SEBI diktat is bad news for BSE

Analysing the impact SEBI's recent order will have on Asia's oldest stock exchange

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"BSE-listed firms' market cap races past \$5 trillion'', adorned the front page of a national business daily last week. The milestone is a celebratory affair for market enthusiasts. But the hero of our story, the very stock exchange at the centre of the good news, has been under the weather in recent weeks.

A recent order from market regulator SEBI asking the Bombay Stock Exchange (BSE) to pay a hefty sum in regulatory fees has thrown the latter's stock out of gear; the stock that gave over fourfold returns over the last year has crashed 19 per cent from its peak this month.

We analyse what the development means for Asia's oldest stock exchange.

What irked SEBI?

Indian stock exchanges are required to pay SEBI a regulatory fee based on their annual turnover. In case of derivatives such as options contracts, the fee is computed on the annual turnover's notional value. However, BSE has been paying the fee on the premium value instead. Here's a breakdown of what this means:

• Notional value of contracts
The notional value is the total value of the underlying assets in a derivatives contract. It measures the size of a contract in terms of its underlying assets' value.
It is calculated by multiplying the number of contracts by the price of the underlying asset. For example, if you have 20 option contracts of 100 shares each, and the share is priced Rs 50 in the cash market, then
Notional value of these contracts = Number of contracts (20) X price of the underlying asset (100 shares of Rs 50 each i.e., Rs 5,000)
Thus, the notional value of these 20 options contracts works out to Rs 1,00,000.
The premium value of contracts represents the price paid by the buyer to the seller for the option rights. It measures the size of a contract in terms of the actual money spent on trading it.
It is calculated by multiplying the premium per option by the number of options contracts traded. For example, if an option has a premium of Rs 5 and 20 options are traded, then
Premium value of these contracts = Number of contracts (20) X premium per contract (Rs 5)
Thus, the premium value of these 20 options contracts is Rs 100.

We can deduce from the above examples that the notional value of options contracts is typically much higher because it reflects the value of the underlying assets and the scale of exposure to derivatives.

Premium value, on the other hand, is always lower as it indicates the actual capital committed to trade the options contracts.

Hence, BSE has been underpaying the market regulator by computing the regulatory fee on the premium value of its turnover. Its bigger cousin, NSE, has always paid the regulatory fee on notional value, so BSE has been told to do the same. Additionally, it needs to cough up the pending dues that have accumulated over the last 18 years, amounting to nearly Rs 195 crore.

Growth in jeopardy

The one-time payment that BSE needs to shell out should not be a major worry. It equals just two quarters of its profits. But what's worrying is that its unique cost advantage is now at risk of disappearing.

BSE's primary revenue source is the transaction fee it charges from traders on each trade done in the cash and derivative segments. These charges made up over half of its total operating revenue in Q4FY24.

In the last year, BSE challenged NSE's monopoly in the derivatives market. This is because its transaction fee for traders has been much cheaper, given that it's charged based on the premium value of contracts, compared to NSE's higher fee (based on notional value). This cost advantage that BSE offered to market participants was among the primary reasons why its equity derivative segment grew exponentially over the last year.

However, SEBI's diktat asking it to switch to notional value-based fee structure puts this growth catalyst in jeopardy. The mandate has forced BSE to increase its tariffs. It raised the transaction charges on two of its most popular options contracts-Sensex and Bankex- from May 13. Meanwhile, its rival NSE has announced a reduction in its transaction charges. With this, BSE's cost advantage is seemingly receding. Its derivative volumes may come under more distress, given NSE offers significantly higher liquidity due to higher volumes. Note that BSE's currency segment was already struggling, and since the launch of NSE's Gift Nifty, the INX volumes have also seen a similar downtrend.

What's more amusing is the stock's misleading valuation. Despite last year's fourfold returns, the stock trades at a P/E of 47 times, which appears reasonable. But a closer look reveals the P/E is low due to an exceptional gain. BSE's recent stake sale in CDSL added Rs 391 crore to its profit, deflating its P/E multiple. However, if one excludes this exceptional gain, BSE's effective P/E is a staggering 95 times!

The regulatory challenge casts doubts over BSE's hitherto cost advantage, which had been its crucial growth driver. We suggest investors consider the combination of high valuations and the growth overhang before making an investment decision.

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