Does algorithmic trading offer an unfair advantage?

Does algorithmic trading offer an unfair advantage?
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First Published: Mon, Aug 24 2009. 09 07 PM IST

Updated: Mon, Aug 24 2009. 09 07 PM IST
While the debate on high-frequency trading continues to rage in the US markets, none of it has reached Indian shores. That’s because India is still in the early adoption phase as far as algorithmic trading goes and only a small proportion of trades are executed in this manner.
Since the impact of this new form of trading hasn’t been felt in a large way, it’s not surprising that no one’s complaining.
Having said that, even while there’s much noise about this in the US markets, there doesn’t seem to be much substance behind the criticisms. So Indian policymakers and market users needn’t be unduly worried about algorithmic trading.
While it’s true that high-frequency traders have an advantage over retail and institutional investors in trade execution, it’s because of the high investments they have made in technology. This isn’t an unfair advantage, simply because anyone in the market can choose to make these investments.
The argument that retail investors and day traders can’t afford such investments doesn’t hold. If their capabilities are used as a lowest common denominator, then trading infrastructure would go back to where it was decades ago and liquidity will drop sharply. Not that anyone’s proposing this, but then that’s the logical end of the argument that some traders can’t gain at the expense of others because of their ability to invest higher sums in technology.
Tech edge: A file photo of traders at the New York Stock Exchange. There’s much noise about algorithmic trading in the US markets, but there doesn’t seem to be much substance to the criticism. Richard Drew / AP
Some traders on the street will always have an edge. This was true even before the advent of electronic trading. Even within trading firms that have made similar investments in technology, the one with superior algorithmic strategies will have an edge.
There may be some nuances of trading in the US markets such as flash trades, which may result in an unfair advantage. Some US exchanges flash quotes to a set of traders a few milliseconds before the quotes are flashed for the entire market. This is done in exchange for a fee.
One argument is that anyone can subscribe to these flash quotes for a fee, and hence it doesn’t qualify as an unfair advantage. But news reports suggest that in some cases these flash quotes resulted in front-running, which is an illegal activity.
Front-running is the illegal practice of a stock broker executing orders on a security for its own account while taking advantage of advance knowledge of pending orders from its customers.
If that’s the case, perhaps there needs to be a review of flash trades, but suggestions that there needs to be legislation which slows some traders will only hurt the market’s liquidity.
Indian exchanges currently don’t flash quotes to any traders on a preferred basis, but the debate in the US and the review of flash trades by policymakers there will certainly be useful for their Indian counterparts, if any Indian exchange proposes a similar model.
Meanwhile, with more brokers providing algorithmic trading services as well as expanding their offerings with new algorithms, the market here is set to benefit from the resultant increase in liquidity.
It has become evident from the experience in the advanced markets that the winners in electronic trading are those who have a first-mover advantage.
This is the reason there is a constant quest for improving data speed or minimizing latency. With the Indian market for electronic trading just about beginning to pick up, there would be ample low-hanging fruit for the early adopters. Unlike advanced markets, competition will not be intense, at least for some time.
Currently, much of the focus seems to be on better order execution through the use of algorithms as opposed to a human trader.
High-frequency trading and strategies such as statistical arbitrage haven’t taken off partly because of the securities transaction tax that increases transaction costs. But transaction taxes are imposed even in some other markets such as South Korea, where some firms have generated good profit from electronic trading. It won’t be long before some smart firms work out models and algorithms that generate decent profit, despite having to pay a transaction tax on every trade.
With competition gradually increasing in the exchange space, working closely with big electronic trading firms could be a major factor in deciding who gains market share. A recent report by Financial News Online, part of Dow Jones and Co. Inc., says that one of the founders of an alternative equities market, Turquoise, admitted that it missed out by not working closely with high-frequency trading firms.
Dow Jones is also the publisher of The Wall Street Journal, with which Mint has a content-sharing agreement.
London-based Turquoise, launched as a joint effort by nine investment banks to provide an alternative trading venue, put itself up for sale last week.
Electronic trading does provide some traders and exchanges an advantage over others, which is both legal and fair, and early adopters can be sure of gaining the most.
In The Money runs every other Tuesday. Comments are welcome at inthemoney@ livemint.com
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First Published: Mon, Aug 24 2009. 09 07 PM IST