CD, corporate debentures, etc are traded in wholesale markets. Corporate bonds markets, on the other hand, allow trading of debt securities issued by private and public corporations.

The debt market in India still falls short of its global peers. While the value of average debt traded over the 45 exchanges was about US$ 422.3 bn in 2008, the bonds traded in India’s two exchanges (NSE and BSE) was worth US$ 68.6 bn.

During FY09, the equity markets were battered all over the globe, but business of the debt market reported significant surge in volumes as investors transferred funds to safer havens. During FY09, the total wholesale debt market (WDM) business on NSE grew by 18.9% y-o-y to Rs 3,359. 5 bn as compared with 28.8% in FY08.

Lack of liquidity and pessimistic sentiments in primary equity markets forced companies to look at alternative methods of raising funds, including through issue of corporate bonds. Though there was significant decline in funds mobilised through equity markets, funds mobilised through private placement of corporate debt grew yearly by more than 60% at Rs 2,071.6 bn in FY09 as compared with Rs 1,286 bn in the previous year.

Due to the equity market’s lacklustre performance and uncertainty over economic recovery, the fund flow shifted from the equity market to corporate bond market. Apart from the surge in private placements, trading volumes of corporate bonds increased y-o-y by approximately 55% in FY09 over the previous year.

Indian broking houses can look forward to a period of growth and consolidation. While opportunities are abound, there is a need for reforms and restructuring in the equity broking industry. There are about 9,000 brokers registered with SEBI but 80% of the turnover in NSE and BSE is accounted for by only 1% of brokers. Consolidation thus becomes relevant in order to form a stronger industry. Many smaller players find it extremely difficult to retain clients due to difficulties in providing better research and value-added services. Consolidation is an answer to these issues as it will help improve quality of service.

Need to educate retail investors

The retail investor’s interest in stock markets has heightened, with greater transparency in stock exchange operations, higher household savings, and the rally in stock markets. Evidently, broking companies have expanded to semi-urban and urban areas to tap growing demand. However, the sudden fall in stock markets has increased the anxiety in these investors who have become risk averse. The investors in the retail segment need to be educated about equity as an asset class and from a long term investment perspective. Many broking companies can impart this training to retail investors through investor camps.

The broking fraternity has long demanded an industry status that would provide them an opportunity to put their demands at different fora. Further, this would aid them in raising funds for their expansion plans, which remains a major hurdle as of now. India’s economic growth and deepening financial system will present broking firms numerous opportunities for growth and expansion.

Moreover, integration of financial markets will enhance the scope of their business and scalability. Access to public equity markets will enable broking firms to raise resources for expansions and growth and to pursue useful business acquisitions. With the growth in international investor interests there is a pressing need to scale up the business and upgrade it to global standard and practices.