Exchanges step in to curb algo speculation

Last week RBI had cautioned against growing use of high-frequency and algo trading in the equity market

Equity markets may not see wild price fluctuations caused due to algorithmic (algo) trading or high-frequency trading (HFT). After algo trading was considered the key catalyst for some of the recent instances of market crash, including a sharp fall in Infosys shares, the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) have imposed separate charges on the use of algos. This, say experts, will curb excessive speculation, misuse of the technology and also keep a check on the pace of rise in algo volumes.

A few algo techniques were under the scanner after trading was disrupted on the NSE twice this year. The issue was so serious that Reserve Bank of India (RBI) last week raised caution against the growing use of HFT and algo in the country”s equity market. RBI said that nearly a fifth of equity derivative orders were coming through HFT or algo trades and implications of these needed to be watched. The exchanges have now imposed a fee of one to five paise per algo order or modification of the trade. The fee could discourage algo arbitrageurs, who speculated in a huge way to take advantage of the one to two paise price spread. 

“Regulations have been made tough enough by imposing a fee on algo trades and modifications. At least 50 per cent of algo trading will be affected by this circular and algo volumes may also fall in the coming days. But then it would be good for the market. Unwanted speculation will be curbed and scope for mischief will reduce,” said Lokesh Madan, managing director of Algo Trading India LLC.
 

TOWARDS FAIR TRADE

• HFT and algo considered key catalysts for recent instances of market crash, including 20% fall in Infosys in seconds 
• Sebi forms guidelines and RBI raised caution on HFT and algo
• Arbitrageurs indulged in excessive speculation using algo techniques 
• This caused trade disruption or fall in price as many brokers did not have technology to track or re-write their algos 
• Trading fee of 1-5 paise imposed to cut Calendar Spread arbitrague, a popularly used technique in the Indian market 
• IOSCO has asked all stock exchanges in emerging markets to deepen understanding of HFT and algo trading

 

Yogesh Radke, head of quantitative research, Edelweiss Securities, said, “The decisions to levy charges on trades with “high order to trade ratio” is in line with Sebi circular on algo trading issued in April. It is aimed at making the system more stable and building a strong risk management.”

According to experts, use of algo trading technique known as “Calendar Spread” (CS) was causing problems. While traders use a number of algo techniques, CS was most popular among arbitrageurs in India. Traders were indulging in arbitrage in the futures and options (F&O) segment to play on a small difference in price between the current month and next month contracts.

To get their price quote among the best or top five, traders followed the Time Series (sequence of numbers collected during regular intervals over a period of time) to track the order book.

Once, the order depth is known, traders kept on modifying their price quote in a way that it got noticed among the top five orders. While these were just fictitious volumes, it caused problems in the absence of highly efficient algo tracking technology.

A majority of domestic stock brokers do not have expertise to re-write their algos and use templates from third party vendors. They do not have expertise to track as to how their algos work. So, when the techniques are closely identical, it causes chaos. It is believed that this is why a buyer was offering higher price for a security than the seller intended to sell and trading was disrupted nearly for an hour on NSE in May.

Algorithms have become a common feature in the trading landscape. It is unthinkable for a broker not to offer these to his clients on demand. These mathematical models analyse every quote and trade in the stock market, identify liquidity opportunities, and turn the information into intelligent trading decisions. Algorithmic trading, or computer-directed trading, cuts down transaction costs, and allows investment managers to take control of their own trading processes. It is a style of trading and not a separate business.

(This a modified version of the earlier report)