Thanks to a Bombay High Court ruling, SEBI has been pushed into regulating high frequency trading. But will its intent rein in unethical brokers armed with algorithms?
By Ajith Pillai
This is a rare instance when a media report, a whistleblower’s three letters and a Bombay High Court order has managed to awaken SEBI (Securities and Exchange Board of India) to look at bringing some order into the Indian stock market currently in the grip of the controversial and often misused technological phenomenon called high frequency trading (HFT). In fact, in August, a policy paper was generated by SEBI addressing this issue. And this could eventually evolve into a new set of rules that could determine the shape of trading to come in this fast-paced digital age.
But that is if SEBI follows through with action despite resistance to controls from the powerful HFT lobby which reportedly controls 40 percent of daily trading. Those who are sceptical about SEBI fulfilling its task as a watchdog agency point out that the policy paper may have merely been drafted to show that action is being taken. Journalist Sucheta Dalal who highlighted the HFT scam pointed out: “While SEBI has set a deadline for submitting comments to its paper on HFT and algo (algorithmic) trading, there is no timeframe for implementing the rules.”
Also, a SEBI official revealed to India Legal that stock exchanges themselves would be averse to drastic controls and changes as it would negatively impact their business. “Much of the fund flow into the markets is thanks to HFT firms. If we bring in too many rules, they will either withdraw or show limited interest.”
HIGH FREQUENCY TRADING
But what is HFT? Simply put, it is the use of computers programmed to trade on their own on the stock market at mind-boggling speeds and which execute millions of multiple orders within microseconds. Such high frequency trading is possible through the use of algorithms which SEBI in its policy paper has defined as “a step by step instruction for trading actions taken by computers (automated systems)”.
According to SEBI, typically, trading algorithms enable traders “to automate the process of taking trading decisions based on preset rules/strategies. Market participants have adopted algorithmic trading as it provides speed and control. Further, delegation of decision making to the algorithms has enabled traders to generate large number of orders in a small interval of time, and at the same time, react to opportunities that may exist for fractions of a second”.
The HFT phenomenon is new to India. Algorithmic trading was only allowed in this country in April 2008, while it marked its entry into the New York Stock Market in 1999 after the US Securities and Exchange Commission gave the green signal to electronic exchanges a year earlier. When it started out, HFT firms in the West could affect a trade within a few seconds. Today, the execution time has been reduced to milliseconds and rogue algorithms are being created by the day to speed up things and to tap loopholes in the system to front-run competition.
In fact, speed is seen as such a big plus that even a millisecond time gained by accessing information on fluctuating stock prices by being in the same location or building (collocation) as the server of the stock exchange is considered an advantage. In other words, the additional nanosecond taken for information to reach someone even 500 meters away from the server would work to their disadvantage and could result in losses running into crores.
SEBI’s declared effort is to create a level playing field for all stakeholders. But there is a question mark over how far it will succeed given the army of geeks capable of creating programs that can bypass any control which has begun to inhabit the financial world. Here are key policy changes and interventions suggested by SEBI.
- Minimum Resting Time: Introducing a minimum resting time of 500 milliseconds for buying or selling. This means that once an order is placed, it cannot be modified during the resting period. Through this, SEBI hopes to eliminate “fleeting” orders that are cancelled or amended within a microsecond. It is this ability to buy and sell in a flash that gives traders using quicker algorithms the edge. No other regulator in the world has introduced such a resting time.
- Structured Data Availability: Currently, information relating to buying, cancellation or modification of stocks traded is provided on a real-time basis through “a tick-by-tick (TBT) data feed” which has to be subscribed for. HFTs mainly use this facility as they have offices within the exchange and benefit from the proximity to the TBT sever as they get the feed a few millisecond faster than those at a distance, putting them ahead of the pack. SEBI wants to introduce a level playing field by providing “structured data” to all market participants at the same time or at prescribed intervals.
- Match Orders in Batches: Evolve a system by which buy or sell orders are allowed to accumulate for a fixed time (the SEBI paper talks of 100 milliseconds) before completing the orders. This may help discourage flash trading. Similarly, introducing random “speed bumps” has been suggested to delay processing orders to bring some parity between HFT and non-algo players.
- Minimum Order Requirement: A “market participant” will have to execute at least one order for a set number of buy/sell requests sent to a trading center. This is expected to reduce hyper-active order book participation in which orders are placed but not executed. It also works to solve the problem of “spoofing” or manipulation of the order book, which has been getting increased attention in countries like the US.
- Separate Queue System: There is a suggestion that a level playing field can also be established by creating two streams to process orders from HFT companies co-located within the exchange and those in locations outside. The orders can be processed in turn, one following the other. This will ensure parity and cut down the advantage leveraged through illegal and speedy access to stock-related data and algorithms.
And yet, despite its belated “show” of good intentions, SEBI was not pro-active to start with and remained blind to the ills of algo trading which were well-known in broking circles. It took an article in the June 19, 2015, issue of Moneylife, a fortnightly business and investment magazine, to bring into the public domain the unethical practices being followed by HFT companies on the National Stock Exchange (NSE).
The Moneylife expose was based on a letter sent by a whistleblower to DB Gupta, DGM, Market Regulation, at SEBI, with a copy marked to Sucheta Dalal, managing editor of the magazine. In the letter, the whistleblower, who worked in the technical team of a Singapore-based hedge fund with “sufficient exposure to the Indian markets,” stated that his intent was to alert SEBI about what was going on at the NSE.
“I wish to draw your attention to a sophisticated market manipulation done at NSE for several years… the market manipulation I am referring to has been occurring by enabling certain vested brokers to get market price information ahead of the rest of the market and thus enabling them to front run the rest of the market,” the whistleblower had written, giving details of the modus operandi being employed to leverage the millisecond advantage.
Before Moneylife published the story, it dashed of queries to the senior management of NSE and SEBI. Both were not only kept in the loop but were also sent repeated reminders, but they chose not to respond. However, NSE filed a Rs 100-crore defamation suit against the magazine and its news portal.
HIGH COURT RULING
The suit was dismissed by the Bombay High Court in a landmark judgment. The Court directed NSE to pay Rs 1.5 lakh each to Sucheta Dalal and Debashis Basu, the editor and publisher of Moneylife, as costs. In addition, the Court imposed a penalty of Rs 47 lakh on NSE and directed it to deposit the money to Tata Memorial Hospital and Masina Hospital, Mumbai, as charity.
In his judgment, Justice Gautam S Patel of the Bombay High Court underlined this significant point: “NSE ignored three messages sent across by Ms Dalal seeking a response before the story was published. This shows that either the NSE was arrogant or there was an element of truth in the allegations, and that NSE had nothing to say.” He further went to observe: “You cannot use defamation to gag the press. How is it defamation when Ms Dalal sent you questions before publishing the article and you (NSE) chose not to respond to the query?”
As a watchdog agency, SEBI had no choice but to act after the adverse court ruling. Moreover, a financial stability report from the RBI (shared with India Legal by a bank official) came out soon after warned of the dangers of algo trading and the risk factors involved. It pointedly said that HFT using complex algorithms and faster communication platforms “needs focused monitoring” as they might pose risks caused by “market manipulations”. The report also touched upon “abnormal market movements in Indian stocks, which have been attributed by market experts to algo trading/HFT”.
“Given the pressure from various quarters, SEBI had to act. Market watchdogs in the major markets across the world have been addressing the issues thrown by the new mode of trading so there was really no choice. One can only hope that those measures which reasonably slow down the pace of trade in a healthy manner without adversely affecting market operations are formalized,” says the official. The finance ministry also swung into action. In the last few months there have been several notes sent to SEBI, including one quoting the whistleblower’s allegation of a “dark cable” or an illegal link between the NSE and the Bombay Stock Exchange, enabling select brokers to buy and sell from one exchange to the other and vice-versa using algorithms.
Proponents of wider use of algorithms have been crying foul (see box) and warn that a Control Raj would severely retard the rhythm and momentum that the Indian stock markets have acquired despite negative global trends. Interestingly, the SEBI policy document neither mentions Moneylife or the whistleblower’s letters.
The watchdog agency has also not completed its investigations into the allegations against NSE.
If and when regulation is introduced, it would be SEBI keeping up with global trends. The watchdog would not want anything more read into its actions.
Lead photo: (L-R) Bombay High Court and SEBI headquarters in Mumbai