Can algos go?

The concern that the wide prevalence of algorithmic and high-frequency trades (HFT) in the financial markets creates an unequal playing field for small investors is valid. By using automated programmes to detect and exploit split-second market opportunities arising from events, corporate action or mis-pricing, algorithmic (algo) traders can crowd out retail day-traders chasing short-term profit opportunities. High frequency traders use their close proximity to exchange servers (co-location) to cash in on price-sensitive information, which can queer the pitch for other participants. But having said this, it is important to recognise that algo trading and HFT, having made their debut in the Indian stock exchanges six to eight years ago, now contribute a sizeable 40 per cent of all cash market volumes. In the process, they make an important contribution to liquidity, market depth and price discovery . This is why, in seeking to impose more stringent curbs on algo and HFT, the Securities Exchange Board of India (SEBI) may now need to tread cautiously.

SEBI’s latest discussion paper suggests as many as seven new rules to restrict algo trades and HFT. Some of these measures are rightly aimed at eliminating ‘spoofing’ strategies used by algos/HFTs to create illusory liquidity that misleads other market participants. A minimum resting time of 500 milliseconds for every order, during which it cannot be cancelled or modified and a regulatory limit on the order-to-trade ratio for every participant (in place of the current fine) are good measures on this score. But other ideas mooted by SEBI to forcibly reduce trading speeds — batch auctions (aggregating orders instead of real-time matching), random execution instead of first-in-first-out and separate queues for co-located participants, could drastically shrink profits from co-location, prompting some of the HFT players to opt out. If this results in permanent withdrawal of liquidity from the market, it will increase impact costs not just for retail day traders, but also for institutions such as mutual funds and pension funds which essentially deploy retail money. Given that retail investors are in most cases at the losing end of day-trades and are increasingly taking the institutional route to invest in stocks, SEBI needs to weigh if this trade-off is worth it.

There are other regulatory actions that SEBI can take. For one, most profitable HFT trades thrive on information asymmetry. And despite elaborate laws prohibiting insider trading, front running and selective disclosures, we know the Indian market is rife with these practices. So, strict penal action against market players who flout material disclosure norms can curb such profiteering. Two, SEBI should ensure that exchanges offer all market players equal and non-discriminatory access to co-location facilities through a transparent process, so that these facilities aren’t cornered by a coterie of connected investors. It must also hold specific exchanges and intermediaries unambiguously accountable for any systemic instability or losses inflicted on markets by algo trades.

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