Sebi’s co-location paper is welcome; not its proposals
4 min read 06 May 2013, 07:47 PM ISTThe paper is a good example of how a public consultation can help avert ineffective policymaking.
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After releasing a discussion paper on risk management at clearing corporations late last month, Securities and Exchange Board of India (Sebi) has issued one on co-location facilities offered by stock exchanges early this month. As pointed out in the previous column, this is a refreshing change at Sebi. Typically, Sebi would have closed-door discussions internally and with market participants and convey its decision to the market through a circular.
The latest paper on co-location facilities is also a good example of how a public consultation can help avert ineffective policymaking. One of the proposals mooted in the paper is that stock exchanges implement a new order handling architecture, comprising of two separate queues for co-located and non co-located orders, such that the order matching engine picks from each queue alternatively. Co-located 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. Sebi’s proposal stems from a concern that this puts brokers and investors who do not have access to such facilities at a disadvantage.
Without getting into the merits of the above concern, there is one major problem with Sebi’s proposal. Large market participants can easily find a way around this by setting up alternate facilities close to the exchanges, apart from using the exchange’s co-located facilities, and attempt at being near the top of both the co-located and non co-located queues. As a result, Sebi’s attempt to create a level-playing field for market participants who don’t have access to co-location facilities will simply fail.
Sebi’s first few proposals are reasonable. The paper proposes that stock exchanges should provide co-location facilities in a fair, transparent and equitable manner. The regulator also wants exchanges to ensure that the size of the co-located space is sufficient to accommodate all stock brokers and data vendors that desire such facilities, as well as avoid situations where a few brokers have a monopoly on the available rack space. Of course, all this should go without saying. But keeping in mind that exchanges are for-profit organizations and their decisions may not necessarily be equitable, it is good for the regulator to release guidelines on co-location facilities.
The pertinent question here is if the regulator should introduce guidelines that ensure a level-playing field between brokers who use co-location and ones who don’t. As pointed out earlier in this column, some trading members will always have an advantage over others with respect to the speed with which they access an exchange’s trading system. This is simply because speed depends on the amount of investment a trading member can afford. If, hypothetically, the regulator disallows co-location facilities, large trading firms will simply rent/buy space as close to the exchange venue as possible in order to gain an advantage over competitors. Only a small proportion of trading firms will be able to afford real estate space close to where India’s large exchanges are currently located. In addition, while some trading members can afford private leased lines and subscribe to tick-by-tick data feed of exchanges, some may be able to afford to connect to the exchange only using an Internet trading facility or a VSAT.
It’s the same with the time involved in analysing market data. Large firms can analyse more data faster because they can afford to invest in sophisticated software and expensive programmers. At the other end of the spectrum, there are some small trading firms who don’t use any software to analyse exchange data, and provide vanilla trade execution services for their customers. Needless to say, it’ll be strange if Sebi proposes regulations to ensure a level-playing field with respect to trade data analysis.
Should the regulator then bother with ensuring a level-playing field with respect to speed of access? While the above line of thought points to a clear “no", Sebi and Indian exchanges must ensure certain checks are in place so that co-location facilities are not abused. One of the concerns with co-location facilities is that it results in a denial of service or even a delay of service to other investors. This can be true if an exchange has capacity constraints and if a barrage of orders from co-located servers slows down the entire system. While this problem hasn’t surfaced so far, Sebi should look at the spare capacity of exchanges periodically. Another safeguard that is already in place is a Sebi-mandated penalty on trading firms that exceed pre-determined order-trade ratios. This has ruled out the possibility of quote stuffing, which is one of ills faced in developed markets. In addition, all of the risk management policies such as margin requirements ensure that risks emanating from a trading member are contained.
With some of these safeguards in place, coupled with a fair and equal availability of rack space for all trading firms, co-located facilities should not pose a problem to the Indian markets. Of course, the good thing about a public consultation is that the regulator can get a number of effective ideas to curb related risks. In fact, the regulator will do well to come out with a comprehensive paper on algorithmic trading so that risks related to this segment can be addressed in the best possible way.
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