This report identifies and evaluates ways to take advantage of regulatory changes in the Indian stock exchange to create liquidity in the equity derivatives segment.

1. • Cognizant 20-20 Insights
Assessing Liquidity
Enhancement Schemes
Executive Summary operators to identify, formulate and implement
various liquidity enhancement schemes (LES) to
The Indian equity derivatives market has grown
boost the illiquid equity derivatives segment. The
to approximately five times the volume of the
goal is to trigger changes in the existing market
cash market in the last decade. This growth has
structure and provide challenges and opportuni-
not been consistent for all derivatives products
ties for exchange operators and participants.
or exchanges. Product-specific index futures and
options (F&O) accounted for nearly 70% of the This white paper identifies and evaluates steps
total volume of the equity derivatives market in that can be taken to take advantage of this
the last four years, with liquidity largely present regulatory change.
in near-month contracts only.
Proposed Liquidity Schemes
In the first half of 2010-11, the National Stock
Exchange’s (NSE) index F&O rose to nearly 82%. In its circular, SEBI suggested a few ways to
Stock-specific trading accounted for just 18% create liquidity in the equity derivatives segment.
of overall futures and options trading. On the Taking the board’s suggestions, and based on our
Bombay Stock Exchange (BSE), stock-specific experience with other exchange operators and
trading barely exists. The NSE and BSE logged an participants, we have identified several ways to
average monthly F&O turnover of 1.17 lakh crore achieve this in the Indian trading context (see
and 4 crore, respectively, over the past year. Figure 2, next page).
As of August 2011, there were 1,599 listed Following publication of the circular, the BSE
companies in the NSE and 5,085 in the BSE. Only launched incentive programs (lower transac-
221 securities (of which 134 were added in July tion fees, volume- and open-interest-based cash
2011) and 236 securities are traded in the F&O incentives) for its members and also plans to
segment of the BSE and NSE, respectively. spend over Rs 100 crore in the coming months on
market-making schemes. The NSE also launched
In its circular in June 2011 (see Figure 1, next page), incentive programs for near-month and following
the Securities and Exchange Board of India (SEBI) two months contracts on the S&P 500 and Dow
provided a big push to Indian stock exchange Jones Industrial Average indices.
cognizant 20-20 insights | october 2011

2. SEBI Circular Details
Key Points
• To be implemented in illiquid securities in the equity derivative segment only.
• All LES schemes, such as Maker Taker, Market Maker and Liquidity Provider, can be adopted.
• Incentives can be paid in the form of fee discounts/adjustments, payment for order flows and stock, in the
form of options or warrants of stock exchanges within prescribed limits.
Entry Criteria Exit Criteria
• New securities. • Advance notice of 15 days.
• Securities getting listed on a new exchange and new segment. • Last 60 days trading volume = 1% of
• Securities where average trading volume for the last 60 market cap of underlying or six-month
average, whichever occurs earlier.
days on the stock exchange is less than 0.1% of market
capitalization of the underlying security. • Exit of LES by initiating stock
• If above is not satisfied, then conditions must exist on a exchange, then all other stock
exchanges must exit.
particular stock exchange, and the scheme can be enforced
by another exchange on the same/similar security.
Gray Areas
• Lack of continuity of LES will discourage exchange • Complexity arising out of simultaneous,
participants and create confusion. multiple LES schemes on same security
• Uniform exit criteria proposed on all LES; this might be for exchange participants.
applicable for some simple schemes but might not work
for other complex schemes.
• Ambiguity on co-relation between illiquid
security present in cash segment and
• Detailed guidelines not present on issues their impact on derivative segment.
(communication channel, timeline, etc.) to be created due
to interdependency of exchanges to initiate/exit LES.
Figure 1
Proposed Liquidity Scheme
LES Description Pros/Cons
Market
• Exchange members who are responsible for creating liquidity by + Ensures liquidity is maintained throughout the
providing two-way quotes during the trading day, as stipulated trading day.
Maker by the exchange. – Not relevant in prevalent order-driven markets.
Fiscal
• Payment for order flows. + Quickest way to incentivize members and easy to
• Discount/Adjustment in transaction fees. implement by exchanges.
Incentive
• Exemption from other exchange fees, such as membership fees. – Additional cost to exchanges and limited duration.
Non-Fiscal
• Guaranteed allocation of order flow among participating + Indirect and less costly form of incentive given by
members. exchange to members.
Incentive
• Shares, including options and warrants, of stock exchange. – No immediate return for members.
Maker
• Transactional charges are levied differently between traders + Allows members to quote better price and
that bring vs. take liquidity to/from the market. Makers of remove the customer priority factor.
Taker liquidity are given rebates, and takers of liquidity are charged. – Discourages customer origin order flow.
• Order trigger mechanism: An incoming customer order starts an + Allows exchanges to concentrate pool of liquidity
auction, which is flashed to trading members, who can respond at pre-determined intervals/actions and enables
with opposite side orders. price discovery.
Call
Auctions
• Liquidity concentrator mechanism: Auctions are held at prede- – Difficult to implement by exchange.
termined time intervals. During the auction, buy and sell orders
are netted to trade at a single price point, at which the maxi-
mum number of orders can be cleared (e.g., pre-open sessions).
Source: Cognizant
Figure 2
cognizant 20-20 insights 2

3. Challenges of Market Maker Model
Challenges
Exchange Operators Exchange Participants
• Need to identify the criteria to select/appoint • Access to/integration with software, which en-
Market Maker. Need to formulate rules around ables quotes to be created, maintained
key areas such as: and disseminated.
> Assigned contracts/series number. > Option 1: Front-office software that interacts
> Time for continuous quoting. with market to generate quotes.
> Maximum time limit for responding to QR. > Option 2: Exchange-supplied auto-quote
> Minimum display time, maximum bid/offer spread. system.
> Non-market-making hours obligations. • Risk management system capable of maintaining
• Additional reporting to regulators. and monitoring inherent risk in real-time.
• Create awareness and train registered • Integrate/build position management system
exchange participants. that updates Market Maker net position in real
• Clear rules governing trading between time.
Market Makers need to be in place.
Regulators
• Strong surveillance system needs to be in place to
• Ensure the policies and procedures formulated
avoid any collusion between Market Maker for their
own interests. by the exchange operators are fair and
transparent.
Figure 3
Market Maker Model Market Makers are more effective in small- and
The Market Maker (MM) model has been adopted mid-caps, which are less liquid compared with
by many exchanges across the world, and it large caps.
plays a key role in the derivatives segment of the
The Market Maker model also poses several
market. The following are some characteristics of
challenges for exchange operators, participants
the Market Maker model, according to Delphine
and regulators (see Figure 3).
Sabourin:1
The Sydney Future Exchange was able to apply the
• Clearing frequency is higher in a limit order
Market Maker model, with the following benefits:
market with Market Maker.
• The presence of Market Maker entails a higher • Decline in average bid ask spreads for the
level of competition for the execution of limit period Nov. 2003 to Jan. 2006 (see Figure 4).
orders. • Rise in average quarterly trading volume for
the period Feb. 2005 to Jan. 2006.
Sydney Future Exchange Pre- and Post-Trade
Quote Spread & Volume Comparisons
0.08 350,000
Pre Post
0.07 300,000
0.06
250.000
Quoted Spread
0.05
Volume
200,000
0.04
150,000
0.03
100,000
0.02
0.01 50,000
0.00 0
11/17/03
12/17/03
1/17/04
2/17/04
3/17/04
4/17/04
5/17/04
6/17/04
7/17/04
8/17/04
9/17/04
10/17/04
11/17/04
12/17/04
1/17/05
2/17/05
3/17/05
4/17/05
5/17/05
6/17/05
7/17/05
8/17/05
9/17/05
10/17/05
11/17/05
12/17/05
1/17/06
2/17/06
3/17/06
4/17/06
Nov ‘03 - Jan ’04
Feb ‘04 - Apr ’04
May ‘04 - Jul ’04
Aug ‘04 - Oct ’04
Nov ‘04 - Jan ’05
Mar ‘05 - May ’05
Jun ‘05 - Aug ’05
Sep ‘05 - Nov ’05
Dec ‘05 - Feb ’06
Mar ‘06 - May ’06
Spread
Source: “Market Insights,” University of Sydney
Figure 4
cognizant 20-20 insights 3

4. Fiscal Incentive Maker-Taker Model
Fiscal incentives are the most tangible form The Maker-Taker pricing model in the options area
of incentives provided by exchange operators has gone in and out of fashion. There have always
to exchange participants, including trading been two schools of thought. Some exchanges in
members, brokerage firms, Market Makers, etc. 2010 (NASDAQ OMX PHLX and JSE) adopted this
(see Figure 5). pricing model (see Figure 6, next page), whereas
the International Security Exchange launched a
Non-Fiscal Incentives modified version of the model to suit its require-
Another way to incentivize exchange participants ments.
is through non-fiscal measures. For instance,
the exchange can provide trading advantages Call Auctions: Order-Triggered Mechanism
to Market Makers (i.e., guaranteed allocation of Incoming orders trigger an auction process,
order flow among participating Market Makers). which is flashed to members to allow them to
This practice is currently followed by one of the participate and improve the price (see Figure 7,
largest options exchanges in the U.S. The Market next page). This gives order originators a chance
Makers are assigned 40% of the allocation during to trade at a price better than what is available
an internalization auction if they are quoting at in the book. This can also be applied to present
the best price. blocked deals to the market, when one order of
the deal is an agency order and the other is a pro-
In addition, the Indian Exchange regulator has prietary order.
allowed operators to allocate shares, including
options and warrants, of the stock exchange as When the Boston Option Exchange (BOX) adopted
incentives, not exceeding 25% of the issued and order-triggered call auctions, it saw an average
outstanding shares of the stock exchange as on improvement in trade price for July 2011, clearly
the last day of the preceding financial year. showing how an auctioned order fetches an
improved price compared with the best available
price for a trade (see Figure 8, page 6).
Incentive Plans Adopted by Various Exchanges in Derivative Segments
Incentive Fiscal Incentive
Exchange Segment Incentive Detail
Start Type
No transaction charges will be levied on trades done.
Additionally, based on number of contracts, waiver of
National F&O of Nifty Junior, transaction charges will be increased.
Stock Jan-08 CNX 100 and Nifty Exemption of fees
No. of Contacts Waiver of transaction charge
Exchange Midcap 50
10 to 30 2 times
31 & above 3 times
Waived off stamp duty, trading fee and
Hong Kong Exemption of fees
Stock & index transaction levy for Market Maker.
Stock Feb-07
Futures & options Differential discounted fees for Market Maker on different Discount/
Exchange
products. Adjustment in fees
Single stock & index Applicable until Dec. 2009, free of charge.
options, options on (Clearing fee will be charged.) Exemption of fees
JGB futures
Tokyo Stock Oct-09
Mini contracts like Applicable until March 2010, free of charge.
Exchange
mini Topix futures, (Clearing fee will be charged.) Exemption of fees
mini JGB futures
Applicable until Jan. 2010, 40 JPY.
Discount/
Nov-09 Topix futures (A new fee schedule [70 JPY per contract] will be given 30
Adjustment in fees
JPY discount during the period.)
For brokers, trading members, Rs 1,050-1,100 to brokers
Bombay
for Rs 1 crore turnover for both buy and sell orders. Payment for
Stock Jul-11 Derivative segment
Nearly double incentive for Market Makers that give order flow
Exchange
both buy and sell quotes.
Source: Various exchange Web sites
Figure 5
cognizant 20-20 insights 4

5. Exchanges That Adopted/Discontinued the Maker-Taker Pricing Model
Exchange Start Date Discontinued Remarks
January-07 NA Uses Maker Taker pricing for
NYSE Arca Options
penny-pilot options..
Chicago Board of Stock Exchange May-07 June-11 Pricing model was changed to flat fee structure..
(CBSX)
August-07 August-09 Reverse of the Maker Taker pricing schemes:
will pay a $0.30-per-contract rebate to those
Boston Options Exchange (BOX)
who remove liquidity and charge those posting
liquidity $0.30 per contract.
Nasdaq Options Market (NOM) August-07 August-09 Shifted back to the traditional model.
September-08 September-09 New fee structure is dependent on value
London Stock Exchange (LSE) traded by individual market participants on the
exchange per month.
Bombay Stock Exchange (BSE) October-09 NA Cash equity segment
Bombay Stock Exchange (BSE) December-09 NA Equity derivative segment
Nasdaq-OMX-PHLX January-10 NA Derivative segment
Johannesburg Stock Exchange (JSE) July-10 NA Equity derivative segment
Source: Various exchange Web sites
Figure 6
Call Auction: Liquidity Concentrator Scheme world, we have evaluated the above schemes on
Under this type of call auction, liquidity is con- certain parameters (see Figure 9, next page).
centrated at a pre-determined interval. It can
Exchange operators should identify securities
be at the opening, closing or during the trading
eligible for LES and start implementing schemes
day. Most stock exchanges rely on the opening
with minimum time to market. They should simul-
call auction method to determine opening prices
taneously work toward building infrastructure
and the continuous auction method during the
and systems for complex schemes, as well as
remainder of the trading session. In contrast,
awareness of these schemes. They should also
stock exchanges in Malaysia and Taiwan utilize
build mechanisms to measure the effectiveness
the call market method as the sole price and
of ongoing schemes.
order matching method.
Exchange participants should build a tool to
Evaluation of the Proposed Schemes evaluate which LES would be beneficial. Addi-
Based on our extensive experience with exchange tionally, they should work toward scaling up their
operators and exchange participants across the systems to leverage market making schemes.
Exchanges Adopting Order-Triggered Auction Mechanism
Exchange Auction Name Description
Price Improvement An auction process through which an ISE member may trade with its
International Securities
Mechanism (PIM) customer’s order as principal or execute its customer’s order against orders
Exchange (ISE)
the member has solicited.
Chicago Board Option Automated Improvement Automated process for crossing of any origin type, which provides potential
Exchange (CBOE) Mechanism (AIM) for price improvement and participation right through an auction process.
Price Improvement PIPs are initiated under specific circumstances on a voluntary basis.
Boston Option Period (PIP) PIPs can be initiated by broker-dealers who are willing to provide their
Exchange (BOX) customers guaranteed execution with their own contra-order or through
the directed order process.
Source: Respective exchange Web sites
Figure 7
cognizant 20-20 insights 5

6. Impact Of Order-Triggered Auction Mechanism On Price
July 2011
Contracts Average
Date Classes Calls Puts Total Volume
PlPed Improvement*
July 29, 2011 1.575 389,033 334,246 723,279 342,833 $0.0063
July 28, 2011 1,575 326,423 258,914 585,337 282,792 $0.0063
July 27, 2011 1,575 388,595 310,805 699,400 346,289 $0.0066
July 26, 2011 1,575 308,764 207,659 516,423 260,978 $0.0068
July 25, 2011 1,577 313,817 245,475 559,292 302,658 $0.0065
July 22, 2011 1,577 371,724 268,842 640,566 374,287 $0.0065
July 21, 2011 1,577 440,880 306,884 747,764 387,781 $0.0064
July 20, 2011 1,577 386,599 255,937 642,536 383,108 $0.0065
July 19, 2011 1,578 449,558 255,411 704,969 412,582 $0.0062
July 18, 2011 1,568 426,532 275,082 701,614 386,131 $0.0052
July 15, 2011 1,568 338,507 265,980 604,487 306,648 $0.0075
July 14, 2011 1,569 332,084 274,578 606,662 309,451 $0.0066
July 13, 2011 1,569 360,937 231,800 610,080 354,500 $0.0057
July 12, 2011 1,569 290,539 276,830 522,339 280,754 $0.0050
July 11, 2011 1,571 320,933 230,514 597,763 331,734 $0.0048
July 8, 2011 1,571 254,099 222,273 484,613 271,995 $0.0055
July 7, 2011 1,571 322,028 222,273 544,301 338,211 $0.0067
July 6, 2011 1,571 225,792 167,138 392,930 235,885 $0.0061
July 5, 2011 1,571 233,459 169,956 397,425 240,453 $0.0055
July 1, 2011 1,572 265,588 200,502 466,090 250,157 $0.0068
* “Average improvement” is the trade-weighted average for all contracts auctioned during the trading session.
Figures are calculated by comparing the auctioned execution price with the best bid or offer, as appropriate, available
on the other six options exchanges at the beginning of the auction.
Source: Boston Option Exchange (BOX)
Figure 8
Evaluation Parameters For Exchange Operators & Participants
Fiscal Incentive Non-Fiscal Incentive Call Auctions
Evaluation Impacted Market Order Discount/ Exemption/ Guaranteed Shares, Maker Order Liquidity
Parameter Player Maker Flow Adj. in Waiver from Allocation Options and Taker Trigger Concentrator
Payment Fees/ Exchange of Order Warrants Mechanism Mechanism
Margin Fee Flow
Business EO High Low Low Low Low Medium Medium Medium High
Complexity EP High Low Low Low Low Medium Medium Medium High
Adaptability EO High Low Low Low Low Low Medium High High
Factor EP High Low Low Low Low Low Medium Low Low
EO High Low Low Low Low Low Low Medium Medium
Cost EP High NA NA NA NA NA Low (if Medium Medium
taker)
Technical EO High Low Low Low Low High Medium High High
Complexity EP High Low Low Low Low High Medium High High
EO High Low Low Low Low Low Low High High
Time to Market
EP High Low Low Low NA Medium Medium Medium Medium
EO: Exchange Operator EP: Exchange Participant
Source: Cognizant
Figure 9
cognizant 20-20 insights 6

7. Gradual Outcomes • The monopolized derivative market share of
NSE will be challenged. This will create the
The introduction of any of these schemes will
opportunity for BSE to make improvements.
result in the following outcomes over a period of
time: Exchange participants will look for solutions
regarding the framework and not particular asset
• Liquidity enhancement schemes will add depth classes.
and reduce the current lopsidedness in the
derivatives area. • Along with the LES scheme, policy changes
will achieve the objective of creating world-
• A gradual increase will occur in the number of
class liquid markets. Such policy changes
eligible securities to be traded in the deriva-
include rationalizing minimum contract value
tives segment.
to attract greater retail investor participa-
• There is the possibility of leveraging the tion; allowing participation of insurance firms,
schemes to other segments, such as currency mutual funds and pension schemes in all types
derivatives, interest rate derivatives and the of derivative contracts trading; and removing
cash segment. security transaction tax (STT) as implemented
• The Market Maker model will take time to pick in Indian markets.
up in the Indian trading environment.
References
“Improving Liquidity in a Securities Market,” Alberta Market Solutions Ltd., October 2003.
“Understand Charges other than Brokerage When Buying and Selling Shares,” Enrich Wise blog,
http://enrichwise.com/2010/03/28/understand-charges-other-than-brokerage-when-buying-and-sell-
ing-shares/
“Market Maker for SME,” Securities and Exchange Board of India Circular, April 2011.
“Comprehensive Risk Management Framework for the Cash Market,” Securities and Exchange Board of
India Circular, February 2005.
“Annual Report 2009-2010,” Securities and Exchange Board of India.
About the Authors
Vinod Malpani is a Manager in Cognizant Business Consulting (CBC). He leads a large team of consul-
tants in the area of exchange operations, brokerage services and related investment banking areas. He
has 12 years of experience in leading consulting engagements and strategic application development of
exchange operators and brokerage firms. Vinod can be reached at Vinod.Malpani@cognizant.com.
Keshav Jhunjhunwala is an Associate Consultant within Cognizant Business Consulting (CBC). He has
over six years of experience in products, domain consulting, application support and application delivery
in the retail and investment bank area. Keshav can be reached Keshav.Jhunjhunwala@cognizant.com.
Acknowledgments
The authors would like to thank CBC’s Rohit Bendre (Rohit.Bendre@cognizant.com) and Tarun Kumar
Jain (Tarun.Kumajain@cognizant.com) for their critical and valuable research efforts.
cognizant 20-20 insights 7

8. About the Practice
Cognizant’s Investment Banking Practice employs over 150 subject matter experts and 3000 associates.
As part of the practice, Cognizant has a sound understanding of the exchange operations business,
as well as vast experience in all the processes involved. Through our association with leading stock
exchanges, including the largest options exchange in the world and leading dealer exchange in the U.S.,
Cognizant has approximately 300-person years of experience in this area.
About Cognizant
Cognizant (NASDAQ: CTSH) is a leading provider of information technology, consulting, and business process out-
sourcing services, dedicated to helping the world’s leading companies build stronger businesses. Headquartered in
Teaneck, New Jersey (U.S.), Cognizant combines a passion for client satisfaction, technology innovation, deep industry
and business process expertise, and a global, collaborative workforce that embodies the future of work. With over 50
delivery centers worldwide and approximately 118,000 employees as of June 30, 2011, Cognizant is a member of the
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