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In this article, Abhishek Bhaduri pursuing Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata discusses the need for stronger regulations in the automated and electronic trading market in India.

Automated and electronic trading refers to high-speed algorithm-based trading that is capable of performing a huge number of trades within a comparably short amount of time in contrast to human-based manual trading. It provides for a relatively efficient alternative to the historical time-consuming methods of trading. Softwares are programmed with predetermined algorithms to place and/or sell orders if and when a particular price is hit.

Electronic-based trading is rapidly replacing manual trading due to its pace and potential volume. As a result of its vast popularity, automated and electronic trading account for a high percentage of actual trading that takes place in the market at any point in a given trading day. Trading in this way has a huge potential for growth but at the same time can be open to misuse and abuse as well by some quarters. As a result, proper sanctions on the power of traders and brokers, and other members working in the field are required and the area needs regulation.

The Discussion paper on Strengthening of the Regulatory framework for Algorithmic Trading & Co-location, issued by SEBI in 2016, described the following:

Algo Trading

Algorithmic trading (for brevity, Algo), in simple words, is a step-by-step instruction for trading actions taken by computers (automated systems). Typically, trading algorithms enable the traders to automate the process of taking trading decisions based on the preset rules/strategies.

High-Frequency Trading

High-Frequency Trading (HFT) is a subset of algorithmic trading that comprises latency-sensitive trading strategies and deploys technology including high-speed networks, colocation, etc. to connect and trade on the trading platform. The growth and success of the high-frequency trading (latency sensitive version of algorithmic trading) are largely attributed to their ability to react to trading opportunities that may last only for a very small fraction of a second. Co-location (for brevity, Colo) has provided the vehicle to high-frequency traders to capture such trading opportunities.

According to data available on record, almost 80% orders are algorithm based and which result to around 40% of the total market trades. This in itself evinces the fact that automated trading is rapidly growing owing to its twin characteristics of being fast, being able to execute operations in milliseconds which formerly used to take several minutes; and the load-bearing capacity, which can undertake orders in huge quantities formerly deemed impossible by the traditional way of manual floor-based trading.

SEBI Regulations

The best way to monitor a technical field which involves intricate calculations and a deep knowledge of the computing system would be the one that hires professionals acquainted with the arena. Traditional law enforcement agencies would normally not satisfy the competence criteria when it comes to detecting and acting upon such violations. So rightfully the responsibility lies with the Securities and Exchange Board of India (SEBI) to keep a check. SEBI has issued guidelines. The SEBI derives its authority from the SEBI Act. Section 11(1) says:-

Section 11 (1) Subject to the provisions of this Act, it shall be the duty of the Board to protect the interests of investors in securities and to promote the development of, and to regulate the securities market, by such measures as it thinks fit.

Pursuant to the above, SEBI issued a Circular dated 30/3/2012 laying down ‘Broad Guidelines on Algorithmic trading’. SEBI has delegated and empowered the Stock Exchanges with vast powers to ensure that algorithmic trading is not misused. The SEBI Circular issues Guidelines for the Stock Brokers as well. Some of the Guidelines issued directed to the Stock Exchanges are as follows:

The stock exchange shall ensure that all algorithmic orders are necessarily routed through broker servers located in India and the stock exchange has appropriate risk controls mechanism to address the risk emanating from algorithmic orders and trades. The minimum order-level risk controls shall include the following:

Price check

The price quoted by the order shall not violate the price bands defined by the exchange for the security. For securities that do not have price bands, dummy filters shall be brought into effective use to serve as an early warning system to detect a sudden surge in prices.

Quantity Limit check

The quantity quoted in the order shall not violate the maximum permissible quantity per order as defined by the exchange for the security.

Similarly, the Guidelines directed towards the Stock Brokers are as follows:

The stockbroker, desirous of placing orders generated using algos, shall satisfy the stock exchange with regard to the implementation of the following minimum levels of risk controls at its end –

(i) Price check

Algo orders shall not be released in breach of the price bands defined by the exchange for the security.

(ii) Quantity check

Algo orders shall not be released in breach of the quantity limit as defined by the exchange for the security.

(iii) Order Value check

Algo orders shall not be released in breach of the ‘value per order’ as defined by the stock exchanges.

(iv) Cumulative Open Order Value check

The individual client level cumulative open order value check may be prescribed by the broker for the clients. Cumulative Open Order Value for a client is the total value of its unexecuted orders released from the stockbroker system.

(v) Automated Execution check

An algo shall account for all executed, unexecuted and unconfirmed orders, placed by it before releasing further order(s). Further, the algo system shall have pre-defined parameters for an automatic stoppage in the event of algo execution leading to a loop or a runaway situation.

(vi) All algorithmic orders are tagged with a unique identifier provided by the stock exchange in order to establish an audit trail.

Regulation Tax

According to Associate Prof Venkatesh Panchapagesan (4), fairly recent crisis situations in USA and India related to complications arising out of Algorithmic and High-Frequency Trading have led to Regulators to contemplate taking measures to ensure that electronic trading is fairly streamlined and does not over exceed its purpose. Further, he states that the Securities and Exchanges Board of India has introduced a ‘Regulation Tax’ on increased use of High-frequency traders and to discourage misuse of the same.

However, he proceeds to further state that recent studies on the Italian Markets have shown that imposition of such taxes have actually resulted in an increase in trading cost and worsened market quality. In India, the initial reaction to the regulation tax led to an increase in High-frequency trading, according to him which was counter-intuitive to the original intention of slowing down the pace of such uncontrolled trading opportunities.

The author begs to differ in this aspect. On the contrary, the author would like to submit that levying a Regulation Tax would go counter to the proposed intention of ‘Regulation’. Apart from sending out the message that the Board is anti-progress; this would lead to a hindrance to regular market operators and discourage newcomers, none of which are conducive to a bubbling bursting developing economy like India, and would not be consistent with the recent government policies when it comes to trade and industry. The author strongly denounces an imposition of such Tax and in the same vein suggests that other regulatory approaches be explored.  

Conclusion

The author submits that during an era where automated and electronic trading is here to stay, we need stricter rules and regulations which can be enforced by way of the proper mechanism. Further, better dissemination of said sanctions should be facilitated by way of notification on the websites so that everyone can get easy information about the rules to follow.

Stringent actions should follow every flouting of the norms and masses should be able to repose their trust in the system that corporate honchos would not be able to get away using the money. However, a delicate balance needs to be maintained between encouragement and restraint.

Algorithmic Trading is something that holds tremendous potential and will boost the economy of the country if executed in the proper way. Traders, brokers, investors and masses at large will stand to benefit with the growth of fast-paced high-frequency trading mechanisms. Therefore, measures should be put in place that will significantly encourage the market players to continue to indulge in the activity. The need for hitting this tightrope-esque balance would mean that the regulators, SEBI and the concerned Stock Exchange officials have their work cut out in the near future.  

Reports [5] suggest that reactions from interested quarters to the on the above mentioned Discussion Paper have been unwelcoming at best. [6] Market Players have unanimously rejected suggestions or any attempt at regulating the electronic trading markets that may result in stemming the growth and development of the parties involved. [7] Human nature normally is very resistant to change and regulations.

Notwithstanding that fact, the author submits that regulations need to be well thought out, carried out and executed in such a manner that serves the two-fold of the purpose of regulating the markets on the one hand and also facilitating free trade and business growth on the other. In addition, it should also provide for necessary sanctions for flagrant use of the systems and delinquent traders and brokers should be punished for voluntary misdeeds. The regulations should be able to strike the desired effect of deterring future miscreant misuse of this wonderful system.

Recent talks [8] seem to suggest that SEBI, in consultation with the Ministry of Finance and after considering opinions from interested parties, will be coming up with new rules and measures to regulate the automated and electronic trading markets. (9) Some of the proposed rules are as follows:

Proposed Measures

  • To have real-time surveillance of all orders and trades.
  • To detect malfunctioning while putting algo trades.
  • To mitigate chances of flash crash and fat-finger error.

     

  • Standardisation of co-location facility to discourage preferential access.
  • Exchanges to publish colo-based latency on their platforms to have equitable access.
  • Formalise market-making scheme by capping order to trade ratio.
  • Differentiated policies surrounding this ratio would reduce chances of squeezing liquidity.

    Lastly the Author submits, that even though not much regulation exists in the modern day system that could effectively keep the high-frequency trading in proper check, thereby effectively giving some of the big corporate houses a virtual free hand to act as they like with impunity, it is heartening to note that the status Quo is changing. Markets are evolving, and SEBI is rising up to meet the challenges expected of it.

It is worth mentioning here that according to the well-established maxim, it is said that ‘No matter how high you are, the law is above you’. The author submits that it is high time that the market players were made to realise the efficacy of the statement. SEBI needs to constantly monitor, evolve and amend the regulations in order to keep pace with the fast-changing nature of the shares markets.

Market Players also owe a duty towards their investors and masses in general to Not employ underhanded techniques to gain an advantage. So the author submits that it would be a combined effort on the part of the Regulators and the Regulated to form a system capable of keeping in check errant elements and also providing significant encouragement and boost to newer entrants. Together they will form the building blocks of the bright future of the Indian economy.

References :

  1. https://en.wikipedia.org/wiki/Automated_trading_system, accessed on 31/1/2018
  2. https://www.sebi.gov.in/sebi_data/attachdocs/1470393485587.pdf, accessed on 31/1/2018
  3. http://www.business-standard.com/article/markets/sebi-may-issue-framework-for-algorithm-trading-soon-117112900431_1.html, accessed on 31/1/2018
  4. https://www.youtube.com/watch?v=9i9mscvo3RQ accessed on 31/1/2018
  5. http://www.livemint.com/Money/bNEE8YVmmogpDXAKNfQBvM/Sebi-paper-on-algo-trading-fuels-disquiet.html, accessed on 31/1/2018
  6. https://www.sebi.gov.in/sebi_data/attachdocs/1470393485587.pdf, accessed on 31/1/2018
  7. http://www.livemint.com/Money/bNEE8YVmmogpDXAKNfQBvM/Sebi-paper-on-algo-trading-fuels-disquiet.html, accessed on 31/1/2018
  8. http://www.business-standard.com/article/markets/sebi-working-with-finmin-on-new-framework-on-algorithm-trading-118010201160_1.html, accessed 31/1/2018

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