Saturday, July 14, 2007

The future of trading

Roughly speaking, NSE has 50,000 trading screens and BSE has 25,000 trading screens. Over and above this, a growing share of orders have been coming into NSE and BSE over the Internet. Recent data shows that the share of Internet trading went up from 3 per cent in 2003-04 to 16 per cent in 2006-07. Given that the broadband expansion in India started only very recently, the outlook for future growth of Internet trading is very good.

The sources of order flow coming into the market, then, are these 75,000 trading screens coupled with a large number of users sitting on their web browsers. All these people add up to a massive virtual trading floor. Their information gets pooled into the price that is revealed, and their disagreements are played out in the order matching process. Their diversity is a key source of liquidity and liquidity resilience [link].

To a significant extent, the same securities firms are playing the same role with commodity futures trading. So even though there is an FMC vs. SEBI separation, there has been de facto convergence. As you walk around India, you routinely see roadsigns of securities firms offering both NSE/BSE and commodity futures trading.

The big puzzle now lies in bringing the potential of this enormous virtual trading floor to infuse life into the moribund fixed income and currency markets.

Outside India, there have been fascinating developments in going beyond the vanilla Internet trading system. The game lies in enhancing the information set of the user while supporting `dumb' transaction services, and in doing better than the awful discussion boards that have proliferated. See link and link. (I had blogged about Zecco before). These sites rely on network externalities - the larger the number of people using them, the more attractive they become. So there may be a tipping point - perhaps 100,000 users? - beyond which they could just explode.

As seen in those two URLs, in the US, the price of brokerage services with some brokerage firms has dropped to zero. In India, that progression cannot be achieved because of the massive government charges which are layered on top of the basic transaction -- see Box 2.8, page 29 of the MIFC report.

These developments have interesting implications for exchanges also. An article in The Economist discusses some of these changes. It talks in hushed tones about an exchange that will sell transactions at a price of $1.2 per trade. In my mind, that's not a big deal; the technology exists today to do much better. The key thing to latch into is economies of scale - by the time you have a factory pumping out 10 million trades a day, the costs get dramatically lower than those seen with small exchanges. As a consequence, I believe that the pressures in favour of low prices paid by customers which will propagate to low prices charged by exchanges will generate a more oligopolistic situation where a few giant exchanges - like NSE and BSE - will dominate the world's trading.

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