Sebi's technical advisory committee has found evidence that the National Stock Exchange of India Ltd violated norms of fair access while providing co-location, which gave some brokers an advantage
The Securities and Exchange Board of India (Sebi) is looking at ways to limit the advantages of co-location and high-frequency trading (HFT), Mint reported earlier this month, based on inputs from people familiar with the regulator’s thought process. The market regulator has talked of making changes in algorithmic trading rules for quite some time now. There were similar reports in mid-2015, although no action was taken (see http://bit.ly/1fG7h41).
Will things be different this time around? Sebi’s technical advisory committee has found evidence that the National Stock Exchange of India Ltd violated norms of fair access while providing co-location, which gave some brokers an advantage. Among other things, the committee has recommended curbs on algorithmic trading. But changes in market structure based on the evidence at hand will be premature and can prove to be counter-productive. Sebi must adopt a consultative approach to its policy-making, and also release the data on which it is basing its decisions.
Besides, since the charges that its committee has brought forward are serious, Sebi must take its investigation to the logical conclusion. Clearly, there is a lot for Sebi to do, and it should make sure that 2016 isn’t a repeat of last year’s experience: all talk and no action.
According to the Mint report, one of the measures Sebi is considering is aimed at restoring parity between those who use algorithmic trading technologies and those who don’t. At first brush, this comes across as a bizarre discussion to have, and reminds one of Sebi’s weird two-queue proposal (see www.bit.ly/1EIaCuF). After all, how can there be parity between a large trading firm using powerful computers and top-notch mathematicians to sniff out trading or arbitrage opportunities and a smaller firm that can afford only cheaper variants? In fact, as some market structure experts argue, there will always be disparity between the haves and have-nots.
But an official at the regulator points out that the issue is far more nuanced. While it’s inevitable that some firms will be able to afford faster computers and communication technology, it would be odd if market participants are given differential access to market data, for instance. As things stand, only members who are co-located get the so-called tick-by-tick market data. Essentially, this includes information on all orders that come to an exchange, including order modifications and cancellations. The have-nots who aren’t co-located have to settle for a much smaller data set—the top five buy and sell quotes—to make their trading decision. For many traders, co-location isn’t feasible, although more comprehensive market data could be useful. Exchanges might argue that taking such a large amount of data would also not be feasible for smaller firms and individual traders, but they can consider arrangements with data providers, who would process the data and provide traders what they require. This could be an area where some disparity can be removed, although, as pointed out earlier, a public discussion will help bring out the pros and cons of such a move.
Another proposal Sebi is reportedly considering is randomisation of orders, to limit the speed advantage of HFT firms. Globally, trading platforms in the forex space such as ICAP’s EBS and ParFx are using this approach to slow down HFT. EBS aggregates orders received in a three millisecond time-frame and then randomises their place in the queue. In other words, the first order to arrive at the trading platform may not necessarily be the first to get executed, hence minimising the need for ultra-fast speed.
Some academicians have highlighted the fact that HFT has resulted in an arms race among trading firms for faster connectivity, and that this can be socially wasteful expenditure.
Based on the comments of Sebi’s advisory committee, India is witnessing not only an arms race, but also possible attempts to collude with exchange officials for faster access. Randomisation of order matching will undoubtedly deal a death blow to all such untoward activity.
But as algorithmic trading firms argue, it will also deal a death blow to many other forms of legitimate algorithmic trading, which will eventually hurt liquidity of the Indian markets.
There’s little doubt that significant market structure changes such as randomisation will add immense complexity, and some trading firms may well shut shop. It seems best that Sebi finds ways to tackle malpractices without tinkering materially with the current market structure.
As an India-based professor of finance points out, trading firms can be expected to be ahead of exchanges, and exploit loopholes in their technology. The best way to tackle this, according to him, is for the exchanges and regulator to have their ears to the ground and take swift corrective action whenever any misconduct comes to light.
But if the regulator believes changes to market structure will deal with the root problem, it should first present data and evidence on why proposed changes are needed, and how they will help, followed by a public consultation process.
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