This year’s Muhurat trading session turned out to be quite inopportune for BSE Ltd. About two hours after the special Diwali-day trading session ended, the exchange told members that all trades done on its equity derivatives platform were being cancelled due to a large movement in the Sensex futures contract. It added that it has suspended the concerned trading member, barring him from taking any further proprietary positions, and is investigating the matter.
According to Bombay Stock Exchange trading members, Sensex futures turnover in the Muhurat session amounted to between Rs 25,000 crore and Rs 27,000 crore, about 100 times its average daily turnover in the previous five trading sessions.
Cancelling trades of that magnitude is clearly not a trivial matter. An incident like this is hardly helpful at this juncture for BSE, which is trying to build its equity derivatives trading platform through an extensive market-making scheme. But more importantly, the experience at BSE last week raises some systemic issues.
The exchange’s circular in this matter puts the blame on one trading member. According to a report in The Times of India newspaper, it is rumored that a Delhi-based broker played havoc with Sensex futures using an algorithmic trading software. This gives the impression that the exchange was a victim of a trading member’s algorithmic trading strategy going awry. But aren’t exchanges supposed to have checks and balances to guard against this?
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True, exchanges the world over have experienced similar problems—for different reasons such as some algos going berserk, sometimes due to market manipulation algos, or at times just a fat finger trade. The major example that comes to mind is the 6 May flash crash, after which many trades were cancelled by US exchanges.
But given that BSE is putting the blame on one trading member, thequestions that arise are: a) Did this member post enough margins to be able to take positions running into thousands of crores and b) Why didn’t the market regulator’s prescribed position limits come into play before things went so wrong? Market regulator Securities and Exchange Board of India (Sebi) has prescribed that a trading member’s position limit should not exceed the higher of Rs 500 crore or 15% of the total market’s open interest in an index futures contract. The market-wide open interest in Sensex futures is around Rs 25 crore. And it will be clearly unusual for a trading member to post upfront margins running into hundreds of crores, knowing that average daily turnover has hovered around Rs 250 crore-Rs 300 crore.
According to one BSE member, the problem trading member first garnered unusually high volumes, exceeding the permissible limit of trading based on the margins he had posted. This caused the exchange’s systems to automatically square-off his positions. When his margins got freed up, his algorithmic trading software entered into large fresh trades, repeating the process.
This version of what happened indicates, like the Times of India report, that an algorithmic software was at least partly to blame. But as pointed out before, the exchange’s systems don’t come out with flying colours either.
Needless to say, this is a case for Sebi to check if adequate checks and balances were in place. One could argue here that exchanges and the regulator should go slow on allowing the use of algorithmic trading software, given the above experience. But this might not be the right response. While it’s true that algorithmic trading software can go awry, the likelihood of one member causing systemic risk will be very low if adequate checks and balances are in place. The current stipulations about price bands beyond which orders won’t be accepted, upfront margins, member-wide and client-wide position limits should be sufficient to take care of concerns about systemic risk.
BSE’s response at this time is that investigations are going on and information is being shared with regulatory authorities. It has declined to share any further information on the issue. It will do well to throw light on the incident soon. As pointed out earlier, cancelling trades in one market segment is not a trivial matter. Markets are increasingly connected. In the above example, the problem broker needn’t settle any of the trades he executed, but there may be trading members who took positions in the derivatives segment and an offsetting position in the cash segment. Or for that matter, some may have taken an offsetting position on National Stock Exchange’s derivatives and cash platform. With BSE’s derivatives trades being cancelled, they would be left with an open position without any fault of theirs. BSE’s cryptic response will be hardly inspiring for the trading members whom it is trying to attract to its derivatives segment. It needs to do much better, given the gigantic task of building market share from near-zero levels.
Vyas Mohan contributed to this column.
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