Mumbai: In a move that will usher in algorithmic trading and transform the Indian stock market, the country’s capital market regulator on Thursday allowed direct market access (DMA) to institutional investors. Foreign institutional investors (FIIs) and domestic institutions such as mutual funds and insurance firms can now directly execute their buy and sell orders without any manual intervention by their brokers.
However, brokers aren’t entirely out of the picture because the trades will still be executed through their systems.
The Securities and Exchange Board of India (Sebi) has not specified any time frame to kick off the new system but said brokers would need to have software and systems in place that support direct access and take approval from the stock exchanges. All orders placed through DMA will be routed through the brokers’ trading system. The brokers will need to maintain a separate database of the orders executed and maintain an audit trail for five years.
Algorithmic trading or program trading refers to orders that are automatically placed in the market by software programs, built on certain mathematical models. In its simplest form, algorithmic trading could be based on a program designed to detect an arbitrage opportunity between the cash and the futures market and place orders on exchanges in real time.
DMA refers to electronic facilities offered by brokers to their clients, which will enable them to place orders directly into an exchange-traded system. Currently, all investors— both institutional as well as retail—place their orders with brokers and the brokers, in turn, enter them into the exchange’s system. This loss of time, or “high latency” in market parlance, substantially reduces the profit-makingpotential of program traders and arbitrageurs who do not have direct access. With DMA, clients who engage in such trades are given equal opportunity vis-a-vis proprietary desks, who already enjoydirect access.
Arbitrageurs are traders who attempt to profit from pricing inefficiencies in the market by making two or more trades that offset each other and capture risk-free profit.
As of now, the DMA facility will be open to institutional investors and the exchanges will have the discretion to allow other category of investors access to this in due course, a Sebi release said.
The Sebi release said one of the advantages of DMA is that “clients can make better use of hedging and arbitrage opportunities through the use of decision support tools/algorithms for trading.” This makes it clear that algorithmic trading will be allowed. Earlier this year, Sebi had cleared the registration of the world’s largest hedge fund, Renaissance Technologies, which is an algorithmic trader.
Sebi also expects direct access to curb front-running to a large extent. Front-running is a market strategy often adopted by the broking community. They buy or sell shares or take similar position in the stocks ahead of large orders given by their institutional clients.
Introduction of DMA will also increase liquidity in the options market where quotes are available on thousands of various options at different strike prices. It is virtually impossible for a human trader to keep track of the arbitrageopportunities and price inefficiencies within these thousands of contracts but asoftware program can easilydo this.
Zac Rosenberg, co-head of Asian equities at Fox-Pitt, Kelton (Asia) Ltd, a company that advises global investors, said such a move would give better opportunity to foreign investors to protect their trading strategies. “The execution of trades in India has beendifficult. This move will definitely reduce the cost for foreign investors. As it will open multiple ways to invest in India, foreign investors could allocate more capital,” Rosenberg added.
However, the new system will not eliminate thebrokers completely. The brokers will continue to prescribe a trading or exposure limit for their DMA investors and monitor them.
“The leakage of trade orders is still possible at any level in the whole chain,” said the head of investments at a large mutual fund house who didn’t wish to be quoted.
“Typically, fund houses have a team of dealers who are well-equipped and trained to interact with the brokers and carry out the trade. We will need to train our dealers to handlethe execution on their own,” he said.
Brokers say DMA will not affect their income. “Execution of a trade forms a small part of the total fees paid by institutional investors. They pay for the value-added services such as research reports and access to the management of the companies,” said Shankar Sharma, vice-chairman, First Global Securities Ltd.
Naresh Kothari, president, Edelweiss Capital Ltd, said: “Investors will trade more frequently even for smaller-return scenarios and brokers will concentrate on executing the large volume orders. So, the overall volumes can go up in the market.”
Incidentally, the introduction of DMA, was among the recommendations of the high powered expert committee on Mumbai as an International Financial Centre (MIFC). Sebi chairman C.B. Bhave was a member of this committee.
“India might be losing half or more of potential order flow by erecting regulatory barriers to DMA,” the report said. The broking community strongly feels that trading turnover will surge following DMA.
However, exchanges will have to step up their investments in technology to cope with the expected surge inorders.
Both the National Stock Exchange and Bombay Stock Exchange have shareholder partners, NYSE Euronext and Deutsche Borse respectively, who are advanced users of technology.
The world over, exchanges are offering brokers co-location facilities, where brokers’ servers are situated close to that of the exchange and latency can be further reduced.
“The long and short of it all is that DMA makes trading cheaper and faster and is a growing option for traders. Moreover, it puts positive pressure on exchanges and other liquidity venues to improve their technological standards and execution quality in order to stay in line with DMA developments,” said David Easthope, senior analyst with Celent’s Securities and Investments group, a research and advisory firm.