Mumbai: The share of trading based on algorithms, or algo trading in popular parlance, has seen a sharp rise in domestic commodity markets, amid regulatory concerns on the volatility that such trading can bring to the markets.
Software codes or algorithms are frequently used to automate and enhance order-matching processes.
While such trading has been popular in the equities segment for some time now, it has picked up relatively recently in the commodities market.
Multi Commodity Exchange of India Ltd (MCX), the country’s largest commodity bourse in terms of market share, has seen the share of algo trades more than double in most commodities since January this year, data from the exchange’s website show. The share of algo trades in commodities such as crude oil, copper, natural gas and silver rose to 30% from 3% in January. Commodities such as aluminium, gold, lead, mentha oil, nickel and zinc currently see 15-25% algo trades in overall trade from less than 10% in January.
A similar pattern is seen in the case of some commodities traded on the National Commodity and Derivatives Exchange Ltd (NCDEX), which dominates the futures market in agricultural commodities.
Algo trades in cotton increased from 10.2% in January to 37% in May, said the exchange in response to an email. Mustard futures saw algo share rise from 4.82% to 10.21% in the same period.
The exchange did not provide historical data for algo trading in the gold hedge and silver hedge contracts. However, an indicator can be derived from the daily trading data available on the site. According to this data, on 29 June, gold hedge and silver hedge contracts of NCDEX saw the share of algo trades as high as 92% and 78%, respectively.
To be sure, some commodities traded on NCDEX such as barley, guargum, maize, sugar and wheat also saw a drop in the share of algo trades between January and May, as per data provided by the exchange.
While opinion is divided on the impact of algo trading on market volatility, the pick-up in such trading in a relatively shallow market like the domestic commodity markets could be a point of concern for regulators. The commodity futures segment registers trades worth Rs.3 trillion every fortnight, as per data from commodity regulator Forward Markets Commission (FMC).
The broader issue has been flagged by the Reserve Bank of India (RBI). In its Financial Stability Report released last week, RBI said the rapid rise in algorithmic trading in recent years highlights the need for caution for India’s securities markets. The RBI report highlighted algo trading in equity has risen from around 11% to 40% between 2011 and 2015.
Some analysts agree with that view.
“All western regulators are struggling with complex algo strategies. Given that the Securities and Exchange Board of India (Sebi) is inherently less pro-market than even many EU regulators, I find it challenging to believe Sebi (pre- or post-FMC merger) is really in a good place to coherently understand and regulate algo trading without a significant upgrading of their capacity,” said Patrick Young, executive director at DV Advisors, a Europe-based capital markets advisory firm.
A mail sent to Sebi remained unanswered. FMC is in the process of being merged with Sebi.
Exchanges, however, say enough checks and balances are in place, both from the regulatory side and from the exchanges.
In January 2013, FMC issued broad guidelines for the use of algo trading, which were strengthened thereafter.
Responding to an email query, an MCX spokesperson said they have taken measures to counter potential threats arising out of erroneous large orders, either through algo or otherwise.
“In commodity markets, unlike in equity derivatives, there is an order per second limit of 20 orders per second… the per order quantity limitation in commodity markets is less than half of that prescribed in the equity derivatives markets which helps in controlling the size of orders,” said the MCX spokesperson.
According to an NCDEX spokesperson, the probability of erroneous trades in the Indian commodity space is limited due to the prescribed daily price limits, adding that the exchange does not allow algo trading in mini and micro contracts.
“Order trade ratio is prescribed whereby any algo software cannot put in too many orders to mislead the market. Exchange has capability to monitor the throughput from the algo traders on a real-time basis to ensure fair and orderly trading in the market,” the NCDEX spokesperson added in an emailed response.
Market participants say algo trading has picked up across major trading segments as larger brokerages and institutional clients are increasingly relying on automated trading systems.
“Commodity exchanges are slowly but steadily using basic algorithms... While its adoption by Indian commodity exchanges is limited today, the percentage of volumes may increase over the coming years,” says Kunal Nandwani, founder and chief executive officer, uTrade Solutions, which specializes in providing algorithmic trading software to market intermediaries.
Nandwani adds that algo trading would play a significant role in improving liquidity in commodity derivatives contracts.