How to achieve safety in payments

by Ajay Shah.

The technological opportunity in payments

In the old days, the field of payments was inextricably interlinked with banking. Money was only held in bank accounts; the only way to move money around was through banks.

Advances in computer technology coupled with financial innovation have changed all this. Banks are no longer the only game in town for the business of holding money. An array of innovators are now in the payments game. A few interesting examples are:

• Paypal is a pure-play Internet company, which rides on top of bank accounts, and gives users a payments solution.
• Western Union moves money from person to person across the globe without referencing a bank.
• M-pesa, in Kenya, does payments over mobile phones. Money is fed into a phone as with topping up a pre-paid card. Money is then transferred to another person using an SMS.

These developments have far reaching ramifications. We can now think of payments as a distinct industry, one that is not joined at the hip with banking. Banking is primarily a risk management business, of coping with callable deposits which have an assured rate of return, even though the assets are opaque and risky. In contrast, payments is primarily a computer technology business, closer to the working of a depository or an exchange.

As Merton Miller said, banking is a disaster-prone 19th century industry. If a critical function like payments can be increasingly decoupled from banking, it would make the world safer.

There are two distinct problems in payments. The first is the systemically important payment system which is the core utility of the currency. In India, it is the RTGS. This is an entirely separate issue. The present discussion  is about the second component of the field of payments: the non-systemically important payments systems which are used by households and firms. This is an ordinary financial technology business.

The problem

When person X wishes to transfer Rs.100 to person Y, if the banking channel is used, the steps are as follows:

1. Person X lends this money to the bank by putting it into a deposit account.
2. He instructs the bank to send this to person Y.
3. At the other end, it shows up as a demandable loan from person Y to the bank.

The balance sheet of the bank is inextricably tied into the payments transaction. Through this, all the problems of banking flow into the field of payments. Banks have opaque assets with 20x leverage or worse. It seems odd to place a mission-critical function such as payments in the hands of such entities. 

In the old world, it was not possible to enjoy the benefits of payments without suffering the credit risk of a bank. One solution that was mooted was for payments to get done in central bank funds. You can do this for a few special situations like the securities clearing corporation, but probably not for most other situations.

The same problem arises with a mobile phone company:

1. When you feed money, by topping up a pre-paid account, this goes into the balance sheet of the mobile phone company.
2. Now you have to hope that when the time comes for you to spend this money, the mobile phone company is still solvent.

Faced with this situation, conservative financial regulators have proposed a few solutions:

1. Mobile phone companies cannot do payments; payments is the exclusive preserve of banks. (This is the state of affairs in India).
2. Mobile phone companies must become limited purpose banks.
3. Mobile phone companies must come under full banking regulation.

All these three solutions are unsatisfactory, because they are rooted in the old paradigm, where payments was inextricably intertwined with banking, and it was felt that this is the only way it could be. We need to look beyond this.

An alternative solution: Segregation of client funds

A remarkably clean solution has been invented in the field of asset management: Segregation of client funds.

Consider a money manager such as an asset management company (AMC). At a legal level, the AMC is a mere advisor. Client money never goes onto the AMC balance sheet. Customer money sits completely separate. If the AMC goes bust, this has zero implications for clients. In the entire history of such arrangements, there has been only one episode (MF Global) where segregation of client funds did not work, in protecting customer moneys. This is in contrast with the history of banking, where failures have been taking place across the centuries, across all countries, with a high frequency.

Under such an arrangement, client funds would always sit separately, segregated from the balance sheet of the payments provider.

Segregation of client funds requires a corresponding supervisory capacity - and MF Global shows us that this supervision can possibly fail. But it would involve a much lower failure rate when compared with the problems of banking.

Implication 1: Mobile phone company as payments provider

Suppose Vodafone is my mobile phone company. When I supply Rs.1000 into my mobile wallet, this would go sit separately in a customer trust. This would not go into the balance sheet of Vodafone. If Vodafone were to go bust, this money would be returned to me. This solves the problem of the credit risk of the payments provider.

If we could do this, it would open up an array of payments innovations. The only regulatory burden placed upon the provider would be: Never ever keep customer money on your own balance sheet. We would then need some small resolution capability to kick in when the payments firm goes bust, to take money out of the customer trust and give it back to the customer.

Implication 2: This can be done with banks also

Bank accounts can be broken up into two kinds: illiquid and liquid. (From a customer perspective, this is analogous to the Tier 1 and Tier 2 of the New Pension System; the former is illiquid and the latter is demandable). Illiquid accounts would be loans from customers to the bank (as all bank deposits today are) and have greater restrictions against convertibility. Liquid accounts would not belong to the bank. They would be segregated client funds, used for payments activities.

This would derisk customers from the problems associated with bank failure. It would greatly reduce the complexities of banking regulation and supervision. It would put banks on a level playing field when compared with other technological strategies in the field of payments.

When banks do not capture the interest income on the liquid accounts, this will force a healthy unbundling of payments and banking. Banks who engage in the payments business would have to explicitly charge for payments services. This would help ensure a level playing field between bank and non-bank players in payments.

Implication 3: How to store segregated client funds

Payment vendors could place client funds into current accounts with the central bank for riskless safekeeping. Or, they could place them into NAV-based money market mutual funds, so as to earn some return.

In this framework, there would be N money market mutual fund accounts belonging to M entities. The payments system would be a technologically diverse array of alternative competing mechanisms through which money flows from account i to account j, which generates a fee income for the payments provider.

Conclusion

The idea of segregated client funds, which is very well established in some areas of finance such as money management, brokerage, etc., can be usefully applied in the field of payments, to cut through the gordian knot of banks and payments.

Trading in the rupee: Starting to look like serious numbers

by Vimal Balasubramaniam and Ajay Shah.

The rupee-dollar is the most important price of the Indian economy. It is discovered on the currency market. What are the contours of this market? Specifically:

1. How big is the daily trading in the rupee?
2. Where does the rupee stand, in global rankings of currencies?
3. Where does trading take place?
4. Where are we on the onshore versus offshore distinction?

How big is the daily trading in the rupee?

Trading in the rupee is composed of the following elements of the market:

	Exchange-traded	OTC
Onshore	Options, futures	Spot, forwards, swaps, options
Offshore	Futures	Forwards, swaps, options

We attempt an estimate of turnover across all components, on 25 May 2012:^[1]

Location	Billion USD
OTC Spot (onshore)	19.82
OTC Forwards (onshore)	4.40
OTC Swaps (onshore)	11.34
Exchange Futures (onshore)	7.02
Exchange Options (onshore)	1.45
Exchange Futures (offshore)	1.17 [a]
OTC (offshore)	20.03 [b]
Total	65.23
Source:- RBI Weekly Statistical Supplement, NSE, USE, MCX-SX, DGCX, and BIS Survey (Tables D.1.1 and D.1.2)
[a] DGCX data as on June 6, 2012 for May 2012.
[b] This is the April 2010 BIS survey valuation of the offshore market, adjusted for the DGCX daily average value (estimated from overall value of futures contracts) for April 2010.

This is an under estimate for two reasons. Data for one important element (offshore OTC) pertains to April 2010; the market must have grown since then. Data from the BIS is likely to not capture activities of non-bank players.

Three interesting facts come out of this. First, that the overall market for the rupee is roughly $70 billion a day. Second, that roughly one-third of it is spot, and the rest is derivatives. Third, that rougly one-third of it is offshore.

Growth in recent years has been tremendous. In May 2000, the onshore market did only $2.7 billion a day. That is, we've got 24x growth over 12 years.

Where does the rupee stand, in global rankings of currencies?

BIS surveys global banks and reveals interesting data about the currency market. However, it is likely that the BIS misses out on a great deal of non-bank activity. If a hedge fund sends an order to an exchange, this is likely to elude the measurement of the BIS.

According to the BIS, in April 2010, the daily average turnover for the INR against the USD was a total of U$41.7 billion. ^[2] INR then ranked 15th (spot), 10th (forwards) and 22nd (swaps) in a pool of 28 currencies covered in this BIS survey. Summing up, the rupee stood at rank 16 in their group of 28 currencies. In the class of emerging markets, the rupee ranked fourth, third and ninth in the spot, forwards and swap markets respectively:

Ranking among EMs
Currency	Spot	Forwards	Swaps
Korean Won	1	1	3
Mexican Peso	2	6	1
Russian Ruble	3	12	5
Indian Rupee	4	3	9
South African Rand	5	9	4
Brazilan Real	6	4	14
Chinese Renminbi	7	2	8
Turkish Lira	8	8	6
Polish Zloty	9	7	2
Taiwan Dollar	10	5	11
Source:- BIS Survey, Tables D.1.1 and D.1.2

The BIS triennial survey included the INR since 1998. The three-yearly snapshot of Rupee's position marks its rise over time. Measuring only the spot market, the rupee ranked 13 (tied with Hungary, Indonesia and Chile) in 1998 and moved to the third position in 2010. In terms of change, the rupee has moved dramatically, perhaps, with no other currency witnessing such rapid change.

Emerging market currencies rank: spot market
Economy	1998	2001	2004	2007	2010
Russia	2	1	1	1	1
Korea	6	2	3	2	2
India	13	10	6	3	3
Brazil	3	4	6	7	5
China	16	18	17	5	5
Chinese Taipei	6	6	4	4	6
Mexico	2	4	2	7	8
Turkey	18	17	17	18	8
Malaysia	16	17	17	13	10
South Africa	4	10	9	8	10
Source:- BIS Survey, Table D.19

The most surprising feature of these results is the extent to which the rupee is a bigger market than the CNY, even though Chinese GDP and internationalisation exceed that of India. It seems to suggest that you'd have to do bigger trades to obtain a 1% change in the INR/USD rate, when compared with the trade size required to obtain the same change with the CNY/USD rate. This helps us see why India has moved into greater exchange rate flexibility when compared with China: there was really no choice.

Where does trading take place?

For the first time, Table D.6 of the triennial survey provides information about where currency trading takes place. A surprisingly diverse set of locations light up:

Location of the currency market (% of turnover)
Location	BRL	CNY	INR	KRW	ZAR
India	--	--	50.02	0.00	0.04
Australia	0.51	0.44	0.31	0.50	1.20
Brazil	29.68	0.01	0.00	0.01	0.07
Canada	4.66	1.36	0.15	0.18	0.39
China	--	24.87	--	0.00	0.06
Hong Kong SAR	--	27.29	10.91	10.33	--
Japan	0.05	0.28	0.21	0.19	4.65
Korea	0.05	0.03	0.02	52.13	0.02
Singapore	1.07	19.01	16.12	21.01	1.18
United Kingdom	19.18	17.29	12.32	10.98	36.43
United States	37.53	7.72	9.26	3.95	8.36
Source:- BIS Survey, Table D.6

Where are we on the onshore versus offshore distinction?

As the table above suggests, roughly half of rupee trading takes place in India. The issues which shape this onshore versus offshore market share are likely to be similar to those seen with Nifty. Recent events are likely to have driven the share of the onshore market to below 50%.

The onshore OTC market consists of forex spot transactions, forwards and swaps. The RBI publishes information on turnover in the onshore spot and forward market and the forward and spot legs of the swap transaction are captured in this data as well. An RBI report on OTC derivatives in 2011 highlights that OTC derivative turnover was 3.53 trillion USD in FY2009-10. Out of this, forex swaps account for over 60% of the total turnover in the same period. Here is the time series for the onshore OTC market:

Source: RBI, Weekly Statistical Supplement (1996 - 2012)

Exchange-trading of the rupee, in India, started in 2010. At a point in time, turnover in exchange-traded currency futures did seem to have overtaken the OTC forward market. The USD-INR futures contract on MCX-SX, NSE, and USE with a contract size of USD 1000 occupied the first three ranks for volume in the world in 2010 and 2011. The USD-INR options contract on the NSE ranked fourth while the EUR-INR futures on the NSE also featured in the top 20 forex futures contracts in the world. The collapse in the following graph, which shows exchange traded onshore turnover, is associated with the CCI order:

Source: NSE, MCX-SX, and USE

Putting together the information from the onshore exchange-traded market (options, and futures) and the onshore OTC market (spot, forward, swaps data from the RBI), one gets a complete picture about the onshore INR market:

Source: RBI, NSE, MCX-SX, and USE

The most recent BIS triennial survey (April 2010) had placed the onshore market (USD-INR) at about U$20 billion. As the graph above shows, current values are more like U$30 billion a day. The offshore market is likely to have grown more, giving total INR turnover of well above U$70 billion a day. This puts the Indian rupee today above the Korean Won as of April 2010.

Conclusions

The Indian rupee has grown rapidly to becoming the sixteenth most traded currency in the world. From less than 0.2% of the world forex turnover in 1998, it has grown rapidly to constitute about 0.9% of the world forex turnover in April 2010. It is one of the biggest emerging market currencies with the Korean Won, Russian Ruble, Chinese Renminbi and the Mexican Peso being its close competitors. The offshore market today is as big as the onshore market, as is seen by other EMs. Today, the rupee does roughly $70 billion a day, roughly where the biggest EM currency (the KRW) was in 2010.

These developments have many ramifications:

1. The rise of a large currency market is consistent with India's rapid integration into the world economy of recent decades.
2. When a market does turnover of $70 billion a day, market manipulation is difficult. Manipulating the rupee is now as hard as manipulating Nifty: both are large globally traded products with highly liquid markets. This is the essence of India's evolution away from an INR/USD pegged exchange rate to a mostly-floating exchange rate: the monetary policy distortions required to support manipulation became too large.
3. As with Nifty, mistakes of domestic policy are giving a substantial shift in India-related finance to overseas locations. The two most important pillars of the Indian financial system are trading in the rupee and in the Nifty, and with both these, India is rapidly losing ground. If present policy mistakes continue, the role of the onshore market will continue to decline, for both the rupee and Nifty.
4. In the last 12 years, there was 24x growth. Suppose there is only 10x growth in the next 10 years. That would take us to $700 billion a day, which would be quite something.
5. Looking into the future, if India is able to continue on the course of high GDP growth and integration into the world economy, the rupee will become a big currency by world standards. The big four currencies today are the USD, EUR, JPY, GBP. It is not inconceivable to think of CNY and INR joining that club. This could connect nicely with a role for India in global finance. But for all these good things to happen, we have to put our house in order.

Notes

[1] Forward market turnover is estimated as purchase + sale - cancellation.

[2] The BIS survey also does cross-border netting - something that we cannot adjust for from the RBI data. However, as Jayanth Varma points out, this may not be a very large number that the overall calculations dramatically change.

Interesting readings

Anil Padmanabhan in the Mint on Indo-Pakistan relations.

Jeff Glekin on Reuters Breakingviews about who could succeed Pranab Mukherjee as FM, and Kaveree Bamzai in the India Today about what could come next if he leaves. Who will be the President? This time, it matters by Satarupa Bhattacharjya of Reuters in Mint.

The delicate technology of creating excellence by Pradip Ghosh in the Telegraph. Also see.

Garima Jain in Tehelka magazine about guns in Punjab. It's remarkable how much our side of the Punjab is like, when compared with the other side.

The Wanderer's Eye is a remarkable blog being written out of India by Aniruddha H. D..



On the problem of the hollowing out of the Indian financial system, read Shaji Vikraman and Ram Sahgal in the Economic Times.

Ravi Jagannathan on Firstpost, on the Sahara vs. SEBI case at the Supreme Court.

Dhiraj Nayyar in India Today on the woes of the Indian oligarchs.

Sajjid Chinoy in the Business Standard on what is going wrong with investment.

A. K. Bhattacharya in the Business Standard on how tax authorities in India have gone astray.

Dinesh Unnikrishnan in Mint about the unique problems of public sector banks.


Sean O'Hagan, writing the Guardian about Robert Capa and Gerda Taro, reminds us that we're stuck in a pastel coloured world.


Paul Krugman has a nice old article on comprehending comparative advantage: Ricardo's difficult idea. He ends with advice which could well be applied to all economic policy debates in India: (i) Take ignorance seriously; they actually do not know. (ii) Adopt the stance of rebel. (iii) Don't take simple things for granted. (iv) Justify modeling.

Jon Lackman in Wired magazine, on what is uber-cool in Paris today.

Opportunities in the Macro/Finance Group at NIPFP

The Macro/Finance Group at NIPFP offers opportunities for interesting and important policy work which is connected with the ground realities of India's economic reform. One of the important projects being undertaken, at present, is research support for the Financial Sector Legislative Reforms Commission.

Policy work is highly inter-disciplinary. The policy group at NIPFP is particularly looking for people with a knowledge of financial regulation and law. Deep practitioner knowledge, about the ground realities of law and regulation are important. Equally important is the instinct of looking beyond the present and envisioning the future, drawing on strong foundations of public economics and international experience. We welcome interest in these positions by people with strong capabilities in at least one of these areas, and curiosity about the other. The ideal candidates would have read the Percy Mistry and Raghuram Rajan reports, and have familiarity with the things being talked about in this blog.

The Macro/Finance Group at NIPFP is a conducive research environment including a modern office. Compensation is generally superior to that seen in government academic institutions. There is joint work and spillovers of knowledge with the quantitative research team within the Macro/Finance Group.

If this interests you, please contact Anurodh Sharma (anurodh54 at gmail.com) with your resume by 22 June 2012, where you clearly identify where your interests and capabilities lie.

Is building and running the IIT JEE a public goods problem?

What should government do?

In the question "What should government do?", economists have one big answer "do the public goods". A public good is something that is non-rival (the consumption by one does not come at the cost of consumption by another) and non-excludable (it is not possible to exclude someone from benefiting from the public good).

The regulation of air pollution is the favourite example which illustrates a public good. Clean air is non-rival (if you breathe clean air, it does not diminish my supply of clean air) and non-excludable (if the air is cleaned up, nobody can prevent me from breathing it in). Indeed, nothing that one person can do can make a difference to air pollution. Only the government can regulate pollution and this deliver clean air.

Similar issues arise with defence, police, judiciary, monetary policy, financial regulation, public health (though not the health of the public), biodiversity, etc., all of which add up to the economists' vision of what government should be doing.

What should government do in the field of education?

Education is substantially a private good. I study, I benefit. There are spillovers ("externalities") to others, and so there is a case for a government subsidy. But barring that, this is a field where the incentives are well aligned for each person to be the main one in charge of his own education.

Public funding solves the problem of externalities. At the level of elementary education, vouchers are a nice way to deliver public funding that is large enough to pay for the externalities. At the level of higher education, public policy can focus on economies of agglomeration alongside some public funding, nudging the outcome in India so that there are 100 high quality broad-based universities.

As I read The delicate technology of creating excellence by Pradip Ghosh in the Telegraph, I was reminded of the public goods character of testing and curriculum development. As he says:

in this very large country with a multitude of school boards and their non-uniform curricula and examination standards, it would be inappropriate to go by board grades because that would yield unreliable, undesirable results — we would not get the best students. And, such a course, therefore, would be unfair both to the aspiring students and to the institutions they would be entering. A single post-high school examination with a well-defined syllabus and a centrally administered paper-setting and grading system was thought to be the best alternative

The production of education services is a private good problem, to be sorted out between one student and one education provider. However, the problems of curriculum and testing have a public goods character. Let's run the tests of a public good, for a nationwide system for standardisation of curriculum and testing.

Is it non-rival? Does the consumption of the services of this system by one person diminish the amount of this system available for another? With computerised testing, there should be full scalability (though Pradip Ghosh argues, in the article above, that there are problems with this).

Is it non-excludable? High quality curriculum is non-excludable in that once curriculum documents are on a website, everyone can download them. Testing is excludable if you want to be cussed about it, but for the rest it should not be possible to exclude anyone from taking a nationwide test.

This argument guides us in thinking about what government should be doing in the field of education:

1. Funding (calibrated to overcome the externalities)
2. Curriculum development
3. Testing
4. Information infrastructure about education service providers (i.e. schools but also all sorts of new ways of organising education service delivery) so as to assist choice by parents and students.

The entire focus of management time, and the entire resources available for the task, should be devoted to these 4 problems.

Central government or local government?

Once we know that testing and curriculum are public goods, we have to ask who should do it.

If an important outcome (getting into the IITs) was linked to regional board examinations, that is a recipe for grade inflation. This is a reason for doing this at the central government.

There are economies of scale. A curriculum only needs to be developed once. This is a reason for doing this at the central government.

In conclusion, the IIT JEE has many problems, but the building and running of high quality examinations is an important task of the central government and should not be diluted or abandoned. The fraction of management time, and resources, that are devoted to curriculum and testing need to go up.

Uptake of systems like Amazon's `Mechanical Turk' in India

I have long been aware of Amazon's `Mechanical Turk', a mechanism through which tasks are farmed out to a large bank of humans. Each human worker has full flexibility on how many hours are worked and when. From the customer's point of view, Amazon supplies an API and access to a very large pool of humans who can perform small tasks. The median wage is $1.4 or Rs.80 per hour. In effect, Amazon has created a large market through which workers can find work, and firms can find workers to perform well defined tasks.

In a recent issue of The Economist, I was surprised to discover (a) that Amazon's Mechanical Turk has 0.5 million workers and (b) that roughly a third are from India. That's roughly 150,000 persons in India who are plugged into Amazon's Mechanical Turk. We don't know how many hours/week are spent in doing labour supply, but it's still a lot.

There are a few other such systems also. Here are links for exploration: oDesk, CrowdFlower, Elance, Amazon's Mechanical Turk.

These mechanisms add up to a whole new world for the functioning of the labour market. For first world customers who would like to connect up to cheap labour in India, our traditional view was that there had to be a man in the middle - a Datamatics or a TCS or an IBM. What these new systems seem to suggest is that for a certain class of tasks, it is possible to disintermediate the Datamatics or TCS or IBM.

For many individuals in India, the flexibility of working from home without rigidity about how many hours are supplied, and when, these systems could be a big win. At present, many households do not have computers and broadband connections, which is an important impediment. But this is also a constraint that is being rapidly eased through 3G, LTE, etc. These developments, put together, could become a whole new chapter in the story of India's connecting up to globalisation.

Hollowing out of the Indian financial system

Business as usual, in India, is taking us to a destination where RBI & SEBI & company will preside over a minor and inconsequential financial system. The bulk of India-linked finance will take place overseas, and the overseas market will dominate price formation for India-related financial products.

Why might this happen?

Finance is the business of bits and bytes. Orders being sent to India can be easily switched to other venues. An array of other venues are now springing up:

1. Nifty futures trade in Singapore on the SGX
2. An array of sophisticated derivatives on Nifty trade on the OTC market offshore (also termed `the PN market').
3. Derivatives on the rupee trade overseas on the OTC market (linear contracts are termed `the NDF market').
4. Trading in individual stocks is taking place on the ADR and the GDR market.

Let's focus on Nifty - the most important financial product in India. (The arguments pretty much identically apply to everything else).

The success and survival of the onshore securities markets is fundamentally about NSE. NSE faces an array of problems rooted in domestic policy (example, example, example, example, etc). The overseas market faces no such problems. The CEO of SGX wakes up in the morning and thinks about competing with NSE. The CEO of NSE wakes up in the morning and thinks of an array of weird things.

And then, there is taxation. The fundamental principle worth using in this field is residence based taxation. We, as India, should not tax the activities of non-residents. For a global investor, sending orders to the Nifty futures on SGX is tax-efficient as Singapore follows a residence-based taxation system. Sending orders to India is inefficient today (owing to the STT and the stamp duty) and could get worse tomorrow (if GAAR is used to abrogate the Mauritius treaty).

We think we are comfortable, because India has capital controls, and residents don't have much of a choice on taking their custom elsewhere. Things aren't that simple. First, non-residents can pioneer sending order flow to overseas venues, and make them liquid. The next stage will be about Indian MNCs, who run global treasuries, who can easily patronise the overseas venues. The third stage will be HNI residents, who can take $200,000 per year per person outside India. In addition, the richest 1% of India would systematically shift money out of the country through various means fair and foul [example].

Put these factors together, and suddenly Nifty futures on SGX are a credible option. And this is exactly how things have worked out. Palak Shah in the Business Standard says:

As on date, the SGX Nifty OI is 27 per cent higher than that for Nifty futures on the National Stock Exchange (NSE). The figures are more alarming if one considers the OI in a single month in May as the built-up positions on the SGX are 70 per cent higher than on the NSE. In May, the SGX Nifty OI was worth over Rs 16,200 crore while that on the NSE stood at over Rs 9,250 crore. As far as three-month contracts go, the Nifty futures OI on the NSE is over Rs 12,750 crore.

In 2008, before these troubles had come together, SGX open interest was 59.78% of NSE. By 2012, where all these problems have come together, SGX open interest has come to 101.77% of NSE's. It is astonishing to see that for the biggest Indian product - Nifty - an overseas exchange has got superior open interest.

In the baseline scenario, Indian policy-making will meander on clueless and unconcerned. NSE will continue to lose ground. Why do we care? Is this mere protectionism - what is wrong if the entire India-linked equity index derivatives business takes place overseas?

• A rich and complex ecosystem of finance has developed surrounding the Nifty contracts. Hundreds of thousands of high skill workers are in this industry. A decisive loss of market share for India would endanger their livelihood.
• The tax revenues associated with all these activities, at present, come to the Indian authorities. The Indian tax man earns income tax (on wages and on corporate profit) and VAT (on an array of activities of the firms). All this will go away if the business shifts to Singapore.
• A sophisticated Indian financial system is required if monetary policy is to be effective. The demise of the onshore financial system will damage the onshore monetary policy transmission. It will further take us back towards a world where government is unable to play a role in business cycle stabilisation.
• Prospects of Bombay emerging as an international financial centre will subside. If we can't even hang on to market share for Nifty or the rupee, where is the question of competing against overseas financial firms or markets on things that aren't India-linked?
• Access to finance for firms will tend to split into a two-tier world: the big firms will go abroad to get their corporate finance done. The small firms will face greater constraints since they will not easily access finance abroad (there is a greater information distance between the typical Singapore investor and the typical Rs.1000 crore or Rs.100 crore Indian company), and the local financial system would be weak.

When India started trying to build a mature market economy in 1991, at first, it felt like a sophisticated financial system would emerge, which would both serve India and start competing for the global market. From 1993 to 2001, India achieved a remarkable revolution in the equity market. This increased optimism in the ability of India to understand problems, to achieve change, and to maintain high ethical standards.

It now seems that those hopes were premature. The more likely scenario is one where India-linked finance will happen offshore, while RBI/SEBI/CBDT/CCI/FMC/IRDA squabble over a minor and inconsequential onshore financial system that is riddled with ethics problems. In the short term, onshore Indian finance will suffer from one setback after another.

We are likely to go back to the conflicted arrangements that gave us the Harshad Mehta scandals of the early 1990s and the Ketan Parekh scandals one decade later. I used to think we were finished with those problems. But we are about to restart on that entire story; there is little institutional memory about how those things came about and how dangerous our present path is. Each future scandal, of this nature, will be greeted with joy by overseas financial providers, who will scoop up market share every time India falls into turmoil.

Many years from now, we may one day get to fundamentally superior governance arrangements in finance, and achieve high ethical standards in public life and securities infrastructure. If this happens, we would be able to come back to these questions. As an example, Japan lost the Nikkei 225 contract to Singapore in the mid-1980s and got back into this to a significant extent 15 years later. In the years or decades that will go by until domestic financial governance structures are corrected, a great deal of organisational capital in the onshore financial system will have been lost.

The revolution in the stock market used to be one of the best success stories of economic reforms in India [link, link]. It may well fall apart in coming months and years.