Sebi seeks external help to frame rules for high frequency trading

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Mumbai: India’s capital markets regulator is considering hiring an external agency to advise it on ways to mitigate risks arising from the increasing use of so-called high frequency trading (HFT) in the stock market, according to two people familiar with the plans.

“Sebi has realized that some norms are required to be introduced to ensure that there is a cooling off mechanism for HFT orders,” said one of the two people cited above requesting anonymity. “Sebi is working on it.” The person added that increasing use of HFT is putting non-HFT traders and investors at a disadvantage.

“This happens because the actual market price of the stock may change if HFT users place large orders for the same stock and call it back in a very short time, faster than the time taken by non-HFT users to place their orders. This creates the risk of common retail investors being misled and discriminated. Some solution to these issues is crucial,” this person said. An email sent to Sebi on Monday went unanswered.

According to data available with Sebi, the share of HFT as a percent of total orders and turnover has been rising steadily. In 2011-12, HFT orders as a percentage of overall orders in the cash equity segment was at 65%. This has gone up to 94% in 2015-16. HFT turnover as a percentage of overall turnover in the cash equity segment has gone up from 25% to 42% over the same period.

In the equity derivatives segment, the percentage of HFT orders has gone up from 78% to 98% between fiscal 2012 and fiscal 2016. The share of turnover has risen from 22% to 56%. Algorithmic trading or HFT refers to the use of electronic systems, which can potentially execute thousands of orders on the stock exchange in less than a second.

Co-location involves setting up servers on the exchange premises. This reduces time it takes for an order to travel to the exchange, giving them a speed advantage over those who are farther away.

Sebi may introduce a pilot project for hedging against HFT risks which will include introduction of “speed bumps” for HFT, order-bunching of trades and some sort of call-auction mechanism, similar to the present system followed under pre-market opening mechanism. A discussion paper on the proposed checks and balances is expected soon.

“All these methods may be implemented on a trial and error basis. Market regulators across the world are trying to figure out a foolproof solution. If any of the three methods or a combination of any two methods helps, it may be continued. A final call will be taken only after extensive consultations,” said the first person.

A “speed bump” helps by slowing down the speed of execution of orders placed via HFT. By doing so, some of the speed advantage available to HFT traders may reduce.

“Apart from high-speed execution of trades, one of the biggest threats posed by HFT is the problem of high-speed mock trades done by order-spoofing. In this, fake orders are pushed into the system and pulled back by HFT users at a very high speed. There are millions of orders which are fed to system by HFT users and pulled back without getting execution, which misleads the market by influencing the price of the security for a given moment of time and nulling the orders placed by non-HFT users and conventional investors. So, Sebi must put in place some ground rules so that a semblance of normalcy comes back to the market,” said Sudip Bandyopadhyay, chairman and managing director of Inditrade Capital Ltd.

The second option being considered by Sebi is to introduce an order-bunching mechanism. Order bunching is done by combining all odd-lot orders for the same stock irrespective of the source of the order so they can be executed together. This may put HFT users at a disadvantage since the first order that hits the system may not be the first to get executed.

According to the second person cited above, order bunching will ensure equitable treatment for all classes of traders and prevent market disruptions due to a large one-sided order placed by an HFT entity.

Sebi is also considering introduction of a sort of call-auction system for HFT trades. Under this system, exchanges will need to collect all the orders via auction windows, match the bids and execute them. This will ensure HFT users will not have first mover advantage.

“Of late, all of us have been witnessing sharp upward and downward movements in the market. Algorithmic trading is responsible for such steep spikes in the market. These are early signs of the risks of potential disruptions caused by HFT. So, it is high time that Sebi works on a possible solution at least to begin with,” added Bandyopadhyay.