Securities and Exchange Board of India (Sebi) is evidently shaken up by the algorithmic trading accident that occurred on BSE Ltd during last year’s Muhurat trading session. Since then, it has said on a number of occasions that it is reviewing the risk management framework for algorithmic trading. Last week, Sebi chairman U.K. Sinha took a step further when he said at the Asia Financial Forum in Hong Kong that it may consider speed limits on high-frequency trading (HFT). Asia Risk magazine, which reported his comments, adds that the policy on co-location may also be reviewed. Co-location facilities enable members to set up automated trading systems in the same building as the exchange, to reduce latency or the time required for data flow between the exchange and the broker’s trading system.
Sinha isn’t alone in expressing reservations about HFT. Some other regulators as well as some politicians in the US have called for a slowing down of HFT. Interestingly, this is despite existing empirical evidence that HFT improves market quality. Besides, clamping down on speed may not be a practical solution. After all, who is to decide what an acceptable level of speed for trade execution is?
By Shyamal Banerjee/Mint
According to Asia Risk, Sinha said, “if somebody has a large pool of money and wants to access multiple trading platforms, having speed is important. But there has to be some limit... As there is a rush towards reducing transaction time in the name of HFT, the question we need to ask is what purpose are we serving by reducing trading time to eight microseconds, or even two microseconds. Is this justified?” In other words, according to him, while there is a case for algorithmic trading and speedy execution of trades, beyond a certain level, higher execution speed may not be justifiable.
It’s important to note here that not all algorithmic trading is HFT. The former encompasses all forms of trading using pre-programmed systems. HFT involves a large amount of trades in a short period of time, with the aim of making profits by quickly buying and selling securities at a small price differential.
Some researchers say that HFT firms provide a market-making function because of the large number of orders they enter into the trading system. Researchers also say that these firms perform the role of arbitrageurs. Both of these roles enhance liquidity and price discovery. Before HFT came into being, trading desks performed these roles with the help of human traders. With HFT, these same roles are being performed at a much faster pace.
So is the additional speed detrimental to the markets? And will clamping down on speed help in any way? At a recent emerging markets finance conference in Mumbai, Pradeep Yadav, W. Ross Johnston Chair in Finance at the University of Oklahoma, pointed out that while research on HFT is still in nascent stages, most of the studies based on empirical evidence suggest that HFT improves market quality. For instance, Joel Hasbrouck of New York University and Gideon Saar of Cornell University, after studying NASDAQ’s trading data in 2007-08, came to the conclusion that low-latency trading improves traditional market quality measures such as short-term volatility, spreads and displayed depth in the limit order book. They define low-latency trading activity as strategies that respond to market events within milliseconds.
And while there have been suggestions that HFT played a role in the “flash crash” in the US markets on 6 May 2010, research based on the day’s trading data has exonerated HFT firms. A study by the US Commodity Futures Trading Commission’s (CFTC) chief economist Andrei Kirilenko, other CFTC staff and affiliated researchers found no evidence to link the flash crash to HFTs. They found, however, that these firms exacerbated volatility.
According to a joint Securities Exchange Commission and CFTC official report, HFTs initially provided liquidity to the large sell order that was identified as the cause of the crash. But after fundamental buyers withdrew from the market, HFTs, and all liquidity providers, also stopped trading and providing competitive quotes.
Existing research, therefore, is far from conclusive that HFTs and the increased speed of trading are detrimental to market quality. One area of concern, clearly, is that regulators haven’t kept pace with the advancement in technology. But the solution to this isn’t clamping down on the markets’ speed, but to beef up the speed at which regulators’ surveillance systems are monitoring the market.
It’s important to mention that Sebi’s recent discomfort with HFT seems to be because of the trading mishap at BSE late last year. One of the exchange member’s algorithmic trading system went berserk, leading to unusually high volumes on the exchange. The exchange responded by annulling all of these trades and suspending the trading member that was responsible. Sebi’s concern because of this incident is understandable. But its decision to keep the matter a secret is unfortunate. Most market participants don’t know what exactly transpired and what the reasons were for the system’s failure. News reports suggest that it was inappropriate risk management at the trading member’s level that led to the problems. If that’s the case, a clampdown on the entire system will be untoward.
Perhaps, there is a case for caution with regards to speed. But first, Sebi must put out its findings on the Muhurat trading mishap and/or other empirical data that suggests a clampdown is indeed necessary.
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