Checks on algos in commodities

Lokeshwarri SK | | Updated on: Jan 15, 2018




SEBI’s recent circular seeks to regulate algos in the best way possible

After taking over as the regulator of commodity exchanges, the Securities and Exchange Board of India has brought out a series of guidelines, consolidating the existing rules governing trading in commodity futures and enhancing and tweaking them wherever required. One such circular was on algo trading, which was issued in September this year. This circular puts out a comprehensive set of rules for exchanges and trading members to ensure that the trading algorithms do not run amok.

The commodity exchanges, MCX and NCDEX, have kept pace with equity exchanges in introducing algo trading — which used computer algorithms to spot trading opportunities and to execute the trades, without manual intervention — way back in 2008. As this mode of trading gained popularity in the large global commodity exchanges such as the NYMEX and the CBOT, the Indian commodity exchanges have followed suit.

Currently algo trades account for around a third of the turnover in many commodities. Opinion is, however, divided on the benefits of algo trades. Those opposing it say that it favours a few large traders, compromising the interests of the smaller traders. Those supporting algo trading say that liquidity has improved since its introduction.

It is however a little late in the day to debate the benefits of algos since banning them can see most markets shrink drastically. It would be better to just regulate them in the best way possible, and that is perhaps what SEBI has done through the recent circular. The salient features of the circular are:

Onus on exchanges

SEBI has stipulated that commodity exchanges should ensure that they have systems that are capable of handling the load generated by algo trades. The capacity of the trading system at the exchange needs to be four times the peak order load encountered. The capacity needs to be reviewed and upgraded in line with increasing traffic and trading on the exchange platform. The surveillance system also needs to be reviewed periodically to see that its speed matches the trading speed.

Exchanges also need to have order-level checks in place to ensure that there is no trading disruption.

Automated checks have to be embedded in their systems that check if the price quoted in the order violates daily price limit, the quantity is within the maximum order size mentioned in the contract and does not violate the position limit at member and client level. Running such checks prior to order execution will prevent flash crashes. Exchanges also need to ensure that only those members permitted by the exchange offer algo trading facility to their clients.

SEBI has asked exchanges to be mindful about protecting the interests of the small investors. Since small investors tend to use mini and micro contracts, caution is advised in allowing algo trading on such contracts.

Preferential treatment to some clients is also not allowed in commodity exchanges, unlike equities. Direct market access is not allowed in commodities and all clients have to put in trade through members only.

Co-location facilities, wherein a client can buy racks close to the exchange server in order to be first in the trading queue, are also disallowed in commodity futures, to ensure a more even ground.

Preventing disruption

The main problem with many algo programs is that they tend to put in multiple orders in the exchange trading system with the intention of executing the order at the best price.

To prevent algos from flooding the system with blank orders, penalty is proposed on members with high order to trade ratio and if number of orders exceed 20 per second.

Exchanges also need to ensure that only those algos that induct fresh liquidity are allowed.

While it all sounds good in letter, implementing the controls will not be easy. The algos keep evolving and those monitoring them need to keep up with times.

Published on December 04, 2016
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