Taxation of transactions in India began with the equity market in 2004. Prior to 2008, the securities transaction tax (STT) was allowed as a rebate against tax liability against Section 88E of the Income Tax Act. This treatment was withdrawn by the 2008 Budget announcement. After that, STT became a substantial influence on the equity market. In understanding the consequences of the STT, there is an absolute perspective and there is a relative perspective.
In absolute terms, suppose you embark on a spot-futures arbitrage and do an early unwind. In this, you buy shares (pay 10), sell futures (1.7) and then reverse yourself (10). Your tax burden is 21.7 basis points. This is a lot of money when compared with the typical bid-offer spread of the Nifty futures which is around 0.5 basis points. The dominant cost faced in doing spot-futures arbitrage is taxation.
In relative terms, there are two issues. The first is an intra-India comparison between equities and commodities. When activity on the equity market was taxed, eyeballs and capital moved to commodities trading. Commodity futures trading has grown by 3.5 times after 2008, while equities activity has stagnated. Most policy makers think this was an undesirable effect, particularly given the fact that India can free ride on global price discovery for non-agricultural commodities but must foster liquid markets in its own equities.
And then, there is an international dimension. When the activities of non-residents in India are taxed in any fashion, they favour taking their custom to places like Singapore, which practice `residence-based taxation’ where the tax base comprises the activities of residents only. We got a sharp shift in equities activity towards locations outside India.
Putting these absolute and relative perspectives together, from 2008 onwards, equity market liquidity has fared badly. This yields an elevated cost of equity capital.
The budget speech has done two things. First, it has dropped the STT rate on futures on equity underlyings from 1.7 basis points to 1 basis points. This is helpful for certain kinds of trading strategies but not for others (e.g. the spot-futures arbitrage described above will gain little). HF strategies that do not involve the spot market will particularly benefit – e.g. imagine an options market maker who does delta neutral hedging on the futures market. Second, it has introduced taxation for non-agricultural commodity futures on an identical basis to the equity futures (i.e. at 1 basis points).
This will have the following interesting implications:
- Capital and labour in securities firms will be less inclined to be in non-agricultural commodity futures. It will tend to move towards agricultural commodity futures, currency futures and equity futures.
- The comparison between offshore venues and the onshore market will move in favour of the onshore market for certain kinds of trading strategies.
- The bias in favour of equity options will reduce; some business will move to equity futures.
- The pricing efficiency of futures will go up.
In this environment, there seems to be a fair arrangement between the equity futures and commodity futures. Conditions seem to be unfair with the equity spot (too high), equity options (too low) and currency derivatives (too low). The next moves on this may appear in July 2014 when the new government unveils its next budget.
One more announcement of the budget speech concerns currency futures: it was stated that FII activity on currency futures will commence. This will also give more activity on currency futures; we now have two reasons for expecting more activity on currency futures (the taxation of commodity futures and the entry of FII order flow). However, the shifting of FII order flow will be a slow process, and a lot of time will be lost on their due diligence of the exchange, safety of the clearinghouse, and so on. While, in the long run, removing capital controls against FII order flow in India is a good thing, it is not an effect that will kick in quickly. Apart from this, most of the action will take place fairly quickly, in early April.
Future finance ministers will need to navigate the difficult landscape of gradually scaling down taxation of transactions while retaining low taxation of capital gains (which has unfortunately come to be seen as a linked issue in the Indian discourse). Along this path, the first priority should be to remove distortions. Our first priority should be to achieve a low rate, a wide base, and the minimal distortions. Reduced rates will always yield welfare gains. The Budget 2013 announcement makes progress on two things (reduction from 1.7 to 1, and reduced distortions between equities and non-agricultural commodities). There is much more waiting to be done: integrating currencies and fixed income, bringing sense to options, and getting away from the very high rates on the equity spot market.
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My previous blog post, on not cancelling trades after a fat finger trade, elicited some interesting email conversations. In a nutshell, there are two views of the world. One camp argues that it is important to prevent fat finger trades and other such weird episodes. This requires building an array of preventive measures. The other side argues that the costs of prevention are high, and what’s really important is to make a resilient market that is able to absorb shocks.
Prevention is difficult for two reasons:
- NSE and BSE are some of the biggest exchanges of the world. We should be pleased that India has two of the great factories of the world doing order matching. But as a side effect, NSE and BSE are at the limits of what today’s CPUs can do. Many, many orders are placed, compared with the number of trades. Pre-trade checks are expensive because the number of orders is high. Fairly trivial notions of pre-trade checks can triple the hardware requirements or worse. We have to ask ourselves: Is it worth driving up the cost of transacting by 3x or 5x or 10x in order to do those checks? In addition, pre-trade checks introduce delays (”latency”) which are not good for the trading process. When an order is placed, the person wants an instant confirmation that it was placed into the order book and ideally matched. More work in screening orders before the trade increases the latency suffered by traders. This, in turn, increases the risk faced by various trading strategies, which has adverse implications for market liquidity and market efficiency.
- What validation rules would you write, pre-trade? There is a danger of fighting the last war. New kinds of problems will inevitably surface in the future. Will we keep on increasing the burden of pre-trade computation, over the years, as the list of potential difficulties goes up through time?
There is a shades-of-gray dimension here. It appears obvious to us that if a computer program is buggy, and puts in a wrong order, this should be blocked. But what when a man-machine hybrid (the typical human trader that operates a computer) makes a mistake? What about a pure human trader that makes a mistake (e.g. saying on the phone “buy me 25 million shares of Infosys” when he meant “buy me 25 million rupees of Infosys”)? Where do you draw the line?
It is better, instead, to see that mistakes are an inevitable part of financial markets
. I would argue that pre-trade computation should be kept to the bare minimum, and that it is instead important to focus on deeper initiatives that will make the market more resilient. We need more eyeballs, more capital, more limit orders, more arbitrageurs, more algorithmic trading, more short selling
. This is what will make the market resilient. A resilient market is one that is ready to accept a diverse array of unpredictable shocks in the future. Until a few weeks ago, we never imagined an order for 17 lakh nifties could be placed. The market did well in absorbing this completely unanticipated shock. The market should be a flexible, intelligent, resilient construct that is ready for all sorts of unexpected events of the future.
Some people say: “We should put in infinite expenses in order to screen orders”. This reflects a lack of economic thinking. The strategies of prevention and cure need to be evaluated from a cost/benefit perspective. Each features tradeoffs. Driving up the charges of an exchange by 3x to 10x, and increasing the latency suffered by every market participant, is a big cost. This should be weighed against the benefits.
I am reminded of a great story told by the Chilean economist Raimundo Soto at a NIPFP/DEA Conference in 2009. He started by describing a cautious 80-year old person, who is very careful about what he eats, who avoids stepping out of the house, and so on. He stays alive, but is perennially afraid that a small sickness will bring him down. And, indeed, when one small common cold comes along, it can have catastrophic consequences for him. Compare this with a 15-year old prancing around the world, tumbling in the dirt, taking risks, and living a great life. He is exposed to many illnesses, but rapidly bounces back from each of them.
Raimundo Soto said that the analysis of capital account convertibility should be rooted in the desire to become this 15 year old rather than this 80 year old. We should be asking: How can the system be made more resilient to shocks? We should not aspire for a Chinese Wall of capital controls that cuts India off from the global financial system; instead we should be doing the things that make India resilient to international shocks – such as develop a sophisticated Bond-Currency-Derivatives Nexus.
In similar fashion, too much of the conversation in India, after the Emkay fat finger trade, is about asking How can such shocks be prevented? I think we should aspire to be like the 15 year old and not like the 80 year old. The really important question is: How can the system be made more resilient to such shocks?
When inexplicable things happen on an exchange, many people argue that those trades should be cancelled. I think it is useful to be clear about the test to apply for this.
The key question should be: Did something foul up in the order matching software? If order matching went wrong, or if there was a systematic breakdown of connectivity to the exchange, then there is a case for cancelling trades. We’d say that persons placed certain orders, but the exchange mis-handled the orders, hence the observed series of matched trades and prices is unfair.
If the exchange and its rules worked as advertised, this reason peels away. In fact, I would argue that particularly when there is a fat finger trade or something like the US `flash crash’, it is important to not cancel trades, to cement faith in the trading process.
The recent events surrounding the fat finger trade by Emkay are a good example of this line of thought. Owing to a human error, a basket trade to sell Rs.17 lakh of Nifty was instead placed as an order to sell 17 lakh nifties (where one `nifty’ is a basket of 50 shares adding up to the present level of the Nifty index expressed in rupees). If Nifty is at 5000, then an order for “100 nifties” is an order for Rs.500,000.
Through this human error, a very large sell order appeared on the market. At that instant, everyone looking at the market would have been taken aback. What was going on? Has a huge event unfolded which some informed speculator knows about, but I do not know about? It takes nerve in that moment to be on the other side of the order. We must reward the people who did not lose their head when everyone around them was losing theirs.
When the big Emkay order came in, many of the orders which were matched were limit orders which had been patiently waiting there. This does not, in any way, change the analysis. Waiting with `deep out of the money’ limit orders is a hazardous business. As an example, consider the persons waiting with deep out of the money limit orders, standing ready to buy at very cheap prices (e.g. 10% below the current market price) when the Satyam scandal unfolded. They lost money big time because the informed speculators, who understood the Satyam announcement and placed massive market sell orders, knew more than them. Waiting patiently with limit buy orders, 10% away from the touch, is not free money. (”The touch” is finance parlance for the bid and the offer price). It is a risky trading strategy.
Two trading strategies matter most in stabilising a market when crazy things have happened. Traders have to be there ahead of time, with limit buy orders far away from the touch. The limit order book should be thick with orders; i.e. the impact cost associated with a giant market order should be low. And there have to be traders who see that the market has crashed, are able to work the phone and gain confidence that this is an idiosyncratic shock, and come into the market and buy. The more the capital and intelligence behind such trading strategies, the more stable the market will be.
If trades are now cancelled, these two trading strategies will have suffered the risk and got nothing in return. In the future, they will be more circumspect about stabilising the market. Similar considerations apply on the other side. When there are strange and large upward moves of the market, we want rational speculators who short sell and bring the price back to fundamentals. The market must be designed in a way that supports and enables this. At present, it is not [link, link].
Fat finger trades will happen. There will occasionally be strange rumours and other odd things that will make markets fluctuate away from fair price. In those situations, what we want most is for clear-headed rational speculators to put large scale capital into making money by stabilising the market. The rules of the market should reward the people who perform these roles. Trades from their orders should not be cancelled.
The Emkay story has gone well for the Indian securities markets. The market design worked as it should have. A human error was made, there was a brief market-wide suspension on the equity spot market (but the futures market continued to work). A call auction took place to discover the price, and within minutes everything came back to normal. Emkay took full responsibility for their trades and came through with the money. We shouldn’t stumble in the policy analysis that follows this story.
All models are wrong, some models are useful. A model reduces complications that are true in return for tractability and insight. In finance, all too often, one complication which has been wished away is transactions costs. A great deal of what we see in the world around us is caused by the costs of transacting. Some of the most important finance is about analyzing the causes and consequences of the costs of transacting.
The bid offer spread as a measure of transactions costs
The first flush of the literature draws on markets with market makers, and treats the bid-offer spread as the measure of the cost of transacting. On the NYSE, the specialist posts a bid price and an offer price. If you do two transactions in quick succession — buy 100 shares and then sell them back — you will be poorer by the bid-offer spread. The spread is like a tax on a speculator doing a round-trip for a small transaction.
There is no doubt that in that environment, the spread measures something important about transacting. Large databases about the spread are available. A whole literature arose which is rooted in the spread as the measure of the cost of transacting.
Limit order book markets are a whole new world in observability of liquidity
The world changed. Across countries and across asset classes, exchanges have been morphing into anonymous open limit order books. The market maker is not as important. On the open limit order book market, the full set of limit orders are observable, using which we can simulate a market order of any size, and calculate the exact cost that is paid. Suddenly, instead of just seeing a bid-offer spread, we see a whole new world which displays the full `liquidity supply schedule’ (LSS) that has the impact cost (in per cent) associated with a single market order of all possible sizes.
|An example of the `Liquidity Supply Schedule’: The impact cost associated with all possible transaction sizes
When the bid/offer stands at 98/102, and the midpoint quote is 100, if a single market order to buy 1000 shares gets executed at an average price of 105, the buy impact cost for 1000 shares is 5%. This calculation, repeated for all possible transaction sizes, paints the full Liquidity Supply Schedule (the LSS).
Once the LSS is visible, and we start thinking about the world in new ways, and the spread feels like a highly unsatisfactory measure of the cost of transacting. At the NYSE, the market lot is 100 shares for all firms. A share price of $5 means the spread refers to the cost of a transaction size of $500. If the share price is $200 instead, the spread pertains to a transaction of $20,000. Hence, the spread is itself not comparable across securities. In contrast, the LSS can be a standardised calculation that is comparable across all firms, with standardised units on the x axis either in rupees or basis points or market capitalisation.
For us in India who grew up with limit order book markets (NSE from 11/1994 onwards; BSE from 5/1995 onwards), the mainstream Western literature seems a little quaint, given their emphasis of the spread as the measure of transactions costs. We are seeing much more of the liquidity elephant through the LSS, while so many researchers are only seeing it’s tail through the spread. In India, the construction of Nifty required the capture of multiple snapshots of the entire limit order book per day, and has generated information about the LSS going back to the mid 1990s.
Since exchanges worldwide have shifted over to an open electronic limit order book, the new focus of measuring liquidity in finance lies in understanding the LSS. What explains cross-sectional and time-series variation of the LSS? What are the consequences of various features of the LSS? These questions have only begun to be addressed in the literature. Rosu has a fascinating recent paper in the Review of Financial Studies, 2009, titled A Dynamic Model of the Limit Order Book that presents one of the first models which predicts the shape of the LSS in an open ELOB market.
Does the impact cost in buying differ from that faced when selling?
One interesting dimension which the LSS makes possible is to think afresh about buying versus selling. The bid-offer spread tells us the round-trip transactions cost. It does not differentiate between buying and selling. When you see that the bid and offer are 100/102, there is no sense in which the transactions cost in buying differs from the transactions cost in selling.
But with the full LSS, we see the impact cost of buying at all transaction sizes separately from the impact cost of selling at all transaction sizes. A first question to ask is: Is there symmetry in liquidity? In the example of the LSS graphed above, it’s quite obvious that the impact cost when buying is superior (i.e. lower) than that faced when selling. But this is just one anecdote.
In a recent paper Measuring and explaining the asymmetry of liquidity, Rajat Tayal and Susan Thomas explore this question. With equity spot trading on the NSE, they find strong evidence in favour of asymmetry: impact cost is higher for large sell market order compared to large buy market orders.
Why might asymmetry arise?
What features about traders in the market generate differences between buying and selling? There is one candidate: how traders perceive sell market orders, particularly large sell orders that come despite constraints on borrowing shares, and restrictions on short-selling.
The speculator who makes a forecast that a share price will go down seldom owns the shares; selling requires borrowed shares. Particularly, in India, where formal mechanisms for borrowing shares are as yet quite small, a speculator who wants to sell physical shares has to mobilise borrowed shares on his own.
This may shape the thinking of the people placing limit orders. When I place limit buy orders (which will get hit by a speculative seller), the adverse selection runs against me. If the speculator was not confident about his forecast, he would not bother to borrow shares and sell short. Only when the speculator is really sure would he take the trouble of borrowing shares and doing a sell order. Hence, the person placing limit orders to buy would demand a bigger price of liquidity (i.e. the impact cost), since he runs a greater chance of losing money when giving liquidity to sellers.
The paper highlights a fascinating identification opportunity : at NSE, alongside the trading of the equity spot market, we also have trading in single stock futures. Everything about the two markets is identical: the same securities, the same trading system, the same participants, the same hours of day, etc. There are only two differences: stock futures trading is leveraged, and stock futures trading has cash settlement — which removes the short-sales constraints. Cash settlement induces full symmetry between buying and selling.
If short sales were the reasons asymmetry in liquidity on the equity spot market, then the stock futures market should have no asymmetry between buy and sell orders. The paper uses the same measurement procedures and statistical tests to compare the asymmetry of liquidity on the spot market as well as for the stock futures market. They find that there is no asymmetry of liquidity on the stock futures market.
If their story is correct, it has many implications. In other market settings observed worldwide, cash settled derivatives should have symmetric liquidity. Physical settled derivatives should have asymmetry – which might get more accentuated as you come closer to expiry. Many natural experiments have taken place worldwide, where futures contracts have shifted from physical to cash settlement: these are all nice natural experiments where changes in asymmetry should become visible. On spot markets, asymmetry should vary with the ease of borrowing. Future research projects could explore these questions.
Financial economics benefits from the best datasets in all economics, and we are able to get sharp and clean papers which pretty decisively answer questions. In India, it has started becoming possible to do innovative work by drawing on data from the open ELOB equity exchanges, CMIE, etc.
Worth reading this response
by Victor the Cleaner in FOFOA comments to this question: “At the moment, in order to influence the Gold price downwards, all that needs to be done by the authorities in LBMA and COMEX, is to raise the margin requirements.”
This is complete and utter nonsense.
LBMA is a trade association and not an exchange and as such does not set any ‘margin requirement’. The LBMA member firms are typically those banks and other financial institutions that trade gold and silver OTC in London, but non-members around the world also trade OTC with these institutions.
When Newmont has some trucks on the road on the way to the refiner, they might want to sell that gold immediately to eliminate any further price volatility from their accounts, and so they might phone JPM and sell that stuff forward. None of the two counterparties is a speculator here. Newmont does have the real stuff, and JPM does have the cash. So even if they would require collateral, this would not influence the price.
Yes, there are probably some raw recruits who follow websites such as TF and who trade COMEX futures in under-capitalized accounts. Yes, CME occasionally raises the margin. Yes, they may just be checking who is the under-capitalized novice and who really has the cash in order to purchase the gold for the contracts they hold. Yes, they may just rip off the clueless novice for fun (and money). But to think this would set the spot price of gold is quite a hubris.
The OTC market is ten times bigger than COMEX, and so it pushes COMEX around in a way that most COMEX-fixated goldbugs don’t understand.
If you want to keep gold cheap in the long run, you need to create a huge volume of gold loans, expand the ‘money supply’. If you want to manage the price of gold intra-day (and yes, there is indeed statistical evidence for this), you need to sell a lot of gold at spot in a short period of time. But you can do this only if you are a credible financial institution and only as long as you can hand over the allocated whenever your counterparties request it. So you need to understand extremely well what you are doing and how much physical per paper you need to be able to show. Hiking the COMEX margin is a side show.
What I find rather disappointing is the extremely poor quality of the discussion that is presented on the typical precious metal websites. This is financial product pushing of the same quality as pre-1999 when they IPO’d the companies that sell dog-food online.
Here are FOFOA, people discuss a very good reason for owning gold. For some reason, the mainstream goldbug websites totally ignore the good reason and push gold with inconsistent nonsense instead.
Why is that? Want to scalp PSLV? Want to create a mania, sell them financial products (including GoldMoney which is no longer ‘money’ by the way) and then when the big blackout comes, grab the gold for cheap from those who sell in panic because they never understood why they owned it in the first place? Very sad. And when the Financial Times calls the goldbugs confused idiots, sadly, there is even some truth in this statement.
If Victor keeps this up I’ll be out of a blogging job.
(ex-Reuters) is reporting that “Gold exchanges in China outside of two in Shanghai are to be banned, authorities said in a statement released on Tuesday.”
Looks like the much hyped Pan Asia Gold Exchange is dead. Not sure where this leaves those who claimed that it “will ultimately destroy the remaining short positions in both gold and silver”.
I will come back to this story but for the moment I want to see how the pumpers and hype merchants spin it, or unspin what they said before.
I also find it interesting that this story breaks at the same time as China Daily reports that “China should further diversify its foreign-exchange portfolio and make more gold purchases when the metal’s price dips but is still at a relatively high level, a senior central bank official said on Monday.”
What is China’s game re gold? How can we weave these two stories into a coherent explanation?
Manganese’s many uses in infrastructure and building materials make its market a strong barometer for gauging the world economy. Soaring growth in countries like China and India has led to high global demand. In this exclusive interview for The Critical Metals Report, Helen O’Malley, a bulk manganese specialist with CRU International in London, discusses how manganese prices are closely tied to the economy and, in contrast to exchange-traded base metals, overwhelmingly determined by supply and demand.
The Critical Metals Report: Economists often use the price of copper as a barometer of global economic health because of its many uses in infrastructure and building materials. Could manganese prices be an even more effective barometer of global economic health? What is your prognosis of global economic health based on what is happening in the manganese market?
Helen O’Malley: Unlike copper and other base metals, manganese is not exchange traded. The price of manganese is overwhelmingly determined by supply and demand. Speculation and confidence levels do not really come into play. Manganese pricing has a lot to do with the general health of the economy. For instance, industrial production and, therefore, levels of demand for steel in the developed world have not recovered to levels seen before the financial crisis. Therefore, a state of overcapacity exists in the manganese ferroalloy sector, so prices have been struggling to reach previous records. This is even though global demand for manganese is at a record high because of soaring growth in countries like China and India.
TCMR: You wrote that for the first time in Q410, China became a net importer of silico-manganese and high-carbon ferromanganese. Will this continue?
HO: That was the first time China became a net importer of manganese alloys, specifically silico-manganese and high-carbon ferromanganese. China has always been self sufficient in manganese alloys and has a great deal of overcapacity itself. To become a net importer is quite surprising.
TCMR: What is the impact?
HO: It is a symptom of the oversupply in the global market. Prices have gotten so low that it is now economical for some mills in China to import manganese alloys. This is not likely to be the start of a meaningful trend nor is China going to suddenly become a major net importer of manganese alloys.
TCMR: China has been stockpiling copper and other base metals. Is it stockpiling and hoarding manganese?
HO: It’s true, stocks of manganese ore at Chinese ports have built up sharply in the last year. In early 2010, stocks were around 2 million tons (Mt.). In May of this year, they peaked to almost 4 Mt., but since then they have eroded back to around 3.5 Mt. The widespread belief is that most of these stocks are held by Chinese traders who bought the material back when the price was higher, in 2010 or even earlier. They will not be releasing this material into market until the price recovers.
The natural level of stocks is bound to be higher now because consumption levels are higher. On a consumption-adjusted basis, stocks are actually around 2008 levels.
TCMR: In July’s CRU Monitor, Bulk Ferroalloys edition, you wrote, “Offsetting the 5% year-on-year drop in Japanese crude steel production, South Korea output was 19% higher than it was in June 2010, while Indian production rose by 7.3%. Output gains have been much smaller in the European Union and the U.S., both in June and for the first half of this year as a whole.” This does not mention China’s percentage gains in steel production, but illustrates the ongoing shift of wealth from the West to the East. Is that permanent?
HO: We can see an extended period of weak and below-trend growth in Europe, the U.S. and Japan. In those countries, the structurally high levels of national debt and the measures taken to address this debt will most likely weigh down on growth for some years. This is a stark contrast to economic growth in China, India and other Asian nations.
TCMR: China now produces approximately 40% of the world’s steel. Would you prefer that steel production be spread over more countries?
HO: Traditionally, steel production facilities are located to serve local or regional demand. China produces so much steel because it consumes so much of it. However, some locations are more cost competitive than others because of factors such as access to raw materials, labor costs and energy costs. Over time, we could see a higher concentration of steel production in lower-cost regions of the world. On the other hand, it is very difficult and costly to permanently close steel facilities, which is perhaps why we are not yet seeing an obvious shift taking place.
TCMR: How is Chinese dominance in steel production influencing the manganese market?
HO: China now accounts for around 40% of global steel production. Five years ago that share was only 30%, and 10 years ago it was 15%. China’s increasing dominance as a steel producer has definitely had an impact on all raw materials markets. It has had an impact particularly on the market for manganese ore because China must import over half of its requirements for manganese ore. It’s a similar situation to what we see in the iron ore market.
TCMR: You said that the manganese ore market has been in a state of oversupply for about a year and that is pushing prices down. When will the market turn? Is the ore market structurally tight or are we on the brink of structural oversupply once a number of development projects in Africa come onstream?
HO: Manganese ore prices have been falling for the better part of a year now, but it seems that prices have been brought low enough to cut out a proportion of the higher-cost supply from the market. Port stocks have been falling for several months now and price stability has returned. This tells me that supply and demand fundamentals are in much closer balance now.
TCMR: When we spoke last May, manganese ore was priced at roughly $8/dry metric ton unit (dmtu). What is a dmtu going for now?
HO: The price of medium-grade ore—say 44% manganese oxide lump—is currently $5.30–$5.40/dmtu, delivered to China.
TCMR: We’re talking about the ore, so that is the straight mined product. What is your near-to-medium term outlook for the manganese alloy market?
HO: In the medium term, looking at the next five years, the drawn-out recovery in steel production in the West will ensure that overcapacity in the manganese sector remains an issue. Ultimately, this means that prices and margins for manganese alloy producers will remain under pressure. One thing to watch is the market for refined ferromanganese. This particular form of alloy is used mostly in the production of high-grade and specialty steel and can also be used as a substitute for electrolytic manganese metal in some steel applications. Intensity of use of refined ferromanganese is rising relatively sharply, so we could see some more upside with demand and pricing of this grade of manganese alloy in the medium term.
TCMR: You had discussed earlier how steel makers in Europe are starting to substitute out the more expensive ferromanganese in favor of the cheaper silico-manganese. What is the impact?
HO: Because ferrosilicon prices have been a lot higher than silico-manganese and high-carbon ferromanganese prices, it is thought that some steel mills in Europe are trying to switch away from the combination of ferrosilicon and ferromanganese by consuming more silico-manganese. Not all steel mills can do this switch for technical reasons and, in the U.S., most mills would not consider switching. We are now slowly starting to see the price gap between ferrosilicon and the manganese alloys close up. But another thing to remember is that ferrosilicon prices are also strongly governed by underlying production costs, which have come under strong upward pressure recently.
TCMR: Is it experimental?
HO: No, the concept of switching between alloys has always been known to the steel industry. It has to do with the economics of using the alloys at their current pricing. However, as I mentioned, technical limitations mean that mills wouldn’t necessarily do this on a short-term basis. Also, some mills are constrained by the type of steel they are producing.
TCMR: Can I get some base prices for a few of the main products you deal with? When you talked to The Gold Report in May 2010, you said they couldn’t manufacture steel without manganese, and manganese ferroalloy prices were 40%–50% lower than the peak levels of 2008. What is the per ton price of ferrosilicon, silico-manganese, silicon metal and high-carbon ferromanganese right now and do those prices compare to 2008 or even a year ago?
HO: Manganese ferroalloy prices have, on average, declined since May 2010. Back then, silico-manganese was priced at around $1,520/metric ton in the U.S. market. Now it is priced at around $1,370/metric ton. We’ve seen a similar decline in the other manganese alloy grades. The reason for this downward trend is the oversupply of manganese alloys. The other important factor is that the manganese ore price has been in decline with manganese ore being the main cost driver of alloy production.
TCMR: What are the main factors behind that fall in the price of ore?
HO: An oversupply. In 2009, rock bottom prices caused the manganese ore sector to aggressively cut its output. When prices recovered over the second half of 2009 and into 2010, production ramped back up to full capacity, ultimately pushing the market back into oversupply. You tend to get this lagged supply response in bulk mined markets because it takes time to ramp up or ramp down production at large scale mine operations and to tune output precisely to the level of demand. In the last year, there’s been a degree of oversupply, but now we are seeing that some of the mines are trimming output again. It is a cyclical effect.
TCMR: Is the sector less exciting to cover when prices are in decline?
HO: No, because you have developments such as production cuts. What becomes interesting is determining who is left in the market and who is going to be forced out of production first.
TCMR: You mentioned earlier that there are a number of development projects coming on in Africa, but we have oversupply now. Is that going to push back the development timetable with those projects or will prices be driven down even further?
HO: South Africa is an interesting example because if you add up all of the potential new supply, it comes to approximately 15 million tons per year (m tpy). This is huge in a market that is around 45 m tpy. In reality, though, in South Africa, restrictions on rail and port capacity will mean that only a portion of this will find its way onto the seaborne market in the next five years. Infrastructure is also a major issue in other African countries where miners are hoping to develop projects. The market for manganese ore could stay tight for some time because these projects will not come online at the advertised dates.
TCMR: Right now we are seeing approximately 95% of all rare earth production being controlled in China. Will we see similar control in the manganese metal side?
HO: Absolutely. Currently, China controls around 95% of the world’s supply of manganese metal and that represents a great deal of risk to consumers of manganese metal in the West, such as in Europe, Japan and the U.S. Not only is there a lot of price volatility, but security of supply is also an issue.
TCMR: Without recommending specific companies, what kinds of manganese or ferromanganese projects are of most interest to the Chinese?
HO: The Chinese and the Indians seem desperate to get their hands on any medium- and high-grade ore deposits. This is to provide them with a greater security of supply of the essential steel-making raw material. You cannot make steel without manganese, so it is a strategic move as well. The challenge is tracking down the remaining high-grade or even medium-grade projects. You want to find one that is not only economical to mine, but also has access to infrastructure.
TCMR: Like a port.
HO: Exactly, a rail or port. South Africa and other African countries have naturally attracted a lot of interest because of the abundant resources of high-grade and medium-grade manganese ore. There are also high-grade deposits elsewhere, such as Indonesia, Australia, Turkey and South America.
TCMR: Have you visited these projects?
HO: I just returned from South Africa where I visited a number of the mines currently in production, as well as a number of the companies in the development stage. It was a very interesting trip.
TCMR: Are there projects in more secure jurisdictions like North America or Australia that are coming onstream in the near-to-medium term?
HO: Australia has a long list of projects, and a number of companies have projects on the table in North America. North America does not have high-grade manganese ore or even medium-grade manganese ore, but there does seem to be, in parts, abundant supplies of low-grade manganese ore.
Some of these companies are looking to upgrade the low-grade manganese ore into a product that can be sold into the market. One of the major products they are looking at is electrolytic manganese metal, which has a variety of end uses, but the main end use is in the steel industry.
TCMR: How far off are those?
HO: Most of these companies are slating project startups toward the end of a five-year horizon. Some of them are making progress with exploration and defining their resource, but there are still several stages in the process to go, including raising finance and bankable feasibility studies.
TCMR: Are there any projects close to putting together a bankable feasibility study that could see greater interest as a result?
HO: Not that I know of, but that is not to say they are not at that stage.
TCMR: Can you provide me with a couple of themes in the manganese space that you expect to play out over the next year or two?
HO: In the next year or two, we could see some of these manganese ore projects develop. Some of the greenfield projects in Africa should move forward and even come into production. It will be interesting to see how that impacts market fundamentals. And I think it will be interesting to see what happens in the manganese metal space because we have definitely noticed interest for companies to try and reduce their current dependency on Chinese supply. With China currently the world’s main producer of manganese metal, steel producers, aluminum producers and other consumers in Europe and the U.S. are dependent on Chinese exports. People are seeking alternative sources of supply.
The structural dependence on Chinese supply has triggered great interest in investing in manganese metal outside of China. Some of these projects happen to be located in North America, but there are also projects in Russia. At present, there is only one manganese metal producer outside of China, and that’s in South Africa.
TCMR: What is the name of that company?
HO: The Manganese Metal Company of South Africa. A number of potential manganese metal projects are in the pipeline, including in North America, but also in other parts of the world. Certainly, that whole area of the market seems to be quite hot right now because prices are high and we have this structural dependency on China.
TCMR: Thanks very much.
Helen O’Malley is a bulk manganese specialist with CRU International in London, England. She manages research activities in the steel raw materials markets including iron ore, metallurgical coal and coke, and the bulk ferroalloys, including manganese, ferrosilicon and silicon metal. Since joining CRU in 2005, she has built up considerable expertise in the bulk raw materials markets with particular focus on iron ore and ferroalloys but more recently extending her involvement across all of the major raw materials markets.
Cross-border exchange mergers are in the news. See Indian exchanges must go regional and then global and Global mergers and Indian exchanges, by Jayanth Varma, who points us to LSE and TMX merge by Jeff Carter on Points and Figures. Also see Stock exchange mergers: the fight for global dominance in the Telegraph.
An article in the Economist, Back for more: Has the global exchange industry lost its marbles again?, is skeptical about various stories that are being told about exchange mergers, but holds forth the possibility that there might be cost savings:
Joining forces does not in itself realise revenue gains or alter this
decline. But it may make it possible to combine the technology and
back-office platforms being used by different exchanges, cutting
costs. Efficiency savings are the one element of the last round of
consolidation that did arrive as promised.
Cost savings are being emphasised again now. The Deutsche Borse and
NYSE-Euronext combination should yield annual savings of ?300m
($412m), the two firms say, equivalent to about a fifth of the
combined entity’s pre-tax profits, while the LSE-TMX deal should
produce savings of about 7%.
In this article, I focus on the question: Is there a big opportunity for reducing cost through exchange mergers?
Getting a sense of the magnitudes
An exchange is an IT system that matches orders. The computational complexity of an exchange is all about taking in a lot of orders per second and computing a lot of trades per second. The output of the IT facility is purely measured by the number of orders that were produced. In the public domain, we see the number of trades, and not the number of orders. Hence, the number of trades is the best public domain source of the size of each exchange, from the viewpoint of cost.
To illustrate the magnitudes involved, last Friday, BSE got 34.1 million orders and did 1.94 million trades. This is an orders-to-trades ratio of 17.6:1 — for each trade that BSE produces, they have to have the IT capacity to process 17 orders. The only way to get up to these kinds of values is by having a good deal of algorithmic trading.
The revenue per trade is, of course, very different across countries. In India, the average trade size on the equity spot market
is $500 and the tariff for the exchange is hence tiny: NSE or BSE earn Rs.0.65 or $0.014 per trade. Using the above numbers, BSE’s earning Rs.0.04 or $0.000795 per order on average. These low low tariffs imply that the revenue, profit and valuation of an exchange in India is tiny when compared with what’s seen abroad. But on the question of cost, there is direct comparability: it costs as much to produce a billion trades in India as it does anywhere else.
From this perspective, let’s look at the biggest factories in the world that produce trades. This is data from the World Federation of Exchanges, for equity trades on the limit order book, in January 2011:
Saving money through unification of data centres?
I do believe that in this business, there are economies of scale. To build a factory that produces twice the trades costs less
than twice the money.
Does this mean that exchange mergers can create value? Not necessarily.
Let’s take one plausible merger from the above. The London SE is a small exchange: they did 19.1 million trades in January. The BSE did 35.1 million trades.
Can one save money by producing 55 million trades in a single data centre? Yes.
Will a BSE+LSE merged entity drop down to one data centre? Of course not! The problem is the speed of light. Today, the
conversations between securities firms and exchanges are reckoned in milliseconds. And in one millisecond, light only travels 300 km. So even without reckoning for switching overheads (which are huge!) it is not feasible to unify data centres apart from local mergers such as CME and CBOT.
Since light moves at a glacial pace, it is simply not feasible to beam orders from London to a data centre in Bombay. So even if BSE
merged with London SE, there would be two data centres. This limits the cost saving. Until we find a way to speed up light, there is going to be no data centre consolidation in this business, other than within small geographical areas (e.g. within Chicago or within New York).
Saving money on software development?
Okay, let’s look further. Could there be cost saving by building one software system and deploying it twice? We’d still spend money to
run two data centres, but we’d have only one expense of building software. Could this work?
It’s much harder than it sounds. It is not often that one gets to fully transplant an exchange software system in a new location: all
too often, the systems have to be significantly different. Regulatory differences, local preferences, history, what users prefer and are
used to: all these shape immense diversity in exchange systems. There can actually be diseconomies of scale, with engineering and
political problems of handling multiple versions.
Another key problem lies in the sizing of the software system. An exchange system that works for BSE will generally involve a different set of engineering tradeoffs when compared with the LSE setting. So ground-up implementations could be more efficient. By this logic, there may be a useful role for cooperation between similar-sized exchanges (e.g. NSE and Shanghai), but not across divergent sizes which are more than 2x apart.
When decision makers think `a system’ can be readily transported across highly diverse order intensities, without regard for the
inefficiencies introduced in this process, I think this has something to do with the lack of engineering backgrounds among these decision makers. On a related note, there isn’t much of a role for exchange software as a software product, other than in the zone of tiny exchanges where an android phone will suffice for order matching. By the time you get to anything in the top 20 exchanges of the world, an efficient implementation will involve large amounts of ground-up development.
A skeptical perspective
NYSE merged with Euronext. Did we see cost reductions? A lot was said about cost reduction at the time of the merger, but I haven’t
particularly seen evidence of this filtering out post-merger.
ASX-SGX: Will they drop down to one data centre? Of course not. Will they unify systems? What will be the cost of system
unification? Does it make any sense to unify systems? It helps that both are similar-sized small exchanges, but the institutional settings are highly different.
NSE and NASDAQ produce a similar number of equity spot trades. In the latest year, NSE spends roughly $150 million a year doing this, while NASDAQ spent $850 million. (NSE produces derivatives trades also, and the NSE number includes the cost of the clearing corporation, so the cost-per-trade edge at NSE is probably of the order of 10x when compared with NASDAQ). The two exchanges are similar in size in terms of the trades per second. Yet, this is not an easy merger opportunity. There will certainly be no data centre
unification. NSE’s knowledge can be used to run the NASDAQ data centre more cheaply, but complex organisational dynamics would have to be navigated in achieving the transition, and this could take decades to pull off. It is hard to get management teams that are
able to play for such long-term gains.
Also see Are exchange mergers always good? by Mobis Philipose in Mint.
There is one kind of exchange merger which I have become increasingly skeptical about: one in which a parent foists computer
systems upon the recipient. I have started worrying that this is a bit of a con, a method to generate revenues from system sales under the garb of partnership or strategic alliances. This is done to some extent by firms that are primarily in the business of selling software and not in the business of running exchanges. Or, to the extent that high-cost exchanges are able to do this, the systems/software revenues are able to mask the deeper problem of a high cost structure.
I have watched the grand global deal-making between exchanges for a long time. In my reckoning, most of it has been a waste of time and money. As one specific example, in my observation in India, some foreign investments into Indian exchanges has been irrelevant, others have directly done damage. None has as yet helped improve product offerings or cost efficiency.
One contract that comes to my mind as one that really worked was Mutual Offset (MOS) between CME and SIMEX, which was done way back in 1984. This was one deal that really mattered and was a good idea. But it was useful in the age before capital account openness – such connections are less important today when capital flows freely anyway. And, remember that it was a mere contract, it involved no complications of ownership and management. So I do think there will be value if the Nifty futures on SGX, CME and NSE are all unified through a mutual offset system: but this does not require anything more complex than signing a contract.
Jayanth Varma says:
It is tragic that at this point of great opportunities and strategic challenges, the energies of Indian exchanges and their regulators are entirely consumed by the debate about whether exchanges should be regulated like public utilities
I disagree. The global exchange M&A story seems to be overrated, apart from the extent to which systems like MOS which can
alleviate home bias (and only require contracts). There isn’t much to gain there. On the other hand, the problem of sound regulation and supervision of exchanges in India is a GDP-scale issue. Indian experience and evidence does not support a complacent approach that the regulation and supervision will work out.
My thinking on this was improved through conversations with Ravi Apte and Ashish Chauhan.
The Budget Speech of February 2010 had announced a `Technical Advisory Group for Unique Projects’ (TAGUP). The press release about creation of this group is out.
Anil Padmanabhan looks back at year 6 of the UPA.
Heather Timmons and Hari Kumar in the New York Times on the carnage on India’s roads.
NSE does Fix.
SEBI’s order on front-running at HDFC AMC. Bhave’s SEBI is a new world of enforcement in Indian finance.
Somasekhar Sundaresan in the Business Standard on the mess in India’s capital controls.
Bibek Debroy in the Indian Express, and an editorial in the Business Standard, on India’s problem with land titles. Most of us in India don’t know about how far back this story goes in other countries : to the Domesday book of 1086 AD, or 924 years ago, in the UK.
Jayanth Varma in the Financial Express on the new world of exchanges. Roughly a decade ago, I had started using intra-day data from NSE and at the time had checked that their trading system clocks were synchronised by NTP — they were.
Ila Patnaik in the Indian Express on the importance of the BSST countries instead of the BRIC countries.
Vikas Bajaj in the New York Times on the difficulties of rail transportation in India.
Gary Schmitt, in the American, worries about the finlandisation of Taiwan.
Nixon’s Nose by Xiaoda Xiao, in Guernica and Angel factories by Anne Applebaum in the New Republic.
Ali Sethi in the New York Times with a piece titled One myth, many Pakistans.
Sebastian Mallaby in the Atlantic on Paul Romer’s work on `charter cities’.
Scott Sumner has an interesting take on the performance of neoliberal policies worldwide.
Rent a white guy.
Scott Adams guide to investment.