Has algo trading hurt investors?4 min read . Updated: 28 Aug 2012, 12:21 AM IST
Has algo trading hurt investors?
Has algo trading hurt investors?
The Delhi high court has allowed a writ petition by Intermediaries and Investor Welfare Association (India), which is essentially aggrieved because automated trading breeds discrimination between rich brokers and common investors. The main argument is that algorithmic trading has created inequality because small investors can’t afford such trading software.
According to a report by Press Trust of India, the petition also alleges that Securities and Exchange Board of India (Sebi) and the finance ministry have been silent spectators on this issue. These statements taken together can give the impression that Sebi hasn’t kept the best interests of retail investors in mind while framing its policies on algorithmic trading. This can’t be further from the truth.
Sebi allowed algorithmic trading over four years ago because it wanted the entire market, including retail investors, to benefit from increased liquidity and lower bid-ask spreads. Besides, in issues related to market structure, Sebi has always been very considerate about the impact on retail investors—often, to a fault. See tinyurl.com/proretail as an example.
Technology savvy market participants are quick to say the inequality argument is frivolous. It’s hard to disagree. There can never really be a pure level playing field in the equity markets. Five years ago, when algorithmic trading hadn’t yet been permitted, small investors were still at a disadvantage compared with rich brokers. To start with, the latter category will always have access to a much larger quantity and a much better quality of fundamental and technical research. Additionally, they have the capacity of hiring a large team of arbitrageurs or set up a proprietary trading desk to profit from some other trading strategy. There’s no way a small investor or a smaller broker can match this.
If Sebi were to actually go about creating a level playing field the way the association defines it, it will have to ban not only algorithmic trading software, but also other investing tools such as Bloomberg terminals and a broking firm’s ability to hire researchers and specialized traders. Why? Because a small investor can’t afford the same luxury. As pointed out earlier, this is a frivolous argument.
John Woodman, chairman of the erstwhile Chi-X Europe, put it aptly in a public hearing held by European Commission in 2010 on the MiFID review, “One person’s level playing field is another person’s unfair advantage. The fact is that people have different skills—and invest in different skills. Equities trading is no different. If I’m a long-term investor, I’m going to put a lot of effort into fundamental research. If I’m short-term, I’m more interested in the analysis of price movements and the speed of execution—as some people once wanted a booth close to a trading floor, so now some want to co-locate their trading engines with exchange systems. If I’m a retail investor, costs of fundamental research or co-lo systems are beyond me. But I still want to be treated fairly and know my orders are valuable to others."
Since Indian exchanges treat all orders equally, subject, of course, to the price-time priority principle, retail investors needn’t worry about being treated unfairly. And while they may not have the ability to send orders at the same speed as rich brokers, there is hardly any case for a retail investor to engage in such ultra-fast trading.
According to the PTI report, the petition alleges market data visible to small investors on the online trading platforms of Indian exchanges are deceptive. By this, they perhaps mean to say it has become extremely difficult for a manual trader to hit a visible quote. But in an electronic trading environment, where nearly 200,000 trading terminals connect with India’s top exchange, it should go without saying that manually trading the market is extremely difficult.
In liquid stocks, where quotes change rapidly, retail investors will certainly struggle to hit the best bid and offer (BBO). But they can easily experience near-guaranteed execution by just putting in a limit order that’s as low as 0.1% higher or lower compared with the BBO for their buy and sell orders.
If a hit of 0.1% is unacceptable, it’s quite likely such a market participant isn’t a long-term retail investor, but more likely an arbitrageur. J.H. Lal, president of Intermediaries and Investor Welfare Association told Financial Chronicle newspaper that high frequency trading has snatched away the arbitrage advantage for small investors making small profits, by favoring the rich that have installed specialized software by making investments. As pointed out earlier, the argument that rich firms shouldn’t be able to invest in technology because some other smaller firms can’t invest similar amounts is specious.
But more importantly, this appears to be a small and manual trader issue, rather than a small and retail investor issue. Sebi and the courts must keep this in mind while dealing with the petition.
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