Trading volumes on SGX in sync with FII flows into the domestic market

Move to curb offshore trading of domestic indices could hurt foreign inflows into India

The measures taken by domestic bourses to put an end to offshore trading of domestic securities could dent foreign institutional investor (FII) flows into Indian capital markets. Historical data suggests a positive correlation between FII inflows in India and the volume of Nifty contracts traded on the Singapore Stock Exchange (SGX). High portfolio flows into Indian markets have been accompanied by an increase in trading volumes in Nifty contracts at the SGX.

Foreign portfolio investor (FPI) inflows into Indian equities rose sharply after the 2009 Lehman crisis, as the US central bank went on a money-pumping spree to avert a global slowdown. This was followed by an equally sharp surge in trading of Nifty futures on the SGX.

The trading data pattern shows overseas investors like to hedge their exposure in tax-friendly jurisdictions like the SGX. This trend is demonstrated by an increase in volumes on the SGX after periods of high FII inflows into India. Volumes on the SGX have also seen a spurt during periods of high volatility in the domestic market.

For example, FPI inflows (on 12-month rolling average) steadily improved from an outflow of nearly a billion dollars in the latter half of 2008 to inflows of $2 billion or more on a monthly basis during the second half of 2010 and early 2011. The rise in FPI inflows was followed by a rise in trading volumes on the SGX Nifty, with a few months' lag.

The numbers of Nifty future contracts traded rose from a 12-month average of around 0.35 million in the second half of 2009 to 1.2 million during the middle of 2012. Volumes surged again as FPIs raised their exposure to Indian equity after a sell-off in mid-2013.

Similarly, the current weakness on Dalal Street and muted FPI inflows have been accompanied by the stagnation in SGX Nifty trading volumes.

"Typically, no large FII takes a huge exposure without a proper hedging mechanism in place. Equity is an inherently volatile asset class. During bouts of high volatility, any large investor safeguards the underlying exposure using the derivatives market. In case of FIIs, they have increasingly preferred trading platforms like the SGX, where the cost of transaction is low compared to the Indian market," said an executive with a brokerage that deals with FIIs.

In recent years, a large part of foreign inflows have been on account of exchange-traded funds (ETFs). Typically, funds that chase a basket of securities, such as the MSCI EM (emerging market) or the MSCI Asia Pacific (excluding Japan) index, invest in the respective countries depending on the weight. India's weight in the MSCI Asia Pacific ex-Japan index is around 12 per cent. ETFs with assets worth around $90 billion track this index. Industry players say most of these investors prefer hedging their exposure on the SGX. A typical hedging strategy involves shorting SGX Nifty contracts instead of selling the entire basket of securities in the domestic market.

The share of Nifty trading volumes on the SGX is around 12 per cent of its overall volumes, in sync with its weight in the MSCI Asia Pacific index.

Earlier this month, Indian exchanges terminated their data-feed agreements with their foreign counterparts. The move could potentially put an end to offshore trading in Indian securities, such as the SGX Nifty.

Experts fear a decline in overseas flows if FIIs do not find a suitable alternative mechanism for hedging.

"Many foreign funds cannot deal directly in the domestic derivatives market due to regulatory restrictions. Such investors may trim their exposure due to lack of hedging tools," said a custodian.

Meanwhile, domestic exchanges and the government are trying to address some of the issues to ensure foreign flows are not negatively affected. The measures include getting clearances for foreign regulators to allow overseas funds to deal in the derivatives market directly and ramping up volumes at GIFT City, an international financial services centre designed on the lines of the SGX.