Issues raised by the freak trade

The erroneous execution of sell orders worth Rs 650 crores … was it a freak trade or an unintended trade? A basket of index stocks sold at market rate is a normal transaction in the stock exchange everyday. Had this order been released in the derivatives exchange or if the market had fallen by only 9 per cent and not closed, it would have been business as usual. There is no ban on short selling, the broker could have always borrowed the shares, delivered the same and purchased them back to reverse the loan.

Why did this event make headlines? What are the real issues? Shouldn’t a sell order that has the potential to trip the market be prohibited? A similar fall occurred in 2008 when large sell orders were placed and the market tripped and remained closed for the whole day.

Maybe it was not possible to associate the order with one particular broker, and, hence, no one was punished and forced to square off their positions. Maybe the international markets were in a tailspin, and so, we expected the domestic market to decline. This means that we are comfortable with markets falling if there is an expectation of the same, even with short sale. However, if it spoils the party during a bull run (thanks to promise of reforms), or if one broker fires the order and does not have shares to back the sale (though he could always borrow the shares), then we cry foul play.

freeze?

Should we have applied the one-hour freeze across all exchanges and all segments? The freeze is applied whenever there is an event that occurs externally like declaration of war, fall of government, policy announcements affecting all stocks (example, freeze on dividend distribution), etc. The market needs time to assimilate the news and plan the subsequent strategy rather than acting on panic without analyzing the news.

Why did it fail?

In the said case, the time break is being advocated to segregate the transactions and annul the same rather than using the time as a cooling window. In this instance, there was no large systemic event that triggered the fall, but it was just one person’s desire (though unintended) to exit the market that triggered the fall. This is a normal course of business, and, hence, the exchanges (in possible consultation with the regulator) decided to resume the market session as soon as possible as other segments and exchanges were open.

Why did the exchange system fail to stop the order since it was very large? The trade guarantee systems have been in place since 1995. There has not been a single default on the part of the exchange in declaring payouts for the past many years. This is primarily due to the fact that brokers have always ensured the integrity of settlement systems by maintaining large margins with the exchange.

In case of most brokers, the margin utilisation is about 60 per cent of the collateral maintained with the exchange. Hence, there was no breach in margins as was suggested by many. This trade was placed in the early hours of the day and hence sufficient margins were available. Why did the circuit filter trip at 14 per cent and not at 10 per cent? Is there a bug in the system?

Let us understand how the index is calculated and how the circuit filters trip. First, the trade prices of the index shares are available to the software that calculates the index. Based on the share prices and the weights assigned to each scrip (which is based on market cap), the system computes whether the circuit limit is breached. If it is, the circuit is applied and the market comes to a halt. This is an automated sequential process. The index is calculated three times every second, whereas trades happen in microseconds.

There is no human intervention. Index scrips do not have any circuits either way — whether up or down and hence the market orders go all the way to the bottom of the order book, and match the quantity to execute the order. If 37 out of 50 scrips go down simultaneously, the resultant prices and thereby the index value will fall substantially, which was 14 per cent in the instant case. The circuit filter trip is a subsequent action and hence the market closed at 14 per cent and not 10 per cent. Therefore, this is not a system bug and this is the only way the system will work because of the sequential nature of calculation.

Annulling trades

Why were the trades not annulled? Annulling of trades is a serious action and has highest impact on the integrity of our markets. Would the persons who have complained on stop-loss trigger do so if the markets had not recovered? If trades were annulled, those who had gained by the fall would cry foul.

The Securities and Exchange Board of India needs to announce guidelines for annulment to have a fair handling of such situation. Any trade cancellation will impact some or the other investor. This is a zero-sum game wherein one person’s gain is loss to another. Transactions had not just taken place in the cash market but across segments, that is, derivatives segment and across exchanges. In fact, a flurry was seen even in the currency markets for a few minutes!

lack of retail investors

Are our markets so fragile that a sale in the early part of the day (when large volumes are traded) cannot be absorbed and brings the market to a halt? Yes, this is the real issue: lack of market depth. The daily turnover is above Rs 1,00,000 crore but a small order of Rs 650 crore cannot be absorbed and market tumbles. The lack of depth is due to paucity of good quality paper, absence of a large number of retail investors and absence of strong institutions like pension funds with long-term perspective. The solution lies in the execution of large divestment programmes by the government, in order to bring large companies to the markets. We need to encourage large institutions like pension funds, provident funds, endowment funds, university funds, etc. to invest at least a portion of their funds into blue-chip companies.

Does lack of depth lead to high impact cost? Yes, an unintended sale of Rs 650 crore had led to a loss of approximately Rs 80-102 crore. This is roughly 12-15 per cent of the impact cost of selling and reversing the trade. Markets abroad have impact costs of 1-1.5 per cent. The loss to the brokers should have been just Rs 6-7 crore. Such a high impact cost is due to the fact that our cash and derivatives markets are not linked on the National Stock Exchange

Linking the two will reduce the impact cost since all positions will come to the market and not be just swept off the floor at the time of ‘money-only’ settlement at the end of the month. Brokers also need to invest more in technology.

There are software systems in broker offices that talk to exchange systems. These systems need higher levels of authentications to prevent such mishaps.

We need to pay more attention to ‘what if’ situations rather than taking our systems for granted. Passwords are not respected and more often, the same passwords are freely used by multiple staff members across various terminals. Hurry to execute the trade and not miss a level is more important than ensuring the accuracy of order parameters. This incident is a real eye-opener for all those involved in trade executions. Care in keying in correct information takes precedence over speed.

(The author is Managing Director, Asit C. Mehta Investment Intermediates Ltd. Views are personal. blfeedback@thehindu.co.in )

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