India's new lending curbs seen squeezing trading firms

The Indian central bank's curbs on bank funding for proprietary trading could spur trading firms to shift business offshore and may force smaller players to shut ⁠down, executives and analysts said.

Proposed rule changes that prohibit banks from lending for proprietary trading and require 100 per cent collateral for ⁠other funding to brokers could see profit margins cut in half and a drop of ‌up to a fifth in derivative trading ​volumes, the executives said.

Reuters spoke to executives at six trading firms, both domestic and foreign. All declined to be identified as they are not authorised to speak to the media.

The Reserve Bank of India's initiative - due to take effect from April 1 - follows a series of steps taken by the government and market regulator to cool the explosive growth in the country's equity derivatives ​market, which has lured mom and ⁠pop investors in droves, but with nearly 90 per cent of them suffering losses, according to an official study.

Analysts say policymakers are wary of the spillover risks to household finances and the wider economy.

LEVERAGE PANGS

Under the current rules, trading firms use bank financing to ramp up leverage and reap big profits, outmaneuvering retail investors with their much higher ⁠level of sophistication. Having to ‌tap other sources of capital that are typically pricier will greatly erode margins, the executives and analysts said.

"Domestic proprietary trading firms fear that their business model has been rendered obsolete," an ‌executive at a domestic mid-sized proprietary trading firm said.

"Large firms may still have some of their own capital to deploy but this will impact their ⁠growth prospects," said the head of a large domestic high frequency trading (HFT) firm.

The National Stock Exchange of India (NSE) is the world's largest venue for equity derivatives, accounting for ‌70% of global index options trades, according to data from the World Federation of Exchanges.

Proprietary trading makes ‌up nearly half of overall derivative trading on NSE by value. HFT firms make up about ‌50% of proprietary trading, according to Jefferies.

SMALLER TRADING FIRMS VULNERABLE

"Smaller proprietary firms that historically leveraged broker funding will ‌be squeezed hardest because they lack large balance sheets or alternate credit access," Mumbai-based brokerage firm IIFL said in a note this week.

The pushback from trading firms echoes the reaction from the brokers lobby, which on Thursday urged a six-month suspension of the proposed rule changes ⁠to allow time for ⁠feedback and an assessment of the impact.

The Reserve Bank of India and the Securities and Exchange Board of India did not respond to emails seeking comment for the story.

Policymakers have been vexed as India's derivatives market swelled to more than double the size of the underlying cash market, a stark and worrying contrast to the 2-3 per cent ratio in major global markets.

Efforts thus far have included increasing fees for trading derivatives, reducing the number of contracts offered by exchanges, and raising taxes on profits from the trades.

But while these measures brought down the number of contracts traded, the total ​value of the trades remains high, suggesting substantial capital continues to be deployed.

The RBI's new initiative to combat ​that may effectively penalise domestic players, according to ​the trading firm executives.

Foreign trading firms could pause plans to set up operations in India and shift existing operations to offshore centres where financing is cheaper, giving ​them a competitive edge, three of the executives said.