'Algo and HFT' technology, a scapegoat for corporate governance lapses

The evolution of mankind into a superior species has been due to its supreme control over machines. For doing repetitive jobs without having human errors, machines are perfect. They deliver pre-defined outcomes with 100 percent efficiency.

Algo trading in financial markets is essentially machine trading in almost the purest sense.

However, the pitch for Algo/HFT (High Frequency Trade) trading in India has been queered, thanks to unrelated issues. What started out as perhaps a corporate governance issue at a stock exchange due to purported misuse of co-location facilities by brokers has quickly snowballed into a controversy, where technologies that deliver faster results seem to be at the receiving end.

In the recent past, there have been a lot of media reports in respect of the Algorithmic / HFT debate and on the need for some tighter regulation. Regulating a technology may not be the best answer.

The issue appeared in the limelight when reportedly a Singapore based whistle blower complained to market regulator SEBI in January, 2015 regarding the 'misuse' of co-location facilities at a leading exchange by some brokers.

While the regulator will ultimately take its views on the alleged transgressions, this episode has brought to the fore the burning issue whether the technology at collocation is being misused by some HFT trading firms, and indirectly putting pressure on SEBI to do something.

Two very different issues viz. corporate governance lapses and advent of a game-changing technology are being unfairly clubbed together, despite not a shred of evidence to conclusively prove that technology is indeed the villain. If anything, the fat finger has caused more market disruptions.

In essence the complaints have alleged two things. One, that there was favorable access granted to some firms and this happened by oversight in system design or by intentional collusion by certain people in the exchange.

Second, some firms were allowed to install high speed links across exchanges using unlicensed vendors, by-passing an internal policy of the exchange. Clearly, these are essentially corporate governance matters.

Algo/HFT trading is not an unfair advantage. Merely using a machine does not hand anybody any great advantage.

Using a car when people walk on roads or use a cycle to commute would by that logic be illegal.

The technology for accessing the exchanges ranges from manual order entry through exchange terminals and Order Management Systems (CTCL), Direct Market Access for sophisticated clients (DMA), Internet trading for retail investors and collocation facilities (colo) for proprietary traders and brokers offering lower latency access to clients.

Algos are used for efficient trade execution. Some types of algos employ trading strategies that are

more reliant on speed of execution and can be referred to as high frequency trading (HFT) algos.

HFT algos are commonly used for market making. Floor brokers/jobbers offered manual market making in the past. However, technology evolution has largely automated this function and enabled

market making in a wider set of the 35000 contracts and securities in India.

The other perspective to understand is whether the collocation provides unfair access to certain

participants. Time is essentially money in the stock trading business. Even when electronic trading started prior to availability of colo facilities, participants outside Mumbai were at significant disadvantage as compared to those located within Mumbai - due to the distance their orders had to travel electronically. Collocation access has now leveled the playing field.

Globally, collocation is a common feature across all mature markets and the market share of algo /HFT is more than half of the volume. The automation in algos enables programs to offer bid/offers in a large number of products concurrently, increasing market efficiency.

Despite all the hullabaloos, no major market has curtailed algorithmic trading as they recognize that the system wide ramification of such a move is disastrous.

Painting algo/HFT trading in bad light is the easiest recourse any authority can take, but that would be unfair.

The two separate issues of corporate governance and technology use need to be treated independently. The use of a technology can be broadened but organization-level misuse is not connected to a particular technology. However, this is what is precisely happening with algo/HFT trading.

While it is irrefutable that when a new technology is adapted in an industry there can always be a few hiccups, but stifling the technology keeps the playing field uneven for a longer period of time.